Suggested Link: Charlie Munger Op-Ed
Warren Buffett's business partner, Charlie Munger, writes an op-ed in today's Washington Post.
Read "How We Can Restore Confidence" by Charlie Munger.
February 11, 2009
On the Geithner Plan
Yesterday, the stock market tanked as Treasury Secretary Geithner outlined his financial stability plan. Blogger Felix Salmon noticed the mirror image:
“I like the symmetry here. On November 21, when Barack Obama announced that he was nominating Tim Geithner to be his Treasury secretary, the Dow rose 494 points and broke through the 8,000 barrier. On February 10, when Geithner gave his first major speech as Treasury secretary, the Dow fell 273 points and broke through the 8,000 barrier.”
I once wrote that “the market is a lot like a fun house mirror”. New data affects prices indirectly. And sometimes the reflection comes out warped. Ben Graham said it best:
“...the influence of...analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.”
I’m not sure if the market decline had more to do with the substance of Geithner’s speech or the sentiments of traders. I certainly didn't think it justified marking American businesses down a couple percentage points.
Personally, I didn’t find the plan especially bad. I thought it would have a lot more detail. I’m glad it didn’t. How could anyone come up with a detailed plan at this point?
Some banks – some very big banks – are going to have to be recapitalized. The only way to start that process is to look at the economic reality under the accounting fictions that are bank balance sheets.
It doesn’t matter if you use mark-to-market or mark-to-model, you’re still going to end up with some very inaccurate balance sheet numbers in times like these.
Markets – be they liquid or illiquid – value assets oddly from time to time. And models are as flawed as their makers.
At least Geithner is talking about a stress test. That sounds like the first step toward recapitalizations.
Unfortunately, he’s also talking about private money coming in to buy toxic assets. Unless there are ironclad government guarantees involved I’m not sure that will fly.
Some of these assets weren’t just overpriced the way houses were – they were inherently flawed.
Toxic Assets
Accountants record. They don’t analyze.
There isn’t a right number and a wrong number. There are just useful numbers and useless numbers.
For example, it makes not one iota of difference to me – as an investor – what dollar value public Company A assigns its 23% stake in public Company B, because public Company B files with the SEC. All I need to know is the number Company A put on its books and where I can read all about Company B. The rest is up to me.
Unfortunately, you can’t do this with “toxic assets”.
In her book Dear Mr. Buffett
“I’ve looked at the prospectuses, and they are not easy to read. If you want to understand the deal you’d have to read around 750,000 pages of documents.”
If you want to understand how CDOs and other toxic assets are built, read Janet's book
A lot of people make the argument that these assets are not toxic at some prices.
Theoretically, that’s true. If there’s value in an asset – at some deep discount to par – a high-risk asset can become a low-risk investment.
But, as I wrote in my review of Janet’s book, these toxic assets are “meta-bets”. A low price is little help if there is inadequate cash flow or collateral built into the asset.
A low price can’t fix an inherent flaw in an asset. If the cash flow generating potential of the asset is almost non-existent, the asset is essentially worthless.
Warren Buffett gave a great example of this kind of inherently worthless asset in his 1990 letter to shareholders:
“At the height of the debt mania, capital structures were concocted that guaranteed failure: In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. One particularly egregious "kill- 'em-at-birth" case a few years back involved the purchase of a mature television station in Tampa, bought with so much debt that the interest on it exceeded the station's gross revenues. Even if you assume that all labor, programs and services were donated rather than purchased, this capital structure required revenues to explode - or else the station was doomed to go broke.”
A lot of these toxic assets were similarly structured. They were built to fail.
A bad house is a good value at some price. A risky mortgage is a good value at some price. But “meta-bets” are trickier. They can suffer from the same sort of problem Buffett described with the very worst junk bonds – you can actually take a good asset, with good cash flows and then put so much debt on top of it that the only way you can fix the problem is by restructuring the debt.
In such cases, a low price is no longer enough. The terms are the problem.
Nationalization
Nationalizing the biggest banks – a surprisingly popular view among bloggers if not investors – doesn’t address the underlying issue of payment obligations that can’t be met.
Recapitalizations would help banks lend, but problems would still linger. And unless nationalizeed much smaller banks – and some clearly don’t need it – I’m not sure you could ever get the kind of clean purge investors and lenders so desperately want.
Restructuring
John Hussman has written about a different approach:
“The heart of this problem continues to be the need to restructure the payment obligations of borrowers. For the better part of a year now, I have repeatedly (and increasingly urgently) advocated the restructuring of mortgage obligations by a variety of methods (collecting the pieces of securitized mortgages through “all or nothing” auctions, writing down principal in return for “property appreciation rights”, etc).”
I agree. We could use a little innovation here. Economists, politicians, and pundits seem to be drawn to the same stale ideas.
We need to fix the balance sheets of both banks and homeowners. The way to do that is to admit that mortgage debt is improperly structured. We need to apply some bankruptcy court like thinking to our approach to insolvent banks and borrowers.
Their current capital is as unsustainable as the TV station Buffett wrote about in 1990. Just as you can’t keep corporations – even good corporations – under a mountain of high-yield debt greater than their cash flows, you can’t keep homeowners in a state of insolvency.
We wouldn’t allow it in individual cases. And yet we’re basically encouraging borrowers to keep trying to meet terms that are unsustainable.
In both cases, we need to admit the insolvency and then move to remedy it through debt restructuring.
That won’t eliminate the need to recapitalize some of America’s biggest banks. But without debt restructuring, I’m not sure recapitalizing those banks that are too big to fail will be sufficient to avoid a long-term credit freeze.
Just think how long it would take borrowers to get out from under their current debt burden. We’re talking about a process of balance sheet rebuilding that would go on for years and years – long after the official end to this recession. I’m not sure you could resume anything like normal economic growth under those conditions.
February 10, 2009
On the President's Address
President Obama spoke about the economy last night. I am not a political commentator, so I may not be able to correctly score the politics of the fight.
The President began by painting gloomy word pictures of a Depression – without actually using the “D” word:
“…They can't pay their bills and they've stopped spending money. And because they've stopped spending money, more businesses have been forced to lay off more workers. Local TV stations have started running public service announcements that tell people where to find food banks, even as the food banks don't have enough to meet the demand... As we speak, similar scenes are playing out in cities and towns across the country. Last Monday, more than 1,000 men and women stood in line for 35 firefighter jobs in Miami.”
Theory
Although the President said – correctly I think – that most economists agree a stimulus is necessary, agreeing a stimulus is necessary and agreeing it is sufficient are two different things. Economists don’t agree a stimulus is sufficient. Nor did most of them think very highly of a New Deal redux like this one until more proven measures – like monetary stimulus – were already depleted.
What economists do agree on is that the economy is very bad and that the number of tools that have been tried before and not yet tried this time around is very low. In technical terms, they are advocating a kitchen sink approach.
Seventy years of social science have given government a whole new toolbox with which to approach the same problems (of 1929) and despite the change in process the outcome has remained the same.
Eventually, this will make for an interesting case study. The idea that the Great Depression was a unique and unrepeatable event will be challenged. The idea that lessons learned in retrospect can be applied in the future has been seriously compromised. It is not clear that in an ever-changing system like an economy, theory could keep pace with reality. Prescriptive economics may not work. But prescriptions have to be made nonetheless.
Politics
The President made some errors last night. He gave in to partisan temptations and reminded Republicans of their previously profligate ways.
An excellent point – if he was aiming for honesty – but honesty is rarely the best policy. Utility is.
He needs to pass bills – not win elections – and maybe his little reminders helped Democratic chances at the ballot box, but he hurt the country’s chances of getting the bills it needs passed. It was an understandable but idiotic mistake. It wasn’t just partisan politics, it was poor tactics.
The President is a lot weaker than he appears. Constitutionally, his legislative powers are – well – non-existent. A President is not a Prime Minister.
The man himself is popular. His policies are not. His party’s majorities are large, but not large enough to pass bills in the Senate – even without any Democratic defections. And there will be defections. Remember, this is a Democratic caucus that includes both a Socialist from a Vermont and a Conservative from Nebraska.
The President, still glowing with inaugural stardust, has had a tough time passing a stimulus bill that most Senators – on both sides of the aisle – actually support in principle. Sure two-fifths of them voted against it, but when has a Senator’s vote told you anything about his principles?
The Hard Part
Most Senators want a stimulus – some stimulus – to pass. The TARP is a different story. It is not popular. It is merely necessary.
Today, the Secretary of the Treasury will present the latest incarnation of the bank-bailout.
The public will hate it. They won’t understand it - neither will I, but that won’t stop me from writing about it – but they will hate it.
The job of Secretary of the Treasury of the United States is one of the most thankless jobs on planet earth.
Throughout history, the post has been filled by some of the country’s most illustrious men – and none of them, not one – has ever gone on to be President.
Clinton is better known than Geithner, but Geithner has the more important – and more difficult – job.
Today, Geithner has to sell the American people something they don’t want.
The President paved the way for him by painting a very dire picture.
Depression
The situation is dire. It is no longer enough to say this is the worst “recession” since the Great Depression. We can now say the only thing comparable to the current economic downturn is the Great Depression.
I’ve been reading a lot of fourth-quarter earnings call transcripts over at Seeking Alpha. And I can tell you the anecdotal evidence is worse than the composite picture.
The biggest thing that jumps out at you – especially when you read about the kind of simple, predictable, “recession resistant” businesses I like – is just how clear the signs of deflation are.
Deflation
Deflation is an increase in the perceived value of cash. When the value of cash rises, the cash price of everything else falls. This is usually when deflation is recognized by economists and journalists. But the root cause of deflation is not a decrease in man’s appetite for goods and services but an increase in his appetite for cash.
A lot of asset prices – like houses, stocks, bonds, gold, and oil – are driven in part by the prices themselves.
What Charlie Munger said about stocks applies equally to other quoted assets:
“They are valued partly like bonds, based on roughly rational use value in producing future cash. But they are also valued like Rembrandt paintings, purchased mostly because their prices have gone up so far.”
This Rembrandt effect makes quoted asset prices unreliable indicators of deflation. Yeah – cash is worth a lot more relative to houses, stocks, and oil than it was a year ago – but is that because the value of cash has risen or because the value of those assets has fallen due to a total Rembrandt reversal?
It’s too difficult to insulate each side of the price ratio from the other. But when demand for goods and services that are repeatedly purchased without much awareness of price suddenly drops off, you have a strong indication that deflation is already occurring.
The reason is simple. The other side of the ratio is pretty stable. For instance, the value of hair cuts doesn’t change much.
Yet, Regis (RGS) reported its first same-store sales decline in 87 years. Regis controls about 4% of the U.S. hair salon industry and operates different salons under different names; so it’s unlikely that its horrific December sales numbers were company specific. Industry-wide numbers are probably about the same.
That means customer counts at U.S. hair salons were down over 10% in December. That doesn’t happen in “normal” recessions. The clear culprit is an increase in the perceived value of cash.
Consumers want to hoard cash more than they want to get their hair cut. That means deflation. And that’s bad.
The Press
Also bad: the performance of the press last night.
These are not normal times. Last night both the President and the country wanted to converse about a single topic of extreme importance – the economy – and the press (with a few exceptions) treated the whole thing like business as usual.
The President’s worst moment was when he answered the Alex Rodriguez steroid question with the same serious tone he had used while explaining the country’s dire economic conditions.
In the President’s defense – he has one setting: serious.
But the combination of the press throwing out the same political potpourri and the President’s face giving equal weight to questions on the economy, baseball, and Iran undermined the purpose of the press conference.
Last night was supposed to be about the economy. No one cares about Iran. Times change and the press needs to change with them.
Related Reading
On Keynes, the Stimulus, and Old Ideas
February 06, 2009
New Podcast Episode: Friday, February 6th, 2009
A new episode of the Gannon On Investing Podcast is now available.
February 05, 2009
New Podcast Episode: Thursday, February 5, 2009
A new episode of the Gannon On Investing Podcast is now available.
February 04, 2009
New Podcast Episode: Wednesday, February 4, 2009
A listener asks
Much of the focus in value investing texts is on finding the right company at the right price, very little time is spent discussing when to sell. Since the decision to sell is contextual to each investment I would like to get an idea of your thought process when it comes to selling.
February 03, 2009
New Podcast Episode: Tuesday, February 3, 2009
A listener asks
How can I apply the concept of intrinsic value to currencies in my international investments? I know how to handle business risk and market risk - but how can I apply the principles of value investing to exchange rate risk?
February 02, 2009
New Podcast Episode: Monday, February 2, 2009
A listener asks
When should you focus on free cash flow and when should you focus on earnings?
On Buffett and Derivatives
Review by Geoff Gannon
Janet Tavakoli’s Dear Mr. Buffett
The personal story begins with an invitation from the Oracle himself:
“Be sure to stop by if you are ever in Omaha and want to talk credit derivatives...”
Buffett had just re-read Tavakoli’s Credit Derivatives & Synthetic Structures
Tavakoli took Buffett up on his offer and recorded the ensuing encounter in Chapter 2 of Dear Mr. Buffett
The promise of this tantalizing morsel will draw buyers in. But readers will find much more than another book on Warren Buffett.
The real story begins in 1998. That’s when Buffett’s Berkshire Hathaway bought General Re. Berkshire was a major insurer with a home-grown reinsurance business. General Re was considered the crème de la crème of reinsurers.
I say “considered”, because unbeknownst to Buffett there was a lot of crap among the crème. That crap came in the form of derivatives.
Meta-Bets
Derivatives are exactly what they sound like. The value of a plain vanilla security like a stock or bond is derived from the underlying business – its assets, earnings, and capacity to meet obligations. These are simple, straight bets.
Derivatives are meta-bets. Like an ironic narrator, they stand a level above the action. Instead of betting on a business, they bet on the betting on that business. Instead of betting on a borrower’s future income and collateral they bet on the bet a banker made on that borrower’s future income and collateral.
If the investment banks that created these derivatives used the same ad agency as BASF, their slogan would be: “We don’t make a lot of the securities you buy; we make a lot of the securities you buy riskier”.
Theory of Everything
Tavakoli has her own Theory of Everything in Finance:
“The value of any financial transaction is based on the timing of cash flows, the frequency of cash flows, the magnitude of cash flows, and the probability of receipt of those cash flows.”
It’s a simple theory. Derivatives are complex. But no amount of complexity can free a security from this iron clad rule.
“In finance, we make up a lot of fancy and difficult to pronounce names and create complicated models to erect a barrier to entry that keeps out lay people. High barriers tend to protect high pay. I’ve written about some of these esoteric products: credit derivatives, CDOs, and more, but before I look at the latest hot label dreamt up, I look at the cash to find out what is really going on.”
So does Warren Buffett.
Buffett Bets
As Tavakoli points out, financial journalists seized on Buffett’s description of derivatives as “financial weapons of mass destruction” while completely ignoring another passage in his 2002 letter to shareholders:
“Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.”
Although Buffett was concerned with the macro-risk presented by derivatives – especially the risk of a collateral requirement death spiral – he was still open to engaging in large-scale derivative transactions when it made sense for Berkshire.
Buffett takes risk from Wall Street firms willing to pay Berkshire well. For instance, Berkshire has assumed the risks of owning certain junk bonds.
But he sets the ground rules:
“He chooses the specific corporate names; he refuses ‘diversified’ portfolios containing a large number of corporations. He does trades in massive size – $100 million or more, if possible.”
Buffett applies the same principles he uses in common stock investing. He likes to be greedy when others are fearful and fearful when others are greedy. He likes opportunities where there is a perception gap – an inappropriate quantitative relationship between price and value that arises from some qualitative bias. And he likes to focus on what he knows. When he bets, he bets big. When he’s unwilling to bet big, he doesn’t bet.
Margin of Safety
Buffett is occasionally willing to assume first-to-default risk on a basket of junk bonds:
“Normally, first to default trades are viewed as the riskiest trades, and junk debt is viewed as the riskiest kind of asset; but Warren builds in a margin of safety that makes this a wise investment as long as Wall Street misprices the risk.”
Market participants who focus entirely on conventional indicators of quality – like triple-A ratings – miss opportunities to get great returns in “bad” assets and open themselves up to the danger of buying supposedly “good” assets at prices that provide no margin of safety – and when levered – provide a real risk of catastrophic loss.
Remember, Buffett bought into Moody’s common stock. He didn’t buy into their ratings system.
With lots of leverage and little value relative to price, you can go broke betting on good assets. Conversely, with little leverage and lots of value relative to price, you can get good returns from bad assets.
Buffett knows that. And he preaches what he practices:
“Investing in junk bonds and investing in stocks are alike in certain ways: Both activities require us to make a price-value calculation and also to scan hundreds of securities to find the very few that have attractive reward/risk ratios. But there are important differences between the two disciplines...Purchasing junk bonds, we are dealing with enterprises that are far more marginal. These businesses are usually overloaded with debt and often operate in industries characterized by low returns on capital. Additionally, the quality of management is sometimes questionable. Management may even have interests that are directly counter to those of debtholders. Therefore, we expect that we will have occasional large losses in junk issues.”
A man famous for stressing the importance of buying into good businesses with high returns on capital run by able and honest management is willing to buy junk bonds of bad businesses with low returns on capital run by incompetent and “questionable” management – when the price is right.
Buffett is always focused on the relationship between price and value.
Tavakoli’s book chronicles the words and deeds of people who dealt in derivatives without knowing – and often without caring – what that relationship was.
Some will call her book a morality tale. I call it a rationality tale.
February 01, 2009
New Podcast Episode: Sunday, February 1, 2009
A new episode of the Gannon On Investing Podcast is now available.
January 31, 2009
New Podcast Episode: Saturday, January 31, 2009
A listener asks...
You mentioned that an hour a week is not good enough for being a successful investor. My question is how much time is enough? I make an effort to read industry news articles and read several value investing blogs everyday but I don't always spend time on a stock screener. I only read financial statements when something catches my eye and before investing, I make it a point to read at least the last 5 years of annual reports of the company. Can this be considered active value investing or should I just restrict my investments to ETFs ?
January 30, 2009
New Podcast Episode: Friday, January 30, 2009
A listener asks...
1. Mohnish Pabrai is about as close to mimicking the Buffett partnership as there is out there right now. What are your thoughts on his recent change in approach to diversification? I understand that he's still remaining concentrated, but he has made a fairly drastic change from just a year or two ago.
2. The second question has to do with top down analysis. Buffett and Lynch are famously not interested in top down analysis, however those that famously called the current crisis (Grantham, Fred Hickey and the like) basically did it on a top down basis, and of course it has me thinking that one of the first questions has to be, "how invested should you be in the first place"? I think you somewhat agree with this, particularly in light of the work that you did on long term normalized earnings of the market, and normalized profit margins, but how do you marry that with Buffett/Lynch's views on limited value of macro analysis?
January 29, 2009
New Podcast Episode: Thursday, January 29, 2009
A Listener Asks...
I'm a computer programmer by trade, as such I find that most of the companies that fall within my circle of competence are tech companies. Should I be concerned about my portfolio being very (perhaps overly) concentrated in the technology industry?
I'm currently finding plenty of interesting companies to look at within the tech industry. But as this has been a notoriously overvalued sector in the past, I expect it will be again at some point in the future. How much time should I be investing in learning about other industries?
January 28, 2009
New Podcast Episode: Wednesday, January 28, 2009
A new episode of the Gannon On Investing Podcast is now available.
On Buffett's Big Blunder
Warren Buffett is getting a lot of criticism for a big blunder. He sold put options on four stock indexes – including the S&P 500.
Buffett described these derivatives in his 2007 letter to shareholders:
“Last year I told you that Berkshire had 62 derivative contracts that I manage (We also have a few left in the General Re runoff book). Today, we have 94 of these...”
Financial Weapons of Mass Destruction
Before criticizing Buffett, we need to take a moment to praise him. After all, the guy had the foresight to clean out the General Re derivatives before the credit crisis hit.
Yes, Berkshire took a loss. And, yes, Buffett clearly overestimated both the rationality and morality of the human capital over at General Re – much as he had at Salomon.
Buffett was never well-liked at Salomon. And I’m sure there are some folks (or ex-folks) at General Re who don’t find him quite as avuncular as he is reputed to be.
I would say they simply don’t understand each other, if I didn’t think the truth was exactly the opposite. Buffett got to know Salomon and General Re better with time – and the better he knew them, the less he liked them.
The General Re derivatives were a disaster averted. Had Berkshire kept the book intact or never acquired General Re, we’d be hearing a lot more about what was in that book.
Is it a mere coincidence that Buffett, the CEO who made the decision to unwind the General Re book, called derivatives “financial weapons of mass destruction”?
No. Buffet saw something in that book. And he did something about it. Most CEOs did not.
Style Drift
Enough praise. Back to the blunder:
“Over the past five years, Buffett frequently called derivatives ‘financial weapons of mass destruction’, comparing derivates to ‘hell...easy to enter and almost impossible to exit.’ Yet, he has, very much out of character, immersed himself in a large and, thus far, unprofitable derivative transaction. His investment successes have not been in speculating in the market (something he has been critical of) but rather by purchasing easily understandable companies with dependable cash flows…”
That’s Doug Kass writing lasting year about Buffett’s style drift. He goes on to write:
“It immediately occurred to me after gazing at Buffett's style drift (manifested in Berkshire Hathaway's large first quarter derivate losses) that he might be increasingly viewed as the New Millennium's Ben Franklin, a man who wrote ‘early to bed and early to rise’ but spent many of his evenings in France, whoring all night…”
Not surprisingly, Kass is negative on Berkshire stock. I won’t argue that point. Berkshire has fallen. And short sellers have made money.
Kass presents Buffett’s derivative transaction as “speculating in the market”.
Insurance
Let me offer an alternate explanation.
Berkshire Hathaway has substantial insurance operations. It is, in fact, a huge insurer of large, often unusual risks. In some cases, Berkshire prefers to keeps such risks to itself instead of sharing them with other insurers.
Buffett does not believe in the Noah’s Ark school of investing and Berkshire does not practice the Noah’s Ark method of insuring. The company bets big in stocks and takes big risks in insurance provided the odds look good and the cost of a losing bet would not imperil the holding company’s health.
That’s the business model. And I love it. If you don’t love it, don’t buy Berkshire. Buffett has been explicit about both parts of the process – the generation of float and the allocation of capital – and he has been explicit about the fact that Berkshire is not a conventional insurance company.
This brings me to a critical point. I disagree with Kass. The put options Berkshire sold aren’t an instance of style drift, because they aren’t investments – they are insurance.
Here’s how Buffett described them:
“These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at the expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make payment only if the index in question is quoted at a level below that existing on the day the put was written…I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15-or-20 year period…in all cases we hold the money, which means we have no counterparty risk.”
As Whitney Tilson noted, it appears Berkshire is not required to post (much) collateral:
“Under certain circumstances, including a downgrade of its credit rating below specified levels, Berkshire may be required to post collateral against derivative contract liabilities. However, Berkshire is not required to post collateral with respect to most of its credit default and equity index put option contracts and at September 30, 2008 and December 31, 2007, Berkshire had posted no collateral with counterparties as security on these contracts.”
Trust
Considering these facts, two possibilities exist:
a) Buffett is lying or otherwise intentionally and materially misrepresenting Berkshire’s derivatives situation.
b) These derivatives pose little to no risk to Berkshire’s solvency or long-term financial health
If Buffett is lying, Berkshire’s shareholders are screwed. But that’s not news.
When you buy Berkshire you are banking on Buffett’s integrity. The guy doesn’t have to be a saint, but he does have to be a halfway decent human being. He controls the company and conducts complex transactions on both the investment and insurance side.
Trust has always been required of those who invested alongside Buffett. In his early partnership days, his disclosures were next to nil, investors’ money was locked up until year-end, and they were putting their trust in a slightly odd young man who worked from home. Those were the ground rules. And they turned some people off. The rest got rich.
If you don’t trust Buffett, don’t buy Berkshire, and don’t believe anything about these derivatives contracts.
Me?
I trust the guy. I’m probably biased. But I’m also probably right.
A Good Bet
Also, I have to admit, if I were running Berkshire and was offered a deal to sell those puts on the terms Buffett did, I would take it.
There is a difference between a good bet and a winning bet. A bet is good when the odds are in your favor and your bankroll can bear the full brunt of an utter and unpredictable loss. A bet is winning when you win. Most people judge themselves on outcomes. That’s insane. You can’t control outcomes. Only process.
Buffett once wrote:
“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”
Those words were written 47 years ago – before Berkshire, before the insurance business – before everything but Graham’s training and Buffett’s rationality.
I don’t know if Buffett will lose this bet. But I do know his style hasn’t drifted an inch.
January 27, 2009
New Podcast Episode: Tuesday, January 27, 2009
A new episode of the Gannon On Investing Podcast is now available.
On Buffett Back Riding
Warren Buffett is best known for his work at Berkshire Hathaway (BRK.A) where he grew book value per share 21.1% a year over the last 42 years.
But Buffett was a money manager long before he was a CEO. He earned his super-investor stripes by running an investment partnership. Buffett Partnership Ltd. beat the Dow every year from 1957 to 1969, never had a down year, and posted annual returns of 29.5% a year. The Dow managed just 7.4%.
Those numbers are phenomenal. And Buffett’s record is all the more phenomenal for its length. How many investors have a track record stretching back half a century?
But past results are no guarantee of future returns. And Berkshire’s size is a guaranteed headwind.
So can you really Buffett-back ride your way to investment success?
Maybe.
But there is a right way to do it and a wrong way to do it.
Common Mistakes in Preferred Stock
The wrongest of the wrong is to buy common stock in companies where Buffett holds preferred shares.
Don’t buy General Electric (GE) and Goldman Sachs (GS) because Buffett told you to. He didn’t. He took a senior position with a double-digit yield. If he wanted to buy the common, he would have bought the common.
Buffett has bought preferred stock before. And, to be honest, it is not his strong suit. One of his worst investment decisions was buying preferred stock in US Air. Berkshire nearly lost everything. The investment worked out, but it was a big mistake – and Buffett knows it.
Another, lesser mistake was buying preferred stock in Gillette.
That investment worked out great. But it would have worked out even better if Buffett bought the common stock instead of the preferred.
For details read Buffett’s 1995 letter to shareholders.
Buffett says he “was far too clever” to take the easier, more profitable route – instead insisting on the more complex, and ultimately less profitable preferred stock.
When Buffett makes a preferred stock purchase, he is actually signaling that he does not like the common stock. He may like the company. He may not. But he certainly does not like the stock.
If he did, he would buy the common stock.
So why did Buffett take preferred shares in GE and Goldman?
Some will argue these are sweet-heart deals pure and simple – and that’s why Warren took them. Buffett certainly got in on special terms.
But, it’s not clear those terms were better than what he could get by buying common stock in a business he loves when market prices are low.
In fact, almost all of Buffett’s biggest successes were either common stock purchases or preferred stock purchases that would have worked out as well or better if Berkshire had bought the common stock instead.
I can think of only two exceptions. Berkshire got some GEICO (now fully owned) and some Freddie Mac (long ago sold) in ways that individual investors could not. Other institutions were offered the same terms as Berkshire. Individual investors were not.
Putting those two purchases aside, Buffett’s best moves at Berkshire have been simple and easy to copy.
Has Berkshire gotten special offers? Sure. But Buffett’s record on such special deals is much spottier than his record of investing on the same terms the little guy could get.
Frankenstein Securities
Why are Buffett’s preferred stock investments often inferior to his common stock investments?
Part of it is the hybrid nature of preferred stock. All of Buffett’s preferred stock purchases combined high yields with the chance to participate in the underlying equity (at some price).
Buffett does simple better than anyone.
Preferred stock is complex. There is a psychological trap of combining a mediocre bond element with a mediocre stock element and thinking you’ve got yourself a great deal. Generally, it is a bad idea to buy such a hybrid unless at least one of the two elements is attractive enough to fully justify the purchase on its own.
Buffett’s preferred investments in GE and Goldman fail this test – at least for an investor as demanding as Buffett. The yields on the GE and Goldman preferred are good, but they are just barely good enough to clear Berkshire’s lowest hurdle of a 10% pre-tax return.
Buffett has said he never considers buying stocks that do not offer at least a 10% pre-tax return. Neither the GE nor the Goldman investments offer much of a margin of safety. Instead they offer a guaranteed, mediocre return (for a long-term Buffett investment) with an equity option.
It’s hard to see how these preferred stock investments meet the same level of quality as Buffett’s big ideas in common stocks.
Most likely, Buffett saw the preferred stocks as good alternatives to fixed-income securities.
That was the logic behind the five preferred investments he made 15-20 years ago. Berkshire swapped lower-yielding securities with no convertibility for higher-yielding securities with convertibility.
That’s a good trade up as long as you don’t come to regret having less cash on hand. Since Buffett made the deals, his opportunity costs have gone up. The value of cash is higher, because stock prices are lower.
Does Buffett regret the deals? I doubt it. But the press has overhyped them. Preferred stock deals are a sign of having a lot of cash to deploy and not a lot of places to put it.
There are two very good reasons not to follow Buffett into GE and Goldman. One: you can’t get the deals he got. And two: the deals he got are not his best investment ideas.
Buffett’s Best Idea
I’m not going to argue for or against any one stock. I’m just going to give you the name of the investment Buffett seems to like most: Burlington Northern (BNI).
Berkshire owns almost 22% of the company. Even for Berkshire, that’s a big stake. And Buffett has kept buying BNI long after the position became public knowledge.
The last purchases I know of were done at $62.15 a share. But Berkshire had been a buyer at prices well above that. Buffett has been buying as recently as this month.
Originally, Berkshire started building positions in several railroads. Then Buffett focused on BNI. Why?
That’s his style. He doesn’t diversify. He concentrates. He doesn’t like small positions. He likes big positions.
And he obviously likes Burlington Northern.
Conclusion
You can ride along with Buffett on BNI or not. But don’t let press reports and hearsay lead you to GE and Goldman – or even worse, to American Express and Wells Fargo and other stocks that Buffett bought into a long, long time ago.
The time to ask whether you should Buffett-back ride is when Buffett is first building his position. This is not a guy who trades a lot.
In fact, he almost never sells. The only way you don’t have to worry about selling is if you do a spectacular job of buying.
So, if you’re looking to ride with Buffett, either buy Berkshire when it trades at a reasonable price – or go in with him on his best investment idea as he’s buying it.
Right now, the only name that fits the bill is Burlington Northern.
January 26, 2009
New Podcast Episode: Monday, January 26, 2009
A new episode of the Gannon On Investing Podcast is now available.
January 25, 2009
On Keynes, the Stimulus, and Old Ideas
John Maynard Keynes was a genius. We can all learn from his example. And the first thing we should learn is to end our foolish love affair with his ideas.
Keynes would not have spent his days warming up some dead man’s leftovers. Keynes would have understood the importance of all we have learned in once disparate fields and what this means for macro-economics.
Complex Problems, Simple Solutions
Economies are complex. But macro-economic solutions remain stubbornly simple.
What exactly is the case for government stimulus?
I don’t mean generally. I mean in this specific situation – right now, today, what is the case for government stimulus?
Forget ideology. Forget theories. Forget models. Think only of the situation we face and the actions we might take.
There will be plenty of time for theories later. But to start by imposing a framework, especially a framework that assumes a special case belongs to a general population, is dangerous.
Why do we assume that special cases belong to populations we know something about?
Because that is what experience teaches us. Our everyday experiences teach us to expect normal distributions. More than that, our everyday experiences encourage us to think that all differences are merely quantitative differences – simply matters of degree – rather than qualitative, systematic differences.
To the extent that the problems, populations, and systems we are dealing with are simple and unplanned I have little problem with making such leaps of faith – extrapolating from a few specific cases to create sweeping general theories.
But when we are dealing with complex, planned systems – systems with actors who learn and adapt, systems with actors who make new mistakes, actors who remember pain and pleasure as vividly as we humans do – when we are dealing with such systems, general theories are dangerous precisely because they are so elegant.
In a complex science, general theories are just special theories that win wide acceptance. If wide acceptance within an academic community was convincing evidence of utility, I would say stick with general theories.
A quick check of human history shows that, no, popularity is not a good indicator of utility. A few bad ideas always slip through – and worse yet, most good ideas – ideas like Keynes’ – outlive their usefulness.
The Burden of a Great Idea
Intellectual lifecycles can be painfully long. First, a great man like Keynes leads the way. Then a lot of not so great men follow. They don’t how to think up the new and useful principles the way the great man did; instead they keep applying old principles to new problems – problems the poor, dead man never saw.
Had he seen different problems, he would have found different solutions. But, he’s dead and his ideas aren’t. So the best a follower can do is warm up the dead man’s leftovers.
Ideas are limiting. The great ones are the most limiting of all.
Warren Buffett was limited by Benjamin Graham’s thinking. He had to learn to keep some principles – Mr. Market and Margin of Safety – and throw out most of the rest.
Warren doesn’t focus on balance sheets. He doesn’t diversify. He does analyze businesses. In each of these things, he is Graham’s polar opposite. And yet Graham was successful. And, for a time, Warren successfully aped him.
But had Warren clung to all of Graham’s ideas, you would never have heard his name. Buffett competed in a system that adapted fast. He kept some general principles. But he threw out a lot of ideas that turned out to be either special applications of general principles or ideas that only worked under special circumstances.
The Danger of General Theories
The danger of confusing what is special and what is general is captured in the title to Keynes' The General Theory of Employment, Interest, And Money.
“I have called this book the General Theory of Employment, Interest and Money, placing emphasis on the prefix general. The object of such a title is to contrast the character of my arguments with those of the classical theory of the subject, upon which I was brought up and which dominates economic thought, both practical and theoretical...”
Did Keynes really think he had come up with a truly general theory? I doubt a man that smart could think something that dumb.
In my post In Defense of Extraordinary Claims I quoted Keynes’ review of Smith’s Common Stocks as Long Term Investments:
“It is dangerous...to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.”
I argued then, as I am now, that people were seeing something special and calling it general. I said then, back in December of 2006, that future stock returns would not match historical returns, because historical returns were achieved under special circumstances – low prices relative to normalized earnings – that no longer existed.
I am sounding much the same alarm here. Everyone from the far-left to the far-right is talking stimulus. Everyone is thumping the bible of spend, spend, spend.
Or almost everyone.
Balance Sheets
In his most recent quarterly letter, Jeremy Grantham notes the importance of repairing the balance sheets of American consumers.
We talk about bank balance sheets. And we talk about consumer spending. But we don’t talk about consumer balance sheets.
Consumers put mortgages on the liability side to finance houses on the asset side. Many of those houses were financed at prices above intrinsic value.
When the market price of houses fell, consumers realized they did not have the ample equity they thought they did but somewhere between a sliver of equity and a deep, deep hole of negative net worth.
That hole has to be filled.
Banks can’t lend with Swiss cheese balance sheets. Nor can consumers spend.
We might do well to talk a little less about the Great Depression and a lot more about Japan.
At this point, the purpose of a stimulus is to bring consumption back in line with what it had been at a time when the illusory wealth of financing assets at prices higher than intrinsic value provided cash flows to consumers that would later be offset by massive asset losses.
You can’t pull that trick off twice. There’s nothing left to borrow against – and there’s nothing saved for consumers to spend.
And, if consumers spend everything they take in today, they keep their balance sheets weak. If they keep their balance sheets weak, they can’t borrow more to spend more today and they have to save more tomorrow.
We need to take the leverage off our balance sheets. Our banks, businesses, and households need to increase equity and decrease debt.
We can do it fast or we can do it slow. But we can’t spend ourselves into financial strength.
Special Problems
Our biggest problem is not underconsumption; it is balance sheet weakness.
The stimulus promoters suffer from man with a hammer syndrome. They have just one tool. It may be a powerful tool. I’m not arguing that point. I don’t have to. It’s the wrong tool for the job.
A stimulus may or may not be a good idea. But it can’t be our only idea.
It’s time to start thinking more like Keynes. The first step is to admit The General Theory is a special theory. Parts of it we can keep. Parts we need to chuck.
But whatever we do we need to adapt.
We have new problems. We need new ideas.
January 22, 2009
Microsoft is Cheap
Go to 24/7 Wall St. and read great coverage of the Microsoft (MSFT) earnings call.
Here is what I wrote about Microsoft in May of 2006:
What price would I be buying Microsoft at? Like I said, this isn't normally the kind of company I would be buying. It is definitely in an industry where there is a lot of uncertainty – at least beyond the Windows franchise (which I do think is completely secure).
For the most part, this is a stock I wouldn't be able to value well enough to buy, because of the future and my lack of understanding of the business.
Having said that, I would certainly buy shares if they reached $17. Before that, I would have some trouble making a decision. The margin of safety simply wouldn't be wide enough in an area I don't understand that well. Maybe I will get a better feel for the company and its competitive position as I look into the stock some more (and write about it here). But, unless and until that happens, it would be hard for me to buy at a price much greater than $17 (where I think it would pretty much be a sure thing).
Because of share buybacks and other changes since 2006, my sure thing price would now be more like $17.50.
Earnings power in terms of free cash flow is probably around $1.75 a share.
No entrenched, wide-moat business this size trades for 10 times its cash earnings power.
Is Microsoft a growth stock?
No.
Is it cheap?
Yes.
If you need to buy a big cap stock, buy Microsoft at $17.50 or less.
December 10, 2008
Random Thoughts
I haven’t posted in a while and thought I might begin with some random thoughts.
Rick Konrad of Value Discipline has posted after a (similarly) long absence. Value Discipline is one of the best investing blogs. If you’ve never read it - start now.
24/7 Wall St. recently posted on More Recession Carnage for Video Games. I would love to have posted on the video games industry (especially publishing) more often on this blog. I rarely have. The reason’s simple: video game stocks have been pricey for much of the life of this blog (2006-present). That’s not true anymore. Unfortunately, so many stocks are now so cheap on a normalized free cash flow (“earnings power”) basis that it’s hard to argue video game stocks deserve special mention.
Take toys. A basket of three of the largest U.S. toymakers: Mattel (MAT), Hasbro (HAS), and Jakks Pacific (JAKK) looks real reasonable. Do the math on what kind of free cash flow these businesses have produced over the years and what kind of prices you can buy them at today. Answer: You’re getting the American toy industry dirt cheap.
Are their risks? In the long-run, their may be greater risks in toys than video games, because toy companies run a greater risk of becoming inflexible enterprises. Regardless, mankind's appetite for toys, video games, and just plain fun isn’t going to be permanently impaired by a recession or depression (no matter how “great”).
Are these businesses recession proof? Nothing’s recession proof. But businesses that make products people are passionate about aren’t a bad place to be in any economic environment. The fact that both industries can and have supported multiple, profitable players isn’t a bad sign either. Toys and video game stocks are both worth buying (even if you can’t separate the wheat from the chaff) when you can get an acceptable no-growth normalized FCF yield on your purchase price.
Focus on free cash flow. Not earnings. I don’t envy anyone who has to tell us what a video game company (or toy company) made this year much less what they’ll make next year. Current sales and expected (normalized) FCF margins are a better way to value these businesses than EPS. Be conservative but realistic. And either buy the best or buy them all whenever you get the right price. In other words, don’t rush out and buy a troubled, hurting quagmire (THQ) at the first twinkling of a turnaround. That’s not necessary when real quality is on sale the way it is today.
Note: Yes. THQ (THQI) is cheap. But ask yourself: do I really need that kind of cheap in my life, when real quality's on sale.
Video game and toy stocks aren’t the only ones being offered at low prices to demonstrated free cash flow. See Microsoft (MSFT) or Energizer Holdings (ENR) for evidence of this market wide phenomenon.
But those are posts for another day.
October 10, 2008
On a Return to Normalcy
It might not feel like it, but yesterday marked the Dow’s return to normal.
Normal valuations that is.
A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, “In Defense of Extraordinary Claims”, I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high:
Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.
That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century.
That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: ’96, ’97, ’98, ’99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than ’65.
As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 – 2007.
We were in unchartered territory.
Not any more.
Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.
So at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.
That may not sound like much to those weaned on the 1982 – 1999 bull market. However, it’s a lot better than the “new paradigm” market that began in 1996. Since we broke into unchartered territory twelve years ago, we’ve done something like 3.4% in point terms.
And over the last ten years: zilch.
Here’s what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained:
Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached "a permanently high plateau" now that a new paradigm has taken hold.
I won't dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won't enough investors wise up to this fact and cause the so-called "equity-risk premium" to disappear.
If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future returns to fall short of historical returns. But, there's no logical reason why normalized P/E ratios must revert to the mean – future returns can be adjusted down, allowing current prices to remain high.
That's true. In fact, the Dow could theoretically trade around a normalized P/E ratio as high as 40-50 without making stocks so unattractive as to completely eliminate them as a possible long-term investment (all of this assumes the equity-risk premium can disappear).
At around 50 times normalized earnings, the math gets terribly unforgiving. As a result, it's hard to imagine any likely circumstances under which a market trading at close to 50 times normalized earnings could be a viable investment option – though it's theoretically possible if long-term interest rates are very, very close to zero.
But, at lower normalized P/E ratios, such as 30 (and certainly 20) stocks could still compete with other investment opportunities. Stocks might lose most (or all) of their edge over other asset classes; but, stock prices wouldn't necessarily have to fall – they could simply offer much lower returns than they had in the past. This could continue indefinitely – in theory.
I say "in theory", because that seems a rather unlikely scenario. There is absolutely no evidence for it in the data. Before 1995, the Dow's normalized P/E ratio had ranged from 6.88 – 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41.
So, a permanent jump to normalized P/E ratios above 20 would be quite a departure from the past. Could the leap be permanent? Could these new, higher normalized P/E ratios become the new norm?
Maybe. If we really are in a new era, the old historical return data isn't relevant – it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we aren't in a new era, the old historical return data is relevant – and normalized P/E ratios must fall.
And they have fallen. Like a rock.
And saved us a lot of time.
Eight and a half years by my calculation.
Without a severe multiple contraction, the Dow would have had to move sideways for something like eight and a half years to give us the same future return increasing effect of the fall from just under 14,280 to just under 8,580.
Of course this only makes sense if you believe as I do that in the long-run your returns in stocks are derived from the relationship between the price you pay and the earnings power you get for your money.
What about earnings power impairment?
Won’t the current financial panic and the (possible) resulting global recession cause a major contraction in earnings power?
Not really. Actual earnings will be impaired. However, “normalized” earnings won’t move much (certainly nothing like the 40% drop in price) – unless we see conditions considerably worse than anything post 1935.
The Dow has been outperforming its expected earnings for a very long time (since the early 90s). That was never going to last.
The Dow’s actual earnings overshoot and undershoot its “expected” (i.e., 15-year normalized) earnings quite frequently; however, the overshooting and undershooting have tended to cancel each other out over long periods of time as you can see here:
From 1935-2005, the percentage difference between the Dow's actual earnings and its 15-year normalized earnings ranged from (62.12%) to 65.14%. The average (mean) difference between actual and normalized earnings was 0.44%. The median difference was 0.09%.
The swings have been huge, but their net effect has been small. Basically, the Dow’s EPS chugs along at about 6% a year. Although it has managed some remarkable hot and cold streaks (none longer than the one that’s ending now) it’s basically a mirror image of underperformance and overperformance.
The Dow gives you 6% earnings growth. What you get depends on what you pay.
Starting today, you’re paying par. You haven’t had that chance in over ten years.
What do I mean by par? Since the Dow is now at (actually a bit below) its average 15-year normalized P/E ratio for 1935 – 2005, your long-term returns should match the Dow’s long-term EPS growth.
Both should be around 6% (ex-dividends).
Long-term future returns should once again be similar to long-term historical returns.
Could the future be different from the past?
Maybe.
But I wouldn’t bet on it.
The last ten years turned out to be nothing new.
Just a detour on the road to normalcy.
P.S.
All this brings up an interesting question – and I know a lot of people may not agree with my strict either/or dichotomy between a price drop or a stock market that does nothing for many years – but assuming the Dow’s normalized P/E had to revert to the mean for it to offer its historical returns once again…
Which would you rather lose: Forty percent or eight and a half years?