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WHEN GOVERNMENTS PRINT MONEY, BUY GOLD
"If you don't trust gold, do you trust the logic of taking a pine tree, worth $4,000-$5,000, cutting it up, turning it into pulp, putting some ink on it and then calling it one billion dollars?" ~~ Kenneth J. Gerbino
Gold bugs have been saying stuff like this for years, and years, and years ... Now with gold's bull market too obvious for even the mainstream financial media to ignore, it is not surprising to see them publishing "What does it all mean?" type analysis. The UK's Telegraph has been blunter that most in this department.
The price of gold tells us a lot about ourselves. It holds up a mirror to the way we are governed, our economy and its prospects. It reflects not only the physical dangers of floods, famine, terrorism and war, but also the financial perils of systemic addiction to debt and budgetary incontinence.
"The modern mind dislikes gold," said Joseph Schumpeter, "because it blurts out unpleasant truths." With gold trading at about $900 an ounce -- more than 200% higher than it was at the turn of the millennium -- today's message from the bullion market is not comforting.
In the eight years since the arrival of the 21st century, the FTSE-100, the London stockmarket's main index, has lost about 15% in value. The shares in companies that comprise "Footsie" usually pay dividends, sometimes more than 5% a year. Gold pays none: never has, never will.
So why have investors been abandoning conventional assets, such as government bonds and stakes in blue-chip businesses, in favor of a metal that appears to offer no reward for holding it? The answer, I am afraid, is crumbling faith in the world's central banks, and in particular the U.S. Federal Reserve, where the presses have been working overtime. ...
Wars in Iraq and Afghanistan, a more muscular Iran and the unpredictability of Moscow are contributing to nervousness. But what is really upsetting investors is the speed at which money is being printed by governments, especially America's, that cannot face the problem of funding wild expenditure plans solely from reserves or taxation. In that sense, the gold price's journey towards $1,000 is a resounding vote of no confidence in authority. It is the market flashing a red light.
This week, the BBC's World Editor, John Simpson, reported under cover from Zimbabwe, where the cost of a meal for himself and some friends in a Harare restaurant was 290 million Zimbabwean dollars. Ever the gentleman, Simpson left a 10-million-dollar tip. In this nightmare state, as Simpson put it, "everyone is a millionaire", yet also, "grindingly poor".
This is an extreme version of what happens when a currency is debauched. Zimbabwe is at the very end of a road down which all excessively wasteful administrations travel. It is a long haul, and not many go all the way like Robert Mugabe. Nevertheless, the price of gold is signaling fears that the U.S. dollar, and to a lesser extent sterling, is on course for painful corrosion.
Currencies come and go, but gold has been a store of value for more than 5,000 years. Gold is rare, but, thanks to Gutenberg, paper money is not. Presented with an opportunity to churn out extra cash at little expense, it takes a special kind of government to resist. Few seem able to do so. ...
Inflation wrecks currencies in the same way that termites destroy wooden houses. The world's two most successful currencies, the U.S. dollar and the British pound, both of which are still used by other nations to hoard wealth, have each lost more than 95% of their value in the past 100 years.
Since 1971, when Richard Nixon broke the dollar's formal link to gold, America has pumped out trillions of new dollars. Money from thin air. China alone is sitting on more than $1,000 billion of reserves, as American consumers pile up debts to buy "essentials" from factories in Shenzhen and Guangdong. No wonder the buck has lost its fizz.
By contrast, there is a finite supply of gold. This keeps it honest. As financial commentator Peter Burshre pointed out: "Regardless of the dollar price involved, one ounce of gold would purchase a good-quality man's suit at the conclusion of the Revolutionary War, the Civil War, the presidency of Franklin Roosevelt and today."
Gold does not always appreciate in price, of course. In 1980, it was selling at more than $800 an ounce. 20 years later, it had dropped to $275. It is theoretically possible to get rich by betting on fiat currencies and against gold. But the scoring average of all those who try is pretty poor.
Ask Gordon Brown. He achieved what most expert dealers can only dream of. In 1999, he spotted the bottom of the gold market, a 20-year low. The trouble was, Brown's order was "sell". As Chancellor, he told the Bank of England to dump nearly 400 tonnes of British gold reserves, since when the price has shot up. That decision cost the Treasury billions.
Control-freak politicians abhor gold because it ignores them; it will not do what it is told. It defies economists and laughs at central bankers. Sophisticates claim that, in a world of electronic money, gold is a barbarous relic. But as the sub-prime horror ravages the international banking system, millions of ordinary savers know better. While ministers debate the merits of flooding the global system with liquidity to ease the credit crunch, Delhi taxi drivers are buying gold, accelerating the shift of wealth from west to east.
"Practically all governments of history," said Friedrich von Hayek, "have used their exclusive power to issue money to defraud and plunder the people." Gold stands in the way of this process; it is a protector of property rights.
If you are still not convinced, let me remind you of what Hitler had to say: "Gold is not necessary. I have no interest in gold. We will build a solid state, without an ounce of gold behind it. Anyone who sells above the set prices, let him be marched off to a concentration camp. That is the bastion of money."
At some stage, the recent price surge will cool. When? No idea. But I do know that, to equal the last peak of $846 ... the price today would have to reach $2,500.
That widely-cited peak price occurred at a parabolic blowoff which quickly collapsed, so say instead that a better reckoning of the previous peak price was more like $700. That still leaves an upside of $2000+ if gold matches its previous peak in inflation-adjusted terms. And that is when measuring inflation using fraudulent government estimates. If you used the growth in the money supply -- however defined -- the upside is no doubt greater. Eyeballing this 10-year gold chart, one can imagine that there is a long ways to go before the chart would take on a blowoff cast, as long as it does not happen too fast as in early 2006.
U.S. RATE CUTS: ANOTHER DRINK FOR THE ALCOHOLIC
"The Edge provides provocative commentary on various topical issues affecting finance professionals," we are informed. Blogger Richard Northedge, "a writer and columnist for several leading UK newspapers and publications," certainly cuts to the chase here.
Slashing U.S. interest rates is a short-term fix for America’s economy -- and thus possibly for the world's finances -- but it is a solution that resorts to the problems that created this mess.
The last time the Fed made an unscheduled cut in interest rates was immediately after 9/11, and though done with the best intentions, it started the low-cost credit regime on which the world became dependent.
The timing, following a crash in world share prices and before U.S. markets reopened after a holiday, suggests the Fed was more interested in saving Wall Street than saving U.S. industry, but it simply stores up problems for later. Lower interest rates mean a lower dollar, which means higher inflation -- which is no good for American consumers or U.S. business.
That is why the Bank of England will not rush to follow the Fed as it did after 9/11. Apart from displaying panic, the Bank would be encouraging inflation (for which it gets the blame) at the expense of boosting the economy (which is not its responsibility). The UK Bank will thus make small cuts at scheduled times.
Anyway, in this changed economic climate, interest rate cuts are not going to have the stimulus they had in recent years. The UK public is not in a mood for consuming, and even if U.S. banks would lend again to American subprime borrowers, do not expect them to go on a spending spree.
But having made this grand gesture to save share prices once, what does the Fed do next time? And the time after that? The Fed ought now to be gently raising rates to strengthen the economy again, but it cannot do that. The deep rate cut is like giving an alcoholic one more drink to keep him happy when the long term solution is to wean him off the stimulant. Unfortunately the U.S. economy is addicted.
Mr. Northedge covers the key issues at hand in a few short paragraphs: (1) The Fed's de facto charter is to save the hides of its rich sponsors, even if that is at the expense of everyone else. (2) More liquidity is not going to improve real economic activity if consumers and businesses are not in a borrow-and-spend mood. (3) The Fed fired a lot of bullets this round. What does it do when it gets short on ammo the next round now, or the one after that? (4) Whatever the risks and illogic of the foregoing, the Fed dares not try the much-needed alternative.
As for the part about the Bank of England displaying comparatively more prudence, well, we shall see. Sometimes virtue is a matter of insufficient temptation.
Will the Cure Be Worse than the Disease?
Fortune Magazine joins the critics of recent Fed policy, including the lastest rate cut:
The wobbly economy is overtaking Iraq as the issue weighing most heavily on the minds of America's voters. And Washington has noticed. The White House and Congress are almost certain to enact some kind of stimulus package. But like all such temporary, feel-good measures, it will generate a quick blip in growth that will quickly evaporate. In reality only one player has the power to do anything swift and decisive: the Federal Reserve. And its chairman, Ben Bernanke, has already made his intentions abundantly clear. Unfortunately, the cure he is prescribing may be worse than the disease. ...
By cutting rates early and often, Bernanke is acting as though a recession -- even a mild one -- would be a calamity that must be avoided at all costs. ... Many on Wall Street back Bernanke. ... But Bernanke is setting the stage for an even bigger recession down the road. Just as the ultra-low rates of the early 2000s created many of the problems we are experiencing today, pumping money into the system would probably stoke inflation, forcing the Fed to hike rates sharply in the near future.
[Carnegie Mellon economist Allan] Meltzer, who is finishing the second volume of his history of the Federal Reserve, warns that Bernanke is risking a disastrous replay of the 1970s, when high oil prices fueled double-digit inflation. Every time the Fed started to tighten and unemployment jumped, chairmen G. William Miller and Arthur Burns lost their nerve. They lowered rates to boost job growth, and inflation inevitably revived, causing a vicious price spiral. The Fed let the disease rage for so long that it took draconian action by chairman Paul Volcker in the early 1980s to finally defeat inflation. The price was a deep recession, with unemployment hitting 11% in 1982. "The mentality is the same as in the 1970s," says Meltzer. "'As soon as we get rid of the risk of recession, we'll do something about inflation.' But that comes too late."
The U.S. economy would never survive a dose of Volckerism today. The background financials are much too weak.
The Fed's supporters tend to downplay those dangers. They contend that the inflation surge is being driven largely by energy costs. Since oil is not likely to rise from its near-$100 level, inflation is likely to tail off in 2008. "That argument is wrong," says Brian Wesbury, chief economist with First Trust Portfolios, an asset-management firm. "As people spend less to drive to the golf course, they will spend the extra money on golf clubs or other products. The Fed wants to reflate the economy, so the money that went into higher oil prices will drive up the prices of other goods."
Fed supporters also point out that the yield on 10-year Treasury bonds stands at just 3.8%, a figure that implies that investors expect inflation to be around 2% in future years. So if inflation is really expected to rage, why aren't interest rates far higher? The explanation is twofold. First, government bonds are hardly a foolproof forecaster. ... Second, investors are so skittish about most stocks and corporate bonds that they are paying a huge premium for safe investments, chiefly U.S. Treasuries. "It's all about a flight to safety," says Meltzer. Stand by for a major rise in yields as the reality of looming inflation sinks in. ...
Sadly, the Fed ... is likely to lower rates every time growth slows or joblessness rises. As a result, it will never tame inflation until it becomes a clawing, bellowing threat. Then we will have to suffer a real recession, the kind we suffered in the aftermath of a time we should study and should not forget -- the 1970s
Criticism of Rate Cut Mounts
Bernanke vs. the bear - 2
Michael Rozeff (same author as piece hashed out here) writes, on the rate cut:
The cut in the FF rate to 3.75% will probably not require the Fed to pump bank reserves up that much. The banks have already been trading reserves at rates there and lower at times during the last few weeks. T-bill rates are already down around 3%. Libor is 4% for 3-month money. We need to wait and see what happens to bank reserves and M1 before we reach a verdict. The FED has a recent history of following, not leading the market.
Stocks opened on a gap down. As so often happens, they have rallied back to fill in that gap. Their usual pattern is next to sag back toward the lows, then have a period of stability or even small rally for awhile. Eventually, however, those lows are again broken as the bear market resumes.
PANIC AT DAVOS!
The global financial meltdown intrudes on the World Economic Forum.
Slate reporter Daniel Gross reports on how the current financial market troubles are impinging on the equanimity of those who came to soak up the rarified atmosphere surrounding the World Economic Forum.
Financiers and CEOs come to Davos to escape the grind of SEC filings, subprime write-downs, and EBITDA, and to indulge their inner wonks. It takes some doing. There is the 8-hour flight to Zurich followed by another couple of hours in a car, bus, or train, chugging slowly up a narrow snowscape, through stands of enormous pines. Then, instead of sitting through sales meetings, placating investors, or scanning bar charts, they can ponder the implications of the human genome project for cancer research, or listen to Tony Blair, or sit in on a panel discussion with food pioneer Alice Waters. It will not be so easy this week
The prebuzz at Davos this year was about the megatrends transforming the global political economy: sovereign wealth funds, sustainability, China, energy, and the promise of medical technology (a topic of increasing salience to Davos's aging baby boomer stalwarts). The early sense was that while the U.S. is slowing and may be in for a rough time, the rest of the world is doing quite well. The U.S. has clearly sneezed, but the rest of the world has yet to catch cold.
That was last week. In the last few days, as conference-goers packed their boots and business cards, global markets have cratered because of continuing troubles in the U.S. and concerns over the stability of the financial new world.
There is a whiff of panic, even high up here in the Alps. When I alit from the train in the Davos Platz, jostled by young Swiss headed for a day on the slopes, my primary concerns were croissants and chocolate. But my traveling companion, a fellow financial columnist, quickly put the kibosh on my schussing plans. Whipping out his BlackBerry, he noted: "They're talking about a coordinated rate cut." In the press center, one of the Swiss army of greeters asked excitedly if I had heard the news. The Dow looked as if it was going to open 500 points down, and the Fed was cutting interest rates another 75 basis points. Suddenly, the prospect of lunch with George Soros tomorrow has become much more interesting. ...
At the opening reception (ooh, there's Emma Thompson!) ... a private-equity guy's eyes were glued to his BlackBerry, checking stock quotes. Based on a few interviews, the early consensus seems to be that the U.S. and its credit problems are partially to blame for the suddenly destabilized global markets. "The whole subprime mess is the fault of American greed, and Bush's fault for not regulating it," Ron J.C.M. Kok, president of the Dutch engineering firm OTB Group, told one of my colleagues. What's more, from my distinctly unscientific sample, global big shots seem to believe that the punk U.S. economy is just something Americans -- and the world -- will have to learn to live with. Jacob Zuma, president of the African National Congress and the likely next president of South Africa (and my nominee for world leader with the most aggressive bodyguards), was philosophical. "No country in the world can escape the impact of what's happening in the U.S.," he said. "But the South African economy has very strong fundamentals." Others were less diplomatic. "The U.S. sucks," said the chief executive of a large U.S.-based auto parts company, referring, of course, to the domestic auto parts market, not the country as a whole.
WALL STREET’S NEXT CRISIS: BOND INSURERS?
More bubble-popping trouble. Stories on the cascading effects and victims of the unwinding credit bubble will continue to come out rapidly. This particular story -- concerning the self-immolation of the bond insurers, who played an important role in the credit bubble -- is noteworthy. If they had just stuck to their knitting, or stayed inside their their "circle of competence," as Warren Buffet and Charlie Munger call it, they would done about as well as they always had, i.e., pretty well. But sitting quietly while there is a mania going on is not the way of human beings, including those who are paid quite well to be stalwart shepards of shareholder capital.
The bond insurers for decades had a dull, steady business of insuring municipal bonds. Then, with the credit bubble gathering steam in the 1990s, they decided to reach for the gold ring. They moved out of their circle of competence and into a business that they (and, it turns out, almost everyone else) did not know very well: insuring the various products created by Wall Street that were backed by alternative mortgages and other exotic debts, and the derivatives created therefrom.
When the bond insurers bestowed a AAA rating on what would have otherwise looked like heap of junk under closer scrutiny, Wall Street's task of pawning the package off on credulous buyers was greatly facilitated. But those buyers neglected to stress test the financial strength of the insurers -- which is always a good idea if one expects an insurer to actually have to pay off some claims. The bond insurers had no history on which to base actuarial risk calculations for these new instruments they were insuring. The insurers had to guess a price that would adequately compensate them for the risks incurred. They guessed wrong, perhaps by an order of magnitude. It looks like de facto bankruptcy is in the cards for all of the insurers, but they may be put on life support to keep the whole truth at bay for a while.
Skeptics have been eying the bond insurers with suspicion for quite some time, wondering what would happen once the real estate/credit bubble reversed. The skeptics were right. However, it took a long time for the defects in the bond insurers' business strategies to manifest in collapsing stock prices. One class of financial industry participants who did not evince much in the way of skepticism was the Wall Street investment banks. They entered into agreements undergirded by the blithe assumption that the financial strength of the insurers was not a concern. They were wrong.
Insurance is an interesting business. Up front the insurer takes in the premiums written less the immediate cost of gathering the premiums (commissions, etc.). The costs of administering the business are fairly easy to estimate. The discounted present value of the claims that will ultimately be paid out is the tricky part. This is where the actuaries earn their keep.
A little detail here is, of course, the small matter of selling coverage at a price and volume to make the premiums/costs/claims equation work out. The insurance business is not a big secret. Competition can be fierce, particularly in standard commodity-like lines (homeowners, small business liability, etc.), where risks are well-known and customers are price-sensitive. But the bond insurance business was not like this. It was oligopolistic, with pricing and volume sufficent for the participants to make a decent return on their capital. The temptation is always present in the insurance business to write premiums up front and hope everything works out for the best later (sound familiar?), especially when entering a new line of business where optimism has not yet been tempered by experience -- or where the brain has been short-circuited, as during a mania. This is the temptation the bond insurers succumbed to, en masse.
The growing crisis at Ambac Financial, one of the biggest bond insurers, is raising questions about Wall Street's exposure as counterparties to the bond-insurance industry coming off a period in which the big banks are reeling from more than $100 billion in write-downs of mortgage-related securities, according to Forbes.
Shares of Ambac, which has already had $8 billion wiped off its value since the start of 2007, and its rival, MBIA, both battered by losses from the collapse of the subprime mortgage market, fell sharply [last] Thursday on concern they would lose their AAA credit ratings.
Ambac dropped 52% and MBIA fell 31% as Moody's Investors Service and Standard & Poor's increased their scrutiny of bond insurers. Credit-default swaps on both guarantors rose to records, signifying that investors see a growing chance that the companies will not be able to pay their debt. ...
In recent years, Ambac, MBIA and others have ventured into insuring credit derivatives and other relatively newfangled fixed-income products invented by and peddled by Wall Street. Ambac guaranteed $38 billion of debt linked to subprime mortgages and has exposure to $45 billion of other mortgage investments
The banks, as counterparties, are on the hook for billions in insurance they bought to hedge credit-derivatives positions. The insurance policies, called credit default swaps, have exploded in popularity in the last few years, with some $45 trillion outstanding.
When Berkshire Hathaway bought General Re, Buffett and Munger set about unwinding GenRe's derivatives contracts. Buffett's pithy post-mortem comment on the adventure (in May 2007): "Four years ago when we started to liquidate GenRe's portfolio, we had hundreds of millions set aside in reserves. We had auditors who can attest that the accounts were marked to market and I wish I had sold the positions to the auditors back then. We would have been better off by about $400 million or so." And this was before the credit/derivative troubles all really came to the fore.
According to Fitch Ratings, Morgan Stanley, Deutsche Bank, Goldman Sachs and JPMorgan Chase were the biggest counterparties in terms of notional value outstanding at the end of 2006, and the market expanded substantially in 2007. Merrill Lynch, Citigroup and UBS were the top three underwriters of structured finance C.D.O.s last year. ...
"The ultimate systemic risk caused by the weakened positions of the monoline insurers is overwhelming and scary," Oppenheimer analyst Meredith Whitney said in a late-December research note. "The impact will be sizable and very negative for the banks."
Bond Insurers Seen Needing up to $200 Billion
People are starting to put numbers on the bond insurers' problems:
A government-brokered rescue plan for U.S. bond insurers of about $15 billion came under fire on Friday, with analysts saying the ailing insurers may need as much as $200 billion to remain viable. A cash infusion would allow the bond insurers to maintain their top credit rating, which is critical to their business of guaranteeing some $2.5 trillion of municipal bonds and asset-backed securities.
Analysts warned some investors would face huge write-downs on the valuation of securities guaranteed by the insurers if they lost their top credit rating, dealing another blow to a bruised U.S. economy. Those concerns contributed to a recent sell-off in stocks.
New York State Insurance Superintendent Eric Dinallo pressed major Wall Street banks this week to contribute billions of dollars to support the bond insurers, also known as "monoline insurers." Some observers on Wall Street and elsewhere believe the New York state-orchestrated plan, which is only in the initial stages, may not go far enough.
"The numbers being bandied about of a $15 billion infusion into the monolines looks to us to be like putting a Band-Aid on a gushing wound," said analysts at hedge-fund Bridgewater Associates in a report to clients on Thursday.
They added that "looking at the price movements on the instruments they insure as well as their existing reserves, we would suggest they would need at least $70 billion on top of current reserves."
Sean Egan, managing director of independent credit-rating firm Egan-Jones Ratings Inc, said he expects roughly $80 billion of eventual losses for the top six monoline insurers.
SOME POINTERS ON PASSIVE INVESTMENT IN THE WORLD MARKET PORTFOLIO
Michael Rozeff follows up his excellent article of last week, "On Sound Fundamental Principles of Investment", which we covered here. He argued that one should put one's investment funds, as distinct from speculative funds that one can afford to play around with and lose, in a pool of assets that replicates a meta-index of all the world's investable assets -- or the "world market-value weighted portfolio". This is easier said than done, so now he is back with implementation suggestions.
This article ... clarifies some questions and provides more specifics. My goal is, at low cost, to get the average investor into a reasonably sensible investing ballpark. In my view, investors should not be spending very much of their capital paying for portfolio construction or portfolio management services. I have two reasons for saying this. One is that a do-it-yourself approach is feasible. There are many index funds that are easy to buy and sell on exchanges as ETFs using a good discount broker, like Scottrade, or through no-load mutual funds. Second, the fees that many portfolio management services charge are too high. The market bears it because many investors lack financial knowledge.
Investors vary in age, income, occupation, tax status, risk preference, and other personal variables. There is no one investment solution suitable for everyone. But, with adjustment to one's cash position, one portfolio of risky securities can serve surprisingly well to achieve the investment goals of preserving capital, obtaining some growth of capital, and keeping risk to a minimum. That portfolio is the world market-value weighted portfolio.
Suppose W is this world portfolio. Suppose you have money to invest, say $1,000. You can vary the risk of your portfolio by what fraction you place in W and what you keep in short-term liquid securities like Treasury bills or a bank account. A risk-tolerant person might place $1,000 in W and none in T-bills. A person more risk-averse might place $500 in each. The fact is, however, that W has rather low risk. Many people will want to invest most of their investable funds in it.
The proportions that the values of major asset classes have within the world portfolio are suitable for a passive investor to mimic. (He repeats from the previous article the reasons this is a good idea.) ... The world market portfolio is likely to be of moderate risk, and the return it might provide of 7% will seem too low for some. But it will provide the highest return for that level of risk that one is likely to find. ...
Some will want to go for the 9% or more that stocks may deliver. ... [T]his is feasible, but it has added risk because one is undiversifying. It is a form of speculation. The fact that stocks have made 9% or more in the past and outperformed bonds does not mean they will do it in the future. In fact, bonds did as well as stocks in the '80s and '90s as interest rates fell. You could place all your money in stocks and be making 9% for many years. Then suddenly you could run into that rare occasion when stocks decline by 90% and then do not recover for 20 years. Stocks are risky. If you place all your eggs in the stock basket, you are speculating. ... Most of us will do some speculation. I suggest keeping one's speculations separate from one's passive investments. Management of them requires very different knowledge and principles.
So far this a recapitulation and reinforcement of what was expressed in the previous article. The bottom line philosophy is, when you deviate from an asset allocation corresponding to the world portfolio ("W") you are speculating, not investing. This is not bad per se. Just do not fool yourself about what game you are playing. Don't bring a knife to a gun fight.
Now, debt. If you want to build up wealth through investment, you must postpone consumption. You must avoid going into debt to finance consumption. $1,000 invested at 7% doubles in about 10 years. ... If you borrow to buy something, not only will you not see that $16,000, but you will be paying someone else interest. Your wealth will not only not grow, you will be enduring something akin to slavery. You will have sold off the rights to your future income from working. ...
When I speak of real estate investment, I most definitely do not mean your home. You should not consider your home as an investment no matter how economists define the term. It is better to think of it as a consumption item. You are buying a bundle of future housing services when you buy a home. Any price change in it is incidental. ... Unless you intend to specialize in homes as a speculative business, forget it as an investment. ... A home eats money. This is not what you want in an investment.
By real estate, I mean commercial real estate. This includes such things as office buildings, warehouse and commercial space, malls, and apartment rentals. It means that you are the landlord. You collect the rents. Now, you are not going to do this yourself. You will do it by buying shares in companies that own and manage commercial properties. ... [R]eal estate investment trusts provide a stock investment that serves the purpose.
By bonds, I mean corporate bonds. I do not include government bonds in the market portfolio. The market portfolio contains securities behind [it] which are real assets that produce income. Behind corporate bonds are the company assets, which provide net wealth. Behind government bonds are future tax payments that come out of taxpayer income. There is no net wealth in these bonds.
It is difficult to submit to the market's pricing and not have a speculative view of our own. ... If you have strong views about the pricing of some sector and you still want to hold the world portfolio, consider phasing in your investment over time. If you think bonds are too high in price, select some horizon, like 12–18 months. Then gradually buy into the bond market. You will be mixing in a moderate amount of speculation into your investment decision. This may satisfy your urge to act upon your own views.
The world portfolio involves a global asset allocation. Investment results hinge primarily on the asset allocation proportions. Managers that advertise tactical asset allocation are speculating on the pricing of various sectors. Passive investment avoids this. Its asset allocation depends on the market value weights.
I have two different methods to estimate market value weights. Both are rough, but they come out close. If the numbers do not all add up, do not worry about it. I have had several classes look into this over the years, and the results always come out about the same. They are approximate, but good enough for practical purposes. We are not sending a rocket to the moon here.
First, for high net worth investors, who hold most of the world's wealth, these weights in risky securities (disregarding cash assets) are about as follows: 35% in stocks, 24% in bonds, 18% in real estate, 23% in other assets. The other assets include all sorts of real assets like gold, timber, art, and commodities. They include foreign currencies, hedge funds, venture capital, private equity, and managed funds. The average investor will not be concerned with many of these things, but we reserve some allocation for real assets below. If and when these assets prove themselves and can be bought by individual investors at a reasonable fee and if they are diversified, then some part of the portfolio could be allocated to them.
The second method uses all sorts of estimates. ... One estimate places world investable wealth at $123 trillion (including government debt). Starting from $123 trillion, subtract $13 trillion for government bonds. That leaves $110 trillion, of which $32 trillion is bonds, $35 trillion stocks, and $43 trillion is other, mainly real estate. The proportions are: 32% stocks, 29% bonds, 39% real estate and other.
These numbers are close to those found for high net worth investors. It is not worth getting too fussy about all this. If other real assets are 10%, that leaves 29% for real estate, which is $32 trillion. ... The precious metals, art, timber, commodities and such are not as large as one might think in contributing to overall world investable wealth. Without going through an elaborate calculation, they add up to 10% at most. I allocate 10%. That is generous. One might make it 5%.
Putting all this together, I suggest these approximate proportions for the world market portfolio: 35% in stocks, 25% in bonds, 30% in real estate, 10% in gold. Then I suggest dividing the bonds into half domestic and half foreign bonds. The real estate may be divided into 1/3 domestic and 2/3 foreign. However, I could not argue with a 50-50 split. The stocks can be divided as 40% domestic and 60% foreign, based on estimates above. We then have:
This portfolio definitely avoids the "home bias" that is typical of many investors who stick too heavily to their own countries. Furthermore, it leans toward the faster growing and less socialistically constrained corners of the globe.
- 14% U.S. stocks
- 21% foreign stocks
- 12.5% U.S. bonds
- 12.5% foreign bonds
- 10% U.S. real estate
- 20% foreign real estate
- 10% gold
The next step is to choose mutual funds for these categories. I can do that in many ways. Whatever selections I might make will be merely suggestive. I have not done a thorough study of all the available indexes and what they contain. I have not broken down the above classes into finer categories. There is a great deal I have not done. It is not clear that it pays to do a great deal more. This is where you can do your homework. You also can subdivide some of the categories still further if you like. My job is done. I have shown you what the passive investing ball game is about.
Mr. Rozeff proceeds to suggest, but not necessarily recommend, various Vanguard -- renowned for its low fund management costs -- funds and ETFs for stocks, bonds, and real estate, both foreign and domestic.
In sum, with about 6 mutual funds and/or ETFs in the proportions suggested, plus a commitment in gold, one can attain an overall portfolio that will be about as worry-free as one can make it. Not only has one diversified very well across sectors and the world, but also within each fund are hundreds and sometimes thousands of securities. Your bet is on the world economy. You cannot make it any more basic than that. You are not speculating on any individual sector, country, company, or type of security. You are so well diversified that a catastrophe in one area should leave you almost unscathed. If the world survives and grows, you will earn a normal rate of return on your investment.
There will be taxes to pay. This is very disturbing. Having paid taxes on your income, you will then pay taxes on what you save. When you die, there will be more taxes. You will wonder why you bothered building up wealth. The government encourages us to be wastrels. It is a wonder that some of us still save. In America, the official saving rate is zero or negative.
Perhaps your best investment is in travel. You can find another place in the world to live, one that does not tax investments the way the U.S.A. does.
INTERESTING “HIDDEN ASSETS” PLAY: DELTEC TIMBER
Whiskey & Gunpowder has had a link to their "featured report" on Deltec Timber Corp. on their home page for quite a while now. The report and the company are still interesting for a number of reasons, not the least being that the stock's price is the same as when the report was first published while the value story itself seems largely intact. We also are a soft touch for low trading volume stocks with lots of off-balance sheet hard assets, like land and natural resources, selling for major discounts to a conservatively estimated valuation.
Financial panics have a way of unsettling the nerves. You seek refuge in things you can trust. Assets you can see and watch over. And sometimes those assets hold their own secrets, which are unveiled only after the passage of a century.
And so it was that one C.H. Murphy Sr. found refuge in the loblolly pines of central and southern Arkansas after the Panic of 1907. Here in the deep-fried South, Murphy not only saved a fortune, he planted the seeds for another. Murphy bought up thousands of acres of timberland. Timberland is one of those old-world assets that never go out of style. Trees grow by the grace of nature's bounties -- sun, rain and warm weather. They hold their value by the grace of a marketplace that needs timber to make things.
If we fast-forward a century, we find that Murphy's old timberland is now in the hands of Deltic Timber (DEL: NYSE). The Murphy family still owns 26% of this timber stock. Deltic is actually a spinoff of Murphy Oil, having achieved independence back in 1996.
I will tell you a little about a unique timber stock: Deltic Timber, which is a fine investment on its own. But the reason I am excited about Deltic has little to do with trees. It is more about what lies beneath.
Deltic Timber Corp. is a natural resources company. Deltic owns 437,700 acres of timberland (see the map, "Murphy's Legacy". The area highlighted indicates counties and parishes where Deltic owns timberland). It also runs sawmills in Ola and Waldo, and has real estate developments in Little Rock and Hot Springs.
Most of this timber is Southern pine. The company is patient in its cuts. It manages to a 35-year cycle, as opposed to the 20-year cycle for most timber companies. Family ownership will do that, I suppose. They are patient stewards of shareholder capital because it is their own investment, too -- always important, this is more so today because many people who run companies have little or no financial stake in the businesses they run.
A recent study by Credit Suisse found that companies in which "founding families retain a stake of more than 10% of the company's capital enjoyed a superior performance over their respective sectorial peers." Since 1996, this superior performance amounts to 8% per year. In Deltic's case, it has whooped its peers in paper and forestry, and it has trounced the popular indexes.
If that superior performance is fundamental, e.g., growth in earnings or shareholder's capital, great. If they are talking stock price -- which they appear to be in this case -- then one needs to check out whether the fundamentals truly support the stock's outperformance. Insider control can be a double-edged sword. In theory, it could align management's interests with the public shareholders, free them from the Wall Street earnings growth game, and enable them to fully concentrate on maximizing true value. Does the name "Berkshire Hathaway" have a familiar ring to it? On the other hand, there are plenty of cases where when spared the possibility of being taken over or ousted, management of an insider controlled company (whether by dint of owning a hefty percentage of the shares, or by control of voting-class shares) rewards itself generously while achieving lousy returns on capital -- for years and years in some cases. You really want to know which case you are dealing with before investing.
So Deltic owns lots of timberland. The company also owns a couple of sawmills. Management maintains these facilities are state-of-the-art. These mills crank out all the sorts of things you would expect a mill to produce: lumber, boards, timbers, decking, finger-jointed studs, etc.
With the housing market falling like an old drunk down a flight of stairs, you might worry about buying a timber company. No doubt, housing woes do not help Deltic. Lumber prices keep slipping. ... Deltic's mills lost money last quarter. However, Deltic made a lot of money in its woodlands segment, in which it harvests timber. The company also has real estate development projects in Arkansas. These are upscale communities with golf courses and the other trappings upscale communities enjoy.
Lumber prices have continued to fall since the report's publication, and are now off almost 50% from the housing boom-driven highs. The company's most recent results are available from its Q3 2007 10-Q. An interesting factoid is that approximately 360 acres of "non-strategic" timberland was sold for $1,964 per acre during the quarter. Also, regarding the real estate segment, no commercial sales closed during the quarter, vs. approximately 53 acres at $246,300 per acre in Q3 2006. However, "interest in Deltic's commercial real estate, especially for multifamily use, remains strong."
Anyhow, this is not an earnings story. If you look at earnings, you see a price-earnings ratio of more than 50 times. [Now apx. 85.] Not cheap by the usual standards. In Deltic, the sum-of-the-parts value of the company's timberland assets, real estate projects and mills covers your investment, which limits your downside. But what is really exciting -- and what provides the upside -- is the potential for the mineral rights of Deltic's land. Namely, I am talking about the potential for natural gas under its trees. Secondly, the potential value of its lands' water rights. ...
Deltic owns 55,000 surface acres within an area known as the Fayetteville Shale Play. Southwestern is the leading energy company operating in this region. Its Web site defines the Fayetteville Shale Play:
"An unconventional gas reservoir located on the Arkansas side of the Arkoma Basin, ranging in thickness from 50-550 feet and ranging in depth from 1,500-6,500 feet. The shale is a Mississippian-age shale that is the geologic equivalent of the Caney Shale found on the Oklahoma side of the Arkoma Basin and the Barnett Shale found in north Texas."
Natural gas aficionados will recognize the equivalents, in particular Barnett Shale -- which some speculate may be the largest onshore gas field in the U.S. As for Arkoma, some call it Barnett's cousin. That leaves Fayetteville in good company. Fayetteville is a large area -- some 2,000 square miles.
Southwestern is already producing copious amounts of gas here. The area has also attracted substantial investments from Royal Dutch Shell and Chesapeake Energy. The latter has already leased more than 1 million acres.
As for Deltic, the potential for lease income from its shale properties is the cream on top for shareholders. In fact, Deltic has already leased 15,000 acres to exploration companies. For this, it gets small lease payments. However, if these exploration companies start to produce gas, then Deltic gets a much more significant royalty stream.
Deltic first disclosed this possibility in its 2005 10-K filing, published in March of last year. The market gave it rave reviews, sending the stock to new highs of $60 per share. But speculators are impatient. The stock drifted lower, and now you can pick some up for $50 per share [exactly where it is now].
I listened to Deltic's latest conference call. [The next one is scheduled for February 7 -- access to the call is available here.] In it, management said they were "anxiously awaiting the results of drilling." On this call, when it came time for questions, there were none. Not a single analyst follows this stock. Good for us.
Very good. In the early 1980s I recall reading up, from a source long since forgotten, on the techniques of a very successful fundamental investor. If he checked out an idea and found it had no analyst coverage he considered that extremely bullish. When publicity and exposure is zero there is no place to go but up.
In its latest quarterly report [Q1 2007, evidently], Deltic disclosed that it sold 680 acres to Central Arkansas Water for $8.2 million, or $12,000 per acre. Again, we must speculate as to how valuable Deltic's water rights may be. Arkansas water rights are not as valuable as Nevada water rights, but they have value. That value ought to rise in the new water-constrained world we are only beginning to see and experience.
In any case, putting a value on Deltic means lots of estimates and guesswork. But when the guesswork gets me numbers comfortably above today's stock price, even on the low end, I get excited.
Timberland at only $1,000 per acre -- which is 20% less than what large tracts of forest have sold for lately -- gives you $437 million right way, or about $36 per share. Then you add in the real estate developments, land and mills -- and you can tack on another $30 per share. That gets you to $66. Take out the debt and you get about $60 per share in a conservative -- and growing -- net asset value.
That does not include any estimate for gas or water rights. Assuming the company produces gas only on the 15,000 acres it has leased gets you another $15 per share or so. Should it produce gas on all 55,000 acres, you get an astronomical figure of around $50 per share. That would double Deltic's share price. And I have not yet guessed at the water.
Timberland may be out of favor today, but it remains a desirable asset. According to this source, nominal rates of return for timberland have averaged 9 to 12%. "University research" supposedly indicates that intensive timber management can produce 12-15% nominal rates of return. In a world where the whole concept of the dollar as a standard of value is up in the air, timberland looks like a good store of real value. The mills might be another matter. And the real estate related developments and land may be going nowhere for a while, although Arkansas was hardly the epicenter of the real estate boom.
According to the Q3 2007 10-Q, Deltic has now "leased approximately 26,000 net mineral acres in [the Fayetteville Shale Play] to various exploration enterprises and has received applicable lease bonus payments in addition to the possibility of future royalty income should production be established. ... [F]uture leasing will probably not be significant unless the defined boundary of the Play expands. The ultimate benefit to Deltic from these mineral leases is contingent on the successful extraction and sale of natural gas from the area." So the outcome there is still uncertain. If the play turns out to have gas in any quantity, recall from this entry in a previous blog that at least one analyst considers natural gas the most promising commodity bet of 2008.
You have a proven operator anyway, even if none of this pans out -- Deltic Timber itself is a wealth-creating business. It has many of the things we look for -- chiefly, lots of tangible assets supporting your investment and a strong financial condition. In addition, we have got strong insider ownership. But best of all, we have got a cheap backdoor play into a promising natural gas and water play.
Deltic's shares are not very liquid. Buy a small amount now and ease in for some more shares as the year goes by. Be patient. It will not double overnight. We are waiting for lightning to strike the pines, so to speak. Look for those drilling results sometime late this year. [We are still waiting.] And be in position to reap the rewards. ...
A REBUTTAL TO RANDY NEWMAN
Short people do got reason to live.
"Selling a soybean contract short is worth two years at the Harvard Business School." ~~ Robert Stovall
Short selling is a tough way to make a buck. You need to be right, and your timing has to be reasonably good too. An unleveraged long position can lose you at most 100% of your investment. If what you bought is backed by something of real value the chances are that you will not suffer the permanent loss of anything close to that.
A stock sold short, on the other hand, can rise without limit. No matter how irrationally overpriced a stock is, it can still rise another 100% ... or 200% ... or 300% ... and more. Shorting into a mania is a sure-fire to turn a large fortune into a small fortune. Recall the dot-com stocks ca. 1998 that were worth nothing but selling at $X, which then went to $X*10 before disappearing off the map. As Vince Lombardi would have said, in short selling timing isn't everything; it's the only thing.
This is not advice to avoid short selling entirely. Just to be careful. Fear is a stronger emotion than greed, so stocks are biased towards falling faster than they rise. And when, e.g., fraudulent or excessively optimistic accounting is suddenly revealed, a highflyer can fall to near zero overnight. Add in that during the credit bubble that is only now deflating there has been a lot of way overly-optimistic or outright fraudulent accounting, with tons of leverage to boot. Many credit bubble stocks have already collapsed, but there is surely more from where that came from. Bottom line is, with the right skillset and mindset, you can make a lot of money quickly.
A benefit of adopting a mentality of looking out for short sale opportunities is this: During a bear market, while everyone around you is lamenting their losses, the gains in your shorts can be offsetting or surpassing the losses in your longs. When the market bottom comes you will not be too traumatized to step in and buy. Every rise and fall becomes a chance to make money. But always keep in mind the very real risks.
Herewith is Whiskey & Gunpowder's say on things short:
In 1977, pop musician Randy Newman released a surprise hit song entitled "Short People". In the lyrics for this satirical novelty song, Mr. Newman lists the flaws and "shortcomings" of the smallest of our fellow men. The song focuses on a repeating chorus of "Short people got no reason, no reason to live."
As could be expected, many of the vertically challenged among us took great offense to the theme and insults of this song. [Markedly short pop songwriter Paul Williams opined at the time that he thought the song was "rather long".] Newman has maintained that the song was written for irony's sake, yet he has still lost some big supporters who happened to come in small packages.
Now more than 30 years later, people are getting back at Randy Newman. We are seeing short people cropping up everywhere these days, and not just the ones shopping at GapKids.
nvestors, many very successful, are increasingly becoming short people, and anyone can do it. ... [E]ven someone as tall as Yao Ming can be a successful short person. All you have to do is have an eye for what will work, but especially an eye for what won't.
Choosing a stock that is poised to rise is a fundamental part of investing. It is something we are taught immediately when we learn about stock markets and the financial industry. But of course, that is only part of the game. Seeing something that will go down can be just as lucrative, if not more so. This is what is known as "shorting."
The practice of selling something short can sometimes be [a difficult practical matter], but the thought process behind it is actually quite simple. When you short a stock, you are basically just betting that the price will soon go down. Like all good investments, it does take a lot of skill and some luck to really be a success, but it certainly offers you a terrific play to make when the markets are in decline.
If you want to short a stock, the first thing you do is contact your broker. Let us say that you think the value for Stock X is far too high and it will soon go down. For example, imagine that Stock X is currently priced at $50. You tell your broker that you would like to short 100 shares of Stock X at its current price.
What happens now is your broker will go out and borrow 100 shares of Stock X from his own inventory or from another brokerage, with the guarantee that the shares will be returned at a specific time. Of course, you will have to pay interest on that borrowing, but that is where the relationship with any other brokerage ends.
Now your broker takes those 100 shares and sells them for $50 dollars each. You now have $5,000 dollars in your account that you have borrowed and will need to pay interest on. If you decide to short this stock for April 2008, that money will sit in your account until that date waiting to buy those shares back.
This is the time when your heart rate may increase a few beats per minute. You may notice some excess sweat on your brow as you wait for your short date to arrive. If you are wrong and the stock price actually goes up, you will wind up paying more money to repurchase the shares than you originally could have in originally.
But if you have made a wise decision, you will not have to. For our example, imagine that the price of Stock X has fallen, and fallen considerably. The price is now $30, instead of the original $50. This is a sharp decline, but nothing we have not seen before. Your April short date finally arrives, and you are now permitted to exhale. Your short option was a success, and now your broker will gladly repurchase those same 100 shares for the much-discounted price of $30.
The shares are repaid to the broker's inventory or separate brokerage house without any explanation or report necessary. Your account now has a balance of $2,000 left, and that is all yours. ... Your gamble paid off, and you are now $2,000 richer [minus commissions].
Those are the mechanical basics. Instead of buying low and selling high, in that order, you sell high and buy low, in that order. That is the theory. In practice some stocks are difficult to borrow and the trade cannot be executed as planned.
The story of Stock X is a simplified and ideal example of shorting. First of all, I was fairly certain the example was going to work out while I was writing it. Second, Stock X exists in an imaginary sector of the market. Those are the easiest to predict. In real life, things get more complicated, but they are still quite manageable.
Finding which stocks to short will take some practice and may not be for beginning investors. But if you have some experience with investing and can see which way the winds are blowing, you are already ahead of the game.
First, pick a company that may be going through some turmoil or management trouble. You may be able to predict that this company will lose value. You can be especially confident if that company exists in a segment of the market that is also in trouble. The combination of bad management and a downturn for the entire industry often leads to incredible short gains.
Think of a once-successful company in the retail garment industry. Maybe this company is in the midst of figuring out where it fits in the market. Its sales have gone down recently and the people at the top have still not figured out how to salvage the business model. This looks like the kind of company you could short, but there is still a big risk. What if management figures it out and the stock shoots way up overnight? You would be left out to dry because of that unforeseeable event.
This is where you have to do some thinking. If you look at the retail industry right now, you can see that it is a troubled market. Lackluster sales in November and December, when the retailers need sales the most, have given people a very dour forecast for retail markets in 2008. Now you have your two ingredients.
You have a struggling company still living off of past reputation that does not yet fit with a changing world. You have a market segment struggling as a whole and desperately searching for a way to rebound. This is the kind of company you can short, and feel pretty confident in doing it.
This retail example is what one might think of as a "fundamental short": overvalued with disappointing -- but probably not catastophic bankruptcy-producing -- results anticipated. Declining earnings and a declining earnings multiple will produce a nicely (for the shorts) declining stock. A real life short story of this general idea follows in the next journal entry.
Now that you know all the tools to become a short person, you can finally be a winner simply by identifying losers. Get out there and stand tall as a successful short person. Randy Newman may not think so, but short people have plenty of reasons to live, and live well.
A Short Story
A different Whiskey & Gunpowder author follows up (presumably intentionally) the piece on short selling above with a possible short sale candidate -- credit boom beneficiary Bankrate, Inc.
Think of the last time you bought a house or refinanced a mortgage. How did you decide on where to get your mortgage? Many mortgage shoppers who compare quotes online discover a stunning array of choices. This development has placed consumers in the driver's seat when it comes to choosing a loan. Since banks have few tools to differentiate their money from their competitors' money, they usually compete by offering the lowest possible interest rate.
At the right price, or interest rate, nearly anyone can get a loan for nearly anything these days. The Internet offers endless information from every imaginable bank, credit union or auto finance company. The value of interest rate information is hard to define. We can safely assume it is not very valuable when it is freely available from multiple sources, and dozens of media channels clamor to offer the same information -- in return for a small commission from bankers.
This business model is fairly simple. It is the business model of Bankrate, Inc. (RATE: NASDAQ). Just like AutoTrader.com funnels car-shopping traffic to car dealers for a fee, Bankrate directs Web traffic to mortgage brokers and bankers for a fee. This is how Bankrate makes its money. It generates sales leads for bankers in exchange for "per click" fees.
Considering that Bankrate does little more than publish interest rate data, why should its stock sell for so many times its earnings? Could such a Web site have a lasting competitive advantage? Why couldn't sites with far larger audiences -- like MSN Money, Yahoo Finance or Google Finance -- chip away at Bankrate's core high-margin business?
More importantly, since Bankrate's customer base is in the midst of a nasty downturn, is it reasonable for the 17 analysts covering RATE to expect 150% earnings growth in 2007 and 20% earnings growth in 2008? I do not think it is.
Bankrate exhibits several traits of what you want to look for in a short sale:
- An expensive stock price.
- A contracting customer base.
- A history of making value-destroying acquisitions.
- Aggressive accounting.
- A very generous stock option program.
The short case certainly seems to be hitting on most if not all cylinders here. But during the bull market in credit it went to the sky, rationally valued or not. So why is the timing right now?
Bankrate is a pricey stock. Given its stratospheric valuation, the market expects Bankrate to deliver blistering sales growth as far as the eye can see. Keep in mind that making a profit on the short side of Bankrate stock is not a bet that business will fall apart overnight; a successful short sale only requires the market to lower its expectation of Bankrate's growth potential just a bit.
In my view, the market is paying way too much for this business, given the numerous threats to Bankrate's rapid growth story. Googling the word "mortgage" turns up a very long list of Web sites offering quotes, with Bankrate in the middle. LendingTree, E-Loan, Quicken Loans and even ABN AMRO and Wells Fargo are listed above Bankrate's site.
It is hard for Bankrate to make the case to its core advertisers that most of the leads it delivers to them are not simply generated in a random fashion. So I do not buy management's case that it can gradually raise prices for its leads over time. Bankrate will remain at the mercy of whatever its big bank customers are willing to pay per "click lead". Also, the more Bankrate tries to raise prices, the more competition it will invite.
As Internet users grow more sophisticated over time, it is reasonable to expect that loan shoppers will search more and more Web sites for quotes. The growth of shopping for loans online benefits the consumers of loan information far more than it ever will the producers of this information.
Everything so far makes a good case that RATE is overvalued. The author then details two recent "value-destroying acquisitions", and notes that company management has indicated it intends to spend the companies considerable cash pile on more acquisitions -- not a positive in view of their history. He also notes that cash came from a secondary stock offering, not from operations -- an offering in which insiders took the opportunity to cash out of $16 million worth of stock. The very fact that management is looking for acquisitions means that organic growth opportunities are getting scarce, and growth-by-acquisition is usually more risky and slower than internally generated growth. (Not always, as some great growth stories have arisen from a public company consolidating smaller competitors. That is not the case here.)
Not only have acquisitions been disappointing and masked decelerating organic growth, but the sheer size of them in relation to Bankrate's business allowed management plenty of leeway to adjust various accounts in financial statements.
Perhaps the most glaring sign of poor earnings quality is [that] ... [u]p until the most recent quarter ending in June, accounts receivable (A/R) had been growing significantly faster than sales for a long time. This is a classic sign that earnings have been getting a boost from aggressive accounting practices.
This could be a sign of customers stretching out their payment periods, rising delinquencies, or the aggressive recognition of sales before the would-be customer is truly on the hook. Whatever the case, it takes cash to fund the receivables buildup. Earnings growing consistently faster than cash flow, or in the face of negative cashflow (think Enron), is a suspicious situation on the face of it.
One share of Bankrate stock is a claim on the cash per share that the company ultimately generates. Thanks to an egregious stock options program, the number of shares outstanding is expanding rapidly, so the cash flow per share faces a major head wind. ...
Bankrate's cash flow is sliced up and served to more and more shareholders each year. The company has issued options to its executives at an average annual rate of 7% of outstanding shares over the past three years. As a company controlled by the board and management, this policy is likely to continue. It is obvious that executives are enriching themselves at the expense of shareholders, because net income must grow 7% per year just to keep earnings per share growth at 0%.
These are all clues of a stock that is on its way down. Keep an eye out for companies like this and you will be sure to spot many more short options. You will need to do your research, but symptoms of a good short rarely ever lie.
As Henry David Thoreau said, sometimes circumstantial evidence is pretty compelling, like when you find a trout in the milk! The short case for Bankrate is rather compelling so far. With a P/E of over 40 and with the stock still selling near its all-time high -- but having labored near that high for two years rather than being in a marked uptrend -- the case is stronger still. It also trades an average volume of over half a million shares per day, so liquidity should not be an issue. Good example.
BERKSHIRE HATHAWAY ANNUAL MEETING 2007 NOTES (PART 1)
In about three months thousands of investors will make a pilgrimage to Berkshire Hathaway's 2008 annual meeting in Omaha, Nebraska in order to imbibe firsthand the truly exceptional wisdom of Warren Buffett and Charlie Munger. Below is a subset of some notes from the question and answer session following the 2007 annual meeting. The session covered a huge number of issues relevant to today's and any day's finacial arena. Original notes were recorded on May 7, 2007 by two gentlemen named Alex Dumortier and Jim Gillies -- who deserve thanks for the manifestly thorough job they did.
Q: I am a little disturbed by remarks by John Templeton, who says that you are being narrow-sighted by not investing more overseas. What would it take for you to go truly global by investing globally?
Warren Buffett: It is not that we haven't looked at marketable securities internationally. We've made some investments. In terms of buying entire businesses, we simply weren't on the radar screen to the same degree that we are in the United States. Thanks to Eitan Wertheimer Chairman of Iscar? -- he contributed to getting us better known. We have no bias to buying marketable securities or whole businesses outside of the United States. We can be very validly criticized for not being better known on that radar screen. We have a selling job to do. Eitan Wertheimer is helping to get Berkshire even better known -- we'll be participating over the next six to eight months in some international sales jobs with Eitan.
We are improving though, we own a number of non-U.S. securities -- including two companies in Germany. We own 4% of Posco South Korean steelmaker?. Don't like to have to report things on a 13-F. In Germany, laws are that if holdings exceed 3% we have to report them. For a company with a market capitalization of $3 billion, 3% represents only $300 million. That 3% threshold is a real minus to us in terms of accumulating shares; we would have to tell the world what we are doing -- not one our favorite activities. It tends to screw up our plans.
Charlie Munger: John Templeton made a fortune going into Japan early and having stocks going up to 30-40 times earnings and that was an admirable piece of investing, but we did all right in the same period.
Typical Charlie Munger drollery here. "All right" is a fair candidate for the understatement of this still-young century.
On the issue of out-of-control executive compensation among the managements of public companies:
CM: Address the problem of unfairness of executive compensation ...
WB: There are more problems with having the wrong manager than with having the wrong compensation system. Any compensation sins are generally of minor importance compared to the sin of having someone who is mediocre running a large company.
That said, there is a natural tendency to "ratchet," and a lack of intensity in the bargaining process. Compare the negotiation of executive pay to collective bargaining with unions on behalf of workers. When have you heard of a compensation committee working until 4 a.m., walking out on negotiations, each side going to the press and declaring an impasse. It just doesn't happen. It is basically play money. I have been on 19 boards and only one compensation committee -- they subsequently regretted that. They want cocker spaniels with their tails wagging, not Dobermans.
What drives a lot of this is envy. I saw this on Wall Street. You could pay someone $2 million and he'd be content until he found out the person next to him was paid $2.1 million and then he'd be miserable. As Charlie said, envy is the dumbest of the seven deadly sins, because you are the one that feels awful -- there is upside to all the others.
CM: The process is contributed to by a wonderful group of people called compensation consultants. That reminds me of the story of the mother who asks her young boy why he told the census taker that his father is serving a jail sentence for fraud. He replies that he didn't want to tell him that he is, in fact, a compensation consultant. ...
[WB:] Back to the issue of compensation. Compensation is not rocket science. We compensate employees based on things that are under their control. Oil executives should not be compensated based on the price of oil, which they have nothing to do with. Now, finding costs that are within executives' control -- someone who can find and extract oil for $6 a barrel, rather than $12 a barrel is worth a lot of money.
CM: If the trappings of power are abused, you'd find a correlation that these companies would be disappointing to investors. All these things can be abused. The best way to tackle this is to provide examples of contrary behavior. The Roman emperor who presided over the greatest period of felicity in the Roman Empire is Marcus Aurelius, who had none of the trappings of wealth, even though he had access to all of them.
On how Berkshire Hathaway would be effected by a big credit contraction:
Q: Can you explain the impact and benefits of a credit contraction on Berkshire?
WB: We do benefit when others suffer -- times of chaos in the financial markets. The junk bond market in 2002, equities in 1974 ... You won't see a bit of "step on the brakes." This is good for Berkshire.
You could very well see an exogenous event that feeds on itself and could result in a huge widening of credit spreads. If you go back several decades ago when credit contracted, it really was not available. We went to the banks, and they would not lend to us. You had real credit contractions then. The only people who would lend to us were in Kuwait and they were only willing to lend us Kuwaiti dinar. Unfortunately, we were concerned that if we were to borrow from them, once it came time to repay our loan, those people might tell us what the dinar was worth in U.S. dollars. ...
CM: The last time we had a credit crunch, we made $3 or $4 billion. I would predict if we really had a big credit contraction after this period that has created so much envy and resentment, we would probably get legislation that many of us would not like.
WB: [The first 100 days after Franklin D. Roosevelt took over, he] got any legislation passed that he wanted because of the dire straits of the times. Nobody wants that to come back. We've learned a lot. I doubt we will see an orchestrated capital contract. In 1998 during the Russian debt crisis and the implosion of Long-Term Capital Management, there was a seize-up in the credit market that was not orchestrated by the Fed. You had some really extraordinary things happening in credit markets, because people were panicking or they thought that other people were going to panic. We will have other events like that again, not exactly the same. As Mark Twain said: "History doesn't repeat itself ... but it rhymes."
We are now well into a credit market "event". Buffett and Munger's actions will soon get a chance to speak for themselves. This coming annual meeting should be an interesting one.
On the extraordinary corporate profitability in recent history, particularly (theretofore) among financial companies:
Q: Corporate profits are very high as a share of labor. Does that make it very challenging for you to find investment opportunities?
WB: I have been amazed that corporate profits have jumped up. When they get up to 8%+ of GDP, that is very high and that has caused no reaction. One possible reaction could be higher corporate tax rates.
Corporate profits have been rising as a percent of GDP and you are quite correct that the share of labor has been falling. Whether that becomes an issue in the next elections ... Congress has the power to do that very quickly -- corporate tax rates were 52% not that long ago. You have companies making 25% on tangible equity when long-term bonds are paying 4.75%. That means that someone else's share of GDP is going down (i.e., labor's share). That could become a political issue; it could be something that Congress does something about. Corporate America is living in the best of all worlds ... history shows that that does not last. I do not expect that to continue.
CM: Of course, a lot of the profits are not in the retailing sector, or the manufacturing sector -- a lot of them are in the financial sector: investment banks, investment management, and private equity, to a degree that is unprecedented.
WB: If you had told us that in a 4.75% bond world, that bank after bank would be making 20% return on equity, we would have said that that was not sustainable. I would bet that there have not been more than two or three years in the last 75 years in which profits have been this high.
Remember all this was said last May. U.S. banks are now reporting big drops in profitability, if not losses. A lot of the decline is from additions to loan loss reserves. In other words, the original reported profits were substantially overstated due to the failure to sufficiently reserve up front -- which would have been the proper time. The 20% ROEs were illusory.
CM: Other companies that have pushed consumer credit so hard, have had big trouble (see South Korea in 1997/1998). I do not think this is the time to "swing for the fences."
WB: And what it did was create some of the cheapest companies ever seen. Things do turn around in financial markets. You will see everything and then some if you are young enough. A lot of people -- they are very smart -- but they are just not wired to think about problems that they have never experienced.
Q: Do you think gambling companies will have a great future?
WB: Gambling companies will have a great future as long as they are legal. People like to gamble and they do so in stocks, incidentally. Day-trading came very close to meeting the standards of gambling. The human propensity to gamble is huge. If the Super Bowl is on -- or even a bad game -- you enjoy more if there's a few bucks on the game. We insure against hurricanes, so I watch The Weather Channel.
When the states found out what a great source of revenue it is, they made it easier and easier to gamble. I put a slot machine on the third floor of my home and I could give my kids any amount (in dimes) and I would have it back by the evening.
To quite an extent, gambling is a tax on ignorance. I find it socially revolting when the government preys on the ignorance of its citizenry. When the government makes it easy for people to take their Social Security checks and pull slot machine handles, it relieves taxes on those who don't fall for it. It is not government at its best.
But it is government at its arch typical. Having a comparatively benign view of government is one of Buffett's blind spots. It is a likely inevitable effect of having rubbed elbows with high level mucky-mucks for so long. It does not seem to affect his business judgement or success. In fact his connections have certainly contributed to his financial success.
CM: The casinos use clever psychological tricks for people to hurt themselves. It is a dirty business and I don't think you will find a casino soon in Berkshire Hathaway.
A classic quote from all-time-great sports writer Blackie Sherrod: "If you bet on a horse, that's gambling. If you be you can make three spades, that's entertainment. If you bet cotton will go up three points, that's business. See the difference?" What would he call writing insurance?
Advice for a young person just starting out in investing:
Q: I am 17 years old and this is my tenth consecutive meeting. What is the best way to become a better investor? Should I get an MBA or get more work experience, etc.?
WB: Read as much as you can -- and not just limited to investing. I don't think there is anything like reading -- you have to fill up your mind with various competing thoughts and sort out what makes sense over time. The earlier you start, the better -- you need to read a lot to see which ideas jump out at you. Once you have done all that, you have to jump in the water, because the difference between investing real money and reading about investing is like the difference between reading a romance novel and ... doing something else. (Laughter) Read and then do some of it yourself.
CM: The whole idea of owning a business is critical. [Berkshire Hathaway Director] Sandy Gottesman runs a large and successful investment company. When a young man comes to Sandy looking for a job, he asks them a very simple question: "What do you own and why do you own it?" If you have not been interested enough to know the answer to that question, he'd rather you go somewhere else.
WB: Sandy would follow it up with questions that would make you defend why you thought the business was cheap and why you were buying it. If can't explain why you own what you own, you have no business owning shares.
What is the right margin of safety for a given business?:
Q: How do you judge the right margin of safety to invest in a variety of common stocks? If it is 10% for a longstanding, stable business, how do you increase it for a weaker business?
WB: We do not try to compensate for problems with a huge margin of safety. We favor businesses where we think we know the answer. If things are so chancy that we cannot come up with a figure, we move on. We want to buy a business that is a great business -- one which will earn very high returns of capital employed over a long period of time, and where the management will treat us right. See's Candy, for example, or Coke, as a stock. We do not need a huge margin of safety in those cases because we do not think we will be wrong. So we do not need to mark the price down -- for those businesses, we will pay $1 for a $1 of present value -- we don't like to, but we will pay pretty close to that.
If you see someone walking in the door, and you can't tell if they are 300 lbs or 320 lbs, you can still see that they are fat. It is those kinds of "fat" pitches that you want.
CM: The concept of margin of safety boils down to getting more for your money than what you are paying.
The phrase "margin of safety" was invented by Buffett mentor Benjamin Graham, in effect the Columbus of fundamental value investing. He did not "discover" it, but he introduced it to a whole new audience.
Q: Given your experience in underwriting insurance, any thoughts on helping to solve the health-care mess?
CM: It's too tough! Warren and I can't solve that one.
WB: We try to look for easy problems -- you can do that in investing. We do not go around looking for tough problems. We do very little in health insurance. If we were looking for solution in the private sector, we would look for one with very low distribution costs. Charlie's view reflects mine at present.
John Quincy Adams, in a very different time in history, said that America did not go abroad in search of monsters to destroy. Buffett and Munger follow an analogous philosophy in that they only take on problems and ventures, within a defined set of criteria, which they think will add value to their operations. As Buffett says below, in a slightly different context, they do not think they have to have an opinion on everything, or on any one thing at all times. They have measurable goals, which in the end, if achieved, lead to generating a positive cash return on capital tied up (after subtracting the opportunity cost of that capital). And, what is not said at this moment in the session, if they discover they were wrong they get out and move on. If Buffett had pursued the U.S. government's typical MO to his original investment in Berkshire Hathaway instead of the course he did, he would still be sinking money into a loss-making New England textile mill. Everyone would be wondering how he went so far astray after his legendary investment coups in the '60s.
On Berkshire's intrinsic value, why it has grown so well for so long, and whether the growth will continued post-Buffett:
WB: The intrinsic value of Berkshire is based on the future amount of cash that can be expected to be delivered by the business from now until Judgment Day, discounted at the proper rate. That is pretty nebulous.
The other approach is to figure out the value of the businesses owned presently. We give you info so that you can figure it out. We own a lot of marketable securities -- it is safe to say that they are probably worth more or less what they are carried for. Plus the operating businesses, and what we think they are worth. Berkshire retains all earnings, but becomes a judgment on what future business is worth. Look back to early Berkshire days, it was worth maybe $12 plus the value of the skill of use of retained earnings. The skill with which retained earnings would be used determines the value of the company. If put to work effectively, then each dollar retained has a greater potential value than simply $1 today that could be distributed to shareholders.
If Charlie and I were to write down what we thought Berkshire is worth on a piece of paper, it would not be the same figure, but it would be pretty close.
CM: What is hard to judge at Berkshire is the likelihood that the future will look anything like the past. Berkshire has been an "extreme" result. What on earth has caused this extreme record to go on for a very long time? I would argue that the young man who was reading everything he could get his hands on became a learning machine, then he got going early. Most people don't even try to create that kind of record. In this field, you improve when you are older; you get an enormous advantage from practice in this field. You shareholders benefited from a very long run by someone who just got better over time, because he was a ferocious learner.
WB: We have a very strong culture of rationality that will continue after I am not around. With our resources, we will keep doing intelligent things -- not spectacular. We will need somebody who does not do any dumb things and occasionally, does some smart things. That can be done.
On the dangers (and uses) of derivatives, and of the short term mind-set that dominates investing today:
Q: On the dangers of derivatives. You have referred to them as "weapons of financial mass destruction." Thoughts on how much longer this might go on, what might derail this bubble, and who should be doing what to mitigate this looming danger?
WB: There is nothing evil about derivatives themselves. We have 60-odd open contracts at this time, but the usage of them on an expanding basis introduces more and more leverage into the system and it is an invisible or largely invisible sort of leverage. If you go back to the 1920s, leverage contributed to the Crash and the extent of the Crash. ...
The introduction of derivatives has made any regulation of margin requirements a joke, an anachronism. We may not know at what point the danger begins, we don't know at what point it will end. We do believe it will go on until we see some very unpleasant things. You saw some examples of what happened from forced sales due to portfolio insurance in 1987.
Portfolio insurance was extolled by academics as a tremendous advance. It was a joke! It was simply a large scale series of automated, stop-loss orders. This was like throwing gasoline on fire. You have the same thing when fund operators who control trillions of dollars in notional principal are all waiting to respond to the same stimulus. It is a crowded trade -- not a formal crowded trade, per se -- but we will get a chaotic situation. I have no idea when that will happen -- I had no idea that shooting the Archduke would cause World War I.
Four years ago when we started to liquidate GenRe's portfolio, we had hundreds of millions set aside in reserves. We had auditors who can attest that the accounts were marked to market and I wish I had sold the positions to the auditors back then. We would have been better off by about $400 million or so.
CM: Accounting contributed enormously to the risk. Compensation for phoney profits is part of the problem. Those in charge of accounting standards say marking-to-market is better. Charlie chastised them, but was told he "just didn't understand accounting."
WB: I can guarantee that of our 60-some derivative contracts outstanding, the values at which they are carried and the amounts at which they are carried by the other side (the derivatives dealer) do not net out at zero. However, Berkshire Hathaway is not compensated based on the value of our derivatives positions.
The accounting legerdemain that has the two sides of a zero-sum game adding up to a positive number stikes us as one of a number of huge issues to work out in the current credit market troubles, all involving getting down to the truth of what is so. Until the accounting becomes honest, with losses properly acknowledged, the system will suffer from lack of confidence. Once things are clear everyone can lick their wounds and move on. With government so intimately involved in the workout, naturally people will try to use their involvement in the process to pawn their losses off on others, e.g., the taxpayers. This will elongate the workout timetable.
Q: The proliferation of short-term mindset in investing. With credit spreads declining and risk premiums decreasing and correlations increasing, is there a healthy dynamic at play?
WB: We do think it is unhealthy. If you take the percentage of bonds and stocks that are held by people who could change their minds tomorrow morning based on some kind of stimulus, the percentage is far higher than that held by long-term investors. There is an electronic herd of people managing huge amounts of money who believe that decisions on their portfolios need to be made on a daily or hourly basis.
There is nothing evil about this, but it is a different game than a buy-and-hold environment. If you are watching other market participants too closely, you need to hit that key faster than the other guy.
You have described a condition that we believe will cause the problem we were talking about earlier. Intelligent people do irrational things en masse. You will see it again, and you are more likely to see it when people are trying to beat markets day by day. When I set up the Buffett partnership in 1962, the market fell. I thought about sending my partners a letter from Brazil to see how they would react; I decided against it because some of them had weak hearts. (Laughter)
When we were at Salomon, people used to talk to us about five or six sigma events [a very large move that would/should be exceedingly rare]. That is fine when you are talking about flipping coins. But that does not apply when humans and human emotions are involved.
On calculating intrinsic value:
Q: How do you determine intrinsic value? Do you use a discounted cash flow or operating earnings multiples? What quantitative approach you use and how many years out do look?
CM: When you are trying to determine intrinsic value, there is no one easy method that can be applied by a computer. By definition, this is a game that must be played with multiple techniques and multiple models.
We are trying to figure out what these corporate "farms" will produce. To do that, you have to think about competitive dynamics. The mathematics of investment were set out by Aesop in 600 BC: "A bird in the hand is worth two in the bush." The questions you need to ask are: How soon do we get the two? Are there more? Which bushes should we buy?
CM: We have never had a system -- most go into the too hard pile, then we sift the ones that are easy. If you are looking for a way to easily evaluate all investments, we cannot help you.
WB: To determine the worth of a McDonald's stand, you have to think about the likelihood of McDonald's changing the franchise agreement and whether people will continue to eat hamburgers. After doing that, you can estimate the earnings in year one, and whether earnings will be a percentage amount higher the year after that. It is all about the evaluating the ability to distribute cash or the ability to reinvest that cash.
Are Chinese banks in danger of collapse?:
Q: Some observers have suggested that the Chinese banking system looks like the Japanese system in the 1990s. Do you think China is at risk of the same dislocations or is more resistant?
WB: I don't know the answer to that. I did not necessarily understand what was going on in Japan. My understanding of Chinese banks is essentially zero.
CM: Stop and think about it -- all of the remarkable progress that we have witnessed in China has been accomplished despite practices at the Chinese banks that you would make you shudder. The banks have been almost doling out money like aid. I would be leery of forecasting an imminent collapse in the Chinese banking sector; they have been doing this for a long time and they are getting better at it.
Is it time to get out of the stock market, as Buffett did in 1969?:
Q: At the head of a $10 billion pension fund, would your behavior reflect the same risk aversion that you displayed in 1969 when you unwound your partnership and do you think that we will see the same mouth-watering opportunities that came about in 1973-1974?
WB: My attitude would not be the same. I believed in 1969 that prospective returns would be about the same for equities and municipal bonds over the next decade and that turned out to be about right. [I] do not regard that the same is true today. If I had the choice between simply buying an index fund for 20 years or the long bond, I would prefer equities.
CM: I don't think that was the answer that was expected, but that is the answer.
WB: We don't have the faintest idea when stocks and bonds will be in three years. We do know what will do better over 20 years. We expect there will be some big disruptions over that period. Nice to have a lot of cash when disruption occurs. We bought $5 billion of equities in the first quarter and it is nothing close to what we were able to do in 1973-1974 in terms of prices, but we would rather own them than have them sitting in cash. We do not think about the market -- you can freeze yourself out that way.
To be continued next week, in Part 2.
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