Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest for Week of April 7, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.


It is bad out there on just about every front – and getting worse. But for some intrepid investors, there has never been a better time to jump in.

It takes rare courage to be willing to buy when the blood is running in the streets, said Nathan Rothschild, one of the founders of the famous/infamous Rothschild banking dynasty. The blood is running now, especially in the sectors most at the effect of the turn of the credit cycle from bubble to bust: financials, real estate, junk credit, etc. So now is a good time to be looking. And some big players are stepping up and buying. The same Rothschild, one of the most successful speculators ever, also famously said: "I never buy at the bottom and I always sell too soon." Implying that today's buyers are not making a timing call. They just see value.

There will be more foreclosures, more personal bankruptcies, more corporate writedowns, more layoffs. More companies will fail and get dismembered because they could not roll over their short-term debt. Consumer spending will probably fall further; home prices almost definitely will, a forecast built into derivatives prices.

For most economists and maybe most investors recession is no longer a question of if or when but how long. "One of the worst since World War II," predicts James B. Rogers Jr., a cofounder, with George Soros, of the Quantum Fund. It will be a long time, he says, before we recover from the "worst credit excesses in U.S. history."

In the credit market's flight to quality, second-tier borrowers are starved. Car rental outfits like Avis Budget Group and Dollar Thrifty rely on generous financing from automakers and off-balance-sheet entities to pay for their fleets, and neither source of capital is gushing at the moment. Businesses with sagging balance sheets include Landrys Restaurants, with $1.3 billion in long-term debt; Blockbuster, with $757 million; and newspaper publisher McClatchy, with $2.5 billion at a time when its readership and ad revenue are sinking

Wall Street and the economy are a mess. So maybe this is a good time to buy something. As the old adage goes, "When blood is running in the streets, the way to make money is to buy assets." The California State Teachers' Retirement System is following such advice. In mid-March, as shares of Bear Stearns collapsed, Calstrs was buying stocks. "We are fishing for opportunities," says Christopher Ailman, chief investment officer. He moved $2 billion of the $165 billion fund out of fixed income into equities and equity futures, including the s&p 500 and the Russell 3000.

Wilbur Ross recently committed over $3 billion to battered assets: municipal bonds, mortgage servicing and bond insurance. "Truly distressed situations are just beginning to manifest themselves in large size," he says. Ross should know: He made a fortune buying steel companies when they were disintegrating.

"In the 17 years my partners and I have been together, we have never been this excited," says Michael Psaros, who runs KPS Capital Partners, a New York City private equity money manager. Its latest fund, with $1.2 billion to put into midtier manufacturing and industrial companies, sat on the sidelines until November, when it bought the metal manufacturing unit of Olin Corp., then picked up the brass and copper unit of Bolton Metals Products. In March it acquired Delphi's bearings subsidiary.

There is other evidence of smart money on the buy side. According to InsiderScore.com, insiders at U.S.-listed stock companies have been increasing their stakes in their own companies for 23 consecutive weeks. Buying among higher-ups, including chief executives, directors and other insiders, has been running well ahead of historic averages, even in some of the most beaten-down sectors. "The biggest stocks in the S&P are as cheap relative to everything else as they have been in 70 years," says Barton Biggs, who manages Traxis Partners, a $1.6 billion New York City hedge fund. He is buying large-cap stocks and shorting U.S. Treasurys. He is betting, in other words, that most people are overvaluing safe things and undervaluing risky things. Hindsight may someday show that Biggs turned bullish too soon (this would not be the first time he made that mistake in his 40-year career). But it is certainly the case that there is more blood on the street, and stocks are cheaper, than a year ago.

That much is safe to assert. Those with more assets to put to work have to confine themselves to larger companies and cannot be as cute with their timing. Having said that, the $1.6 billion the Mr. Biggs manages is pocket change by today's standards. He neither has a strong need to buy now, nor does he need to concentrate on large-cap stocks. So his current activity is noteworthy.

You can always seek shelter from the storm, and retreat into two-year T notes paying all of 1.61% (when inflation is 4%). Or you can flirt with danger, and consider the exploits of seasoned adventurers who are taking on risk. Where the action is:

Financial Services [see table]

"This is as good as it ever gets," says Richard Pzena, who manages $21 billion for Pzena Investment Management, including the $5 billion John Hancock Classic Value Fund. That one got smacked last year, losing 14% of its net asset value by dint of its 40% exposure to financial companies, including Citigroup, its 2nd-largest holding. Even after Citi's scary $18 billion in writedowns and 55% plunge in market value over the last year, Pzena is doubling down on the stock, pointing to the strength of its credit card unit, wealth-management services and retail branches. "Most of the businesses are only modestly impacted by the crisis," says Pzena, who spent a decade in equities research at Sanford C. Bernstein and took over the Classic Value Fund in 1996. For those reasons, he is also buying shares of Bank of America and Lehman Brothers and acquiring bigger stakes of Freddie Mac and Fannie Mae. ...

With all due respect to Mr. Rzena, having 40% exposure to financials at the peak of a credit bubble and after the group had been in a 17 years or so bull run was not particularly street smart. Any resemblance of the financials to "value" was purely coincidental. You have to credit him with the courage of his convictions, but the financials are not where we would look for value now except for certain special situations, especially if acting in a fiduciary capacity on behalf of others.

John Linehan, portfolio manager of the $7.5 billion T. Rowe Price Value Fund ... often sits on stocks for five years. Lately, with a long horizon in mind, he has bought insurance giant American International Group, and considers it cheap at a recent $42.80. This, despite AIG's $11 billion writedown related to guarantees sold to fixed-income investors. Book value, he expects, will be $50 a share by 2010. "AIG is still a very reasonable story given its earnings capability," he says. He also likes Merrill Lynch, thanks to its army of retail brokers and its stakes in investment manager BlackRock and in Bloomberg, the financial information giant. "The sun is going to come out," Linehan insists. "You have to remind yourself when it's dark out there.

Not too dark for Wilbur Ross. In early March his W.L. Ross & Co. spent $1 billion or so to buy municipal bonds -- he will not specify which ones -- rocked by uncertainty over the insurers, like MBIA and Ambac, that guarantee them. He got them, he says, at "substantial discounts from par." Panic selling of some AAA-rated issues also made a shopper of William H. Gross, manager of the $124 billion PIMCO Total Return ... the world's largest bond fund. He picked up $1 billion-plus worth of munis, he says, in "a couple of hours" -- an unusual move, considering that the fund's many investors do not need the tax advantages of such bonds. Still, he apparently could not resist the yields. ... Gross picked up $100 million worth of April 2018 Goldman Sachs bonds, paying a taxable 6.15%. "Goldman and Merrill are under pressure," Gross says. "There are bargains everywhere."

Real Estate [see "shopping list"]

Since late last year a lot of big money has gone into sketchy mortgages and securities created from them. Latest entry: Lewis Ranieri, who more or less created the business of carving up Ginnie Mae mortgage securities into tranches when he worked at Salomon Brothers. He is in the midst of raising $2 billion for the Selene Fund to buy mortgages directly -- that is, some of the $4.2 trillion worth of troubled stand-alone loans that have not been repackaged and sold off but languish on the books of the biggest banks. The idea is to pick up mortgages at a steep discount from the banks and leave the owners in their homes by offering them new loans with reduced interest payments and principal amounts. Stanford Kurland, former president of Countrywide Financial, is pursuing a similar strategy with his reported $2 billion Private National Mortgage Acceptance Co., a newly announced joint venture between BlackRock and Highfields Capital Management.

Mr. Kurland certainly brings the virtue of firsthand knowledge of his field to the table. The ink is still drying on some of the discount mortages his company originated.

The housing meltdown has drawn a lot of players. Hedge funds ... are pouring billions of dollars into the game, some focusing on the $6.9 trillion worth of securitized first mortgages, others on stand-alones. Goldman Sachs reportedly launched a $1.8 billion Mortgage Credit Opportunities fund to invest in the housing market. Bill Gross's PIMCO is reportedly raising $2 billion for distressed debt. ...

You have to love Goldman. Make money creating a mess, then make more cleaning it up.

Wilbur Ross recently agreed to buy H&R Block's mortgage-servicing business, which handles $53 billion of outstanding mortgage balances. The sum going to Block is only $41 million, but Ross's investment fund will pour in another $940 million in new capital, which will be used to temporarily cover payments to lenders on behalf of late borrowers. The fund will be first in line in any foreclosures. Ross aims to recover these advances as borrowers make good on their loans, or their houses get sold off. He will try to offset the higher costs of servicing sour loans by boosting fees to homeowners and banks

What about commercial real estate? Occupancy rates and rents are still pretty healthy in most of America. That said, some value-minded investors who have avoided REITs are finally buying into the beaten-down shares. Investment manager RidgeWorth Capital Management, which manages $74 billion, has been dipping into REIT shares -- especially those of companies with downtown office buildings, like the 3.7%-yielding shares of S.L. Green Realty, which owns 25 million square feet of office space in New York City. "We are getting into Green's properties at $500 a square foot when they would sell for $800 to $1,200 a square foot on the open market," says fund manager Donald Wordell. ...


With consumer confidence scratching a 35-year low and dire predictions that Americans may start saving money again, instead of spending it, this is a terrible time to buy retail stocks. Except for one big thing: They are cheap. The S&P Retailing Index is down 25% from a year ago.

The retail industry is such a big, fragmented, and varied industry that it is not surprising some bottom fishers are looking here.

"Retailers have been massacred," says t2 Partners' Tilson. "We think this is when real money can be made." He started buying shares of Target at $65 last year and still likes it at a recent $49.69. Target represents 10% of his fund, a token of his faith that, within two years, earnings will recover and the stock price double, thanks to share buybacks and company expansion. Christopher Walsh, a retail analyst and money manager at Fred Alger Management ... loves the panic selling. "Expectations are so low," he says. "This is what we have been waiting for." He has bought a half dozen retailers like Kohl's, whose shares are down 47% from their 52-week high. Damn the recession; Kohl's is expanding and also signing up exclusive brands like the kitchenware designed by celebrity chef Bobby Flay.

Bookseller Borders Group shocked investors by grabbing a $43 million infusion from hedge fund Pershing Square. Shares of Borders quickly fell 40% to $4.20, half of tangible book value -- often a sign of impending bankruptcy. Tilson says sellers were right, that management is "inept," but reasoned that Borders throws off enough earnings before interest, taxes and depreciation to justify a tripling of the share price. He bought some shares at $4.72; they recently traded at $5.78.

Bernard Lirola, manager of the $175 million Needham Growth Fund in New York City, is a fan of retail, too. Stalking bargains is "like fly fishing," he says. "They pop up fast and don't last long." He has been buying shares in Luxottica, which sells eyeglasses through LensCrafters and shades via Sunglass Hut, despite recessionary angst that has sent the stock down 36% from its 52-week high. In the face of higher gas prices, he began picking up shares of CarMax, the car vendor (mostly used cars) in February, when they were trading at $19.50, down 30% from July 2007. No matter that short interest in the stock hovers near a 5-year high. With just 5% of the fragmented jalopy market, CarMax, Lirola figures, has lots of room to zoom. Insiders at AutoNation, the dealer network, have bought a net $259 million worth of company stock over the past year, including $40 million in the last month.

Distressed Assets [see table]

You cannot walk anywhere on Wall Street these days without stepping in some kind of toxic assets. Distressed debt funds raised $35 billion last year, reports Private Equity Intelligence, adding that there is $48 billion waiting on the sidelines. Some folks, like David Matlin, chief executive of MatlinPatterson Global Advisers, are not waiting. His Manhattan firm put $450 million into Thornburg Mortgage -- getting notes that yield 18% and warrants, at a penny each, that could add up to 19% of the rapidly collapsing residential lender. Thornburg shares have sunk 94% since August, to a recent $1.59. Still, as of December 31, Northern Trust Co. (with 4.9%) and Davis Selected Advisers (4.6%) were believers.

Fear is also carving out opportunity in securities backed up by mortgages on commercial real estate. Malon Wilkus, who runs American Capital Strategies, a publicly traded $19 billion buyout firm, has added $70 million worth of commercial-mortgage-backed securities over the last three months. The A- to BBB-- rated bonds, Wilkus says, are yielding 16% to 19% and have an astonishingly low default rate (0.5% of the loans). "It's just unbelievable," he says. "A recession will hurt, but prices are such it would take a depression before some of these securities would lose [principal]." They are cheap because sellers, many of them shaky hedge funds investing on credit, have held fire sales of even good assets to pay back worried lenders. What is more, the bonds are priced off a thinly traded derivatives market that has been massively shorted lately and so may have exaggerated the odds of default. "For those with capital, this is a great time," says Wilkus.

Junk [see table]

Spreads on junk bonds -- the difference in yields between corporate and comparable Treasury bonds -- have been climbing, from 2.4 percentage points in June to a recent 8 percentage points, as measured by Merrill Lynch's Master II High Yield Index (a collection of bonds with a weighted average credit rating of B1). Exploiting market jitters, late last year State Street Corp. launched a junk bond ETF (exchange-traded fund) called the SPDR Lehman High Yield Bond Fund. With $200 million in assets, the fund invests in out-of-favor debt from casino operator Harrah's (yielding 10.75%, maturing in 2016), Ford Motor Credit (9.75%, 2010) and the Hertz Corp. (8.875%, 2014).

You need an industrial-strength stomach. More and more junk is getting reclassified as "distressed" -- that is, offering yields at least 10 percentage points above yields on similar Treasurys. In January 11% of junk bonds were distressed; in late March, 22%. One issuer worth a look, says Martin Fridson, who heads high-yield research firm FridsonVision, is the battered newspaper chain McClatchy. While it is debt-load and long-term prospects are grim, Fridson thinks it can muddle through and recommends its bonds maturing in 2011 that yield a satisfyingly fat 15%.


Ken Fisher thinks Goldman’s demotion of perma-bull Abby Cohen is a buy signal.

Ken Fisher seems like a bit of a perma-bull himself, to his great financial and reputational benefit so far. But he says not so in this article. We have said it before, and undoubtedly will say it again: He gets the benefit of the doubt until he falls on his face.

I am getting a lot of hate email these days. This onslaught is not entirely a bad thing. It reassures me that my bet against the crowd is a wise one. I am bullish and have been steadily since the July 8, 2002 issue [of Forbes]. In my January 28 column [link] I reiterated the upbeat outlook and reminded you that the fourth year of a presidency only rarely delivers losses to stockholders. Now, with stocks globally (as measured by the Morgan Stanley All-Country World Index) down 8.6% so far this year, people are telling me I am an idiot. Someone posted to the Forbes Web site, "Hi Ken. It's been an absolute pleasure watching you vie for the 2008 Henry Blodget Award. Keep up the good work!"

Gloat for now, but please note that 2008 is not over. I still think the year will end in the plus column. And I am never happier than when I am alone.

My critics call me a perma-bull. They forget I called the last three full-fledged bear markets right here in Forbes -- reasonably well and better than most -- and mostly alone (June 15, 1987; November 27, 1989; February 19, 2001). [Pretty good calls.] I know I may be wrong now. But I see what has happened since January 1 as just a major correction, very comparable to 1998, with a few things flip-flopped, as described in my February 25 column [link].

On March 13 Goldman Sachs demoted market strategist Abby Cohen for having been bullish too long. That day marked the bottom of the back half of what I think is a double-bottom whose first bottom was in January. I see Goldman's move as bullish. That once famous market timer Joe Granville materialized out of nowhere saying that we are beginning a bad bear market. I would bet against Joe any time. Gloomy people are saying that we are in the midst of the worst financial crisis since the 1930s. They said the same thing in 1998. Bullish!

You cannot find a time in the 20th century when, less than five months into a real global bear market, people were talking bear market and recession in any visible numbers. But they always talk disaster during corrections. Check out "Russian Financial Crisis" on Wikipedia. The second sentence says 1998 was a "global recession ... which started with the Asian financial crisis in July 1997." Wrong. There was not a global recession then. There is not one now.

An old saw says, "You should be fearful when others are greedy and greedy when others are fearful." Clearly folks are fearful now. So you should be greedy. Another saw: "Buy when there is blood on the streets." There is plenty of blood, or at least depression, on Wall Street. So keep buying. As I have detailed in recent months, the market should be led by its biggest stocks. Here are four I like.

All my life General Motors (GM) and Ford Motor (F) have tried to go bankrupt. It takes them a long time because, even at this sorry task, they are not very competent. I have faith. They will eventually succeed, which will benefit Toyota (107, TM), the world's leading carmaker.

Toyota grows, increases profits and gains market share. It is cheap because people fear weak auto sales, high-price oil, the economy, credit crunches, Japan and their mother's shadow. But at less than 12 times likely earnings for the March 31, 2008 fiscal year and at 70% of annual revenue, you get one of the world's great megacap stocks. Some firms cannot get credit the way they did before. AAA-rated Toyota can get even more than before. This is an easy ride.

Fisher also likes: (1) British Petroleum (62, BP) at 9 times 2008 estimated earnings and a 4.4% yield. (2) Bear Stearns rescuer JPMorgan Chase (46, JPM) at 9 times 2008 estimated earnings and a 3.2% yield. And (3) Abbott Labs (55, ABT) at 15 times estimated 2008 earnings and a 2.4% yield.

These are all stocks a large cap value buyer could endorse. They could be expected to weather a bear market storm relatively well. So Fisher is talking bullish, but his actions indicate some caution.


The risk of a European fissure is underpriced in some countries’ bonds.

William Rees-Mogg has some interesting observations about a set of market statistics that gets very little publicity (we never have seen it mentioned before): the spread among the longer term government bond rates for the countries in the eurozone. Due to the stability of the spreads it is clear they are being fixed. Normally one would observe some fluctuations as the risk of a rupture in the EU waxed and waned. And, Ress-Mogg points out, the risk is currently waxing.

There is a table in the Financial Times that everyone ought to follow, though it refers to fixed interest securities and moves rather slowly. It is something I regard as a thinking point. It portrays one of the core relationships of global finance, and it is always worth asking oneself why the relationships are what they are, and why they have moved as they have moved.

The table is ... always to be found on the page labeled "Market Data," along with global equity prices, volatility indexes, and variegated statistics. It is labeled "Ten Year Gov't Bond Spreads." It lists the yields on 21 different government bonds, all with a 10-year life.

It gives the spread based on German bonds and on U.S. T-Bills, but its greatest interest is that it gives a Germanocentric view of the world. It makes very clear the central role of Germany in the eurozone, just as the deutsche mark had a central role in the Exchange Rate Mechanism before the European currencies, or most of them, converted to the euro.

Conveniently, the 10-year German bond, denominated in terms of euros, is the strongest of the euro bonds, and the only one that currently has a yield below 4%. The range of euro bonds is quite wide, though they are all an expression of the same currency. The most expensive euro bond is the German, which yields 3.96%. The cheapest is the Greek, which yields 4.46% -- precisely 0.5% above the German yield.

I do not know who fixes this market, but it looks as though someone does, and they do it in the interest of the euro as a currency. The German-Greek spread is remarkably stable. There seems to be an underlying determination not to allow the spread to widen to the point at which the euro itself would be threatened.

Clearly, the Greek bonds are overvalued in terms of long-term risk. There is no risk at all that Germany will have to leave the euro -- certainly no foreseeable risk. I suppose some explosion of the oil market might threaten the whole eurozone, as the oil shocks of the 1970s caused global inflation. But apart from that, one would have to invent terrorist fantasies to create a scenario in which Germany might be forced out of the euro system.

Not so with Greece, which has the weakest of the euro currencies. If Greece was not a member of the eurozone, Greek interest rates would presumably be higher than the 6% of Australia or New Zealand, on any normal financial criteria. Moreover, this applies to a tier of southern European countries in the eurozone. Greece yields 0.5% above Germany, but Italy is very close to that level, at 0.47%, as is Portugal. Only Spain, at 0.28%, is level with a central eurozone country such as Austria.

The risk that is being underpriced is the risk of two Europes. Politically, two Europes could come into being if German and British policy were to diverge, on the issue of federation -- the next British government may be more anti-federalist than the present one -- or in response to competition for oil supplies. Financially, the two Europes could come into existence because the southern four -- Greece, Italy, Spain, Portugal -- could no longer stand the strain of a high-priced euro.

At present, I would not myself put the two Europes as a very high risk, either on political or financial grounds. But the risk is there, and it is almost certainly underpriced, because of intervention, presumably by sources close to the European Central Bank. On a 10-year view -- and these are 10-year bonds -- I would put the two-Europe risk as significant. The Lisbon Treaty, which Britain will ratify without the government daring to have the promised referendum, will raise the two-Europe risk, rather than reduce it.


It might seem self-evident, but such things fade into the background during a credit boom: For a bank to have a competitive advantage worthy of the name, it must have access to cheaper than average funds (after deducting for all gathering costs) or be successful at making higher than average (post-loan losses) yielding loans. If a financial company whose business consists of borrowing funds on the wholesale market and lending into the highly competitive corporate, government, or mortage market -- this describes a lot of hedge funds as well -- is showing higher than average returns versus history or non-financial business, figure that the situation will not last. Likely the company is lending more to dicier risks, or has mismatched the durations of its deposits and loans and is susceptible to a long-term rate rise.

Despite our general skepticism regarding stepping in and buying financial stocks now, with a great credit unwind possibly still in its early stages, we can see the virtues of ones with good franchises. Banks good at expanding a low-cost deposit base have good franchises. You just have to be sure they do not fritter the benefits away with lax lending standards. With this in mind, top-ranked bank analyst Gary Townsend helped Forbes come up with a few banks that might be worth looking at. If you cannot resist the lure of bank stocks, this is a good place to start.

When Gary Townsend visits Manhattan, he often stops by the busy intersection of 55th and Sixth. On three of the corners are branches for some of the most influential U.S. banks: Citibank, Wachovia and Commerce Bank. After 15 years as a federal bank regulator and then 10 more as a banking analyst at Friedman, Billings, Ramsey & Co., Townsend sees things in those branches that others do not.

Bank stocks have been creamed lately, but Townsend knows that those with the strongest deposit expansion will be in great shape once the current unpleasantness ends. The banks that do it best are usually the smaller ones, with assets under $50 billion, because they are more focused on individual customers than the big boys who like dealing with sovereign nations and hedge funds (see table). Many of the best deposit growers have assets under $10 billion. "Deposit growth finances asset growth," he says. "Deposits are the growth engine."

It pays to listen to Townsend, 56, who has been a top-ranked analyst. Forbes.com named him 2007's best brokerage analyst for commercial banks, and analyst ranker StarMine has long placed him among the leading 10% of all analysts for stock picking and earnings forecast accuracy. He recently jumped from Friedman, Billings in November to cofound his own investment firm, Hill-Townsend Capital, which is in the process of launching a hedge fund.

When Townsend visits a branch, he counts the tellers on duty, the customers waiting in line and how long they take to get through. Much like a retail analyst who reviews same-store sales comparisons, Townsend studies federal reports to figure out how fast a bank is increasing its deposit base on a per-branch basis (for branches open at least two years). "Deposit growth takes talent," he says. "A lot of bankers are mediocre and can't do it well."

The smallish lenders like Commerce and Corus that are good at attracting deposits do so for a reason: These are cheap and fairly stable sources of funds. Most checking accounts pay no interest. Money market accounts and certificates of deposit pay around 3%. Nowadays banks must pay double that or more when they issue bonds.

Match up smallish Chicago lender Corus Bankshares (assets: $9 billion) and giant Citigroup ($2.2 trillion). Corus's deposits are 94% of total liabilities and Citi's are 40%. Citi can raise money in the commercial paper market; Corus cannot always do the same. But it is dangerous being an overnight borrower these days. Funds could dry up or get expensive overnight.

Deposits/liabilities and loans/deposits are good measures of a bank's deposit gathering abilities, and loan letting restraint.

Townsend's business partner is Vernon W. Hill II, 62, the deposed chairman of 470-branch Commerce Bancorp. Says Townsend about him: "He's controversial, but he also is very successful." Hill was criticized for directing company business to relatives, although it was fully disclosed. Amid a flurry of investigations, he stepped down last year. But look at what he accomplished. He founded Commerce Bank in 1974 with an initial investment of $1.5 million. Today its market value is $7.2 billion, as it prepares to be acquired by Canada's Toronto-Dominion (which will rename it TD Commerce).

Commerce and other retail-minded banks had a growth spurt in the 1990s. That was when the large banks were retreating from branches, convinced that the Web would render face-to-face banking obsolete. Turned out that on a matter as important as money, people still like to see the repository of their savings. The big banks figured out that 80% of their business was coming from 20% of their customers, who were primarily high-net-worth and commercial clients, so why bother catering to the masses with expensive operations? "The 80/20 rule became a fad," says Townsend. The result: Customer service deteriorated. The big banks are now, belatedly, rediscovering deposit capital.

Commerce draws in noncustomers by letting them use its free coin-sorting equipment and paper shredders. No frustration with chained-down pens that do not work -- at Commerce there are cups of ballpoints being given away. It has a notary (free) on the premises, and Commerce branches are open seven days a week. Something is working here. The branch on 55th, which opened 7 years ago, has deposits of $343 million. The Citibank branch across the street has only $131 million in deposits after 29 years in business.

It is too late to buy Commerce shares but not too late to look at the 290 other publicly traded banks with between $1 billion and $50 billion in assets. With help from Townsend, we picked out six with deposit growth of 10% or more yearly since 2003. While Townsend does not necessarily endorse these banks' stocks, they all appear to have solid franchises.

The best deposit gatherer of this bunch is Chicago's Corus, up an astounding 33% on average over the past five years. Like other lenders, it now is suffering from a surge in bad condo construction loans in places like Florida. Earnings fell 44% in 2007. But it is cheap. Every [$10 or so] share you buy of Corus gets you $14.35 of book value plus the potential profitability of $12.65 of deposits. (Corresponding numbers for JPMorgan Chase: A $43 share gets $37 of book value and $1.43 in deposit terms.)

Both in price/earnings and price/ book terms, the banks on our list are cheaper than the S&P 500. Many lost money in the most recent quarter, and some for all of 2007, because of bad mortgages and other credit woes. They will be back.


Every company expects a certain percentage of their receivables to go bad. If the percentage is small and the losses are realized quickly, the accounting treatment is routine. What if the percentages involve a nontrivial percentage of company capital, and the losses are realized over many years? This is the case with banks and other loan-making businesses, where a certain percentage of loans will default somewhere down the line. Similarly, although the action is on the liability side of the balance sheet in their case, insurance companies will pay out an indeterminate amount of claims sometime in the future -- perhaps more than a decade later with some "long tail" lines.

Prudent accounting treatment recognizes this fact of business, and financial accounting and tax rules mandate/allow an upfront deduction for future losses from current income. For a company focused on maximizing after-tax cash flow, as opposed to reported earnings, the incentive is to push that reserve for future losses as high as possible. Not surprisingly the IRS does not like that.

The SEC also frowns on such a practice. Why? Companies may want to set aside extra reserves in good times and later run the reserves down in tougher times. This will help the company report "smooth", predictable earnings so beloved by Wall Street, and possibly help the company garner a higher earnings multiple on its stock. In the SEC's eyes, the practice is dishonest, even though analysts are fully apprized of the changes in a company's loss reserves over time and can make their own assessment of earnings quality based on that.

And, astonishingly, the FDIC also discourages the practice. Accounting rules do not permit the building of reserves during good times, says the FDIC chairman. Classic bureaucratic ineptitude and shortsightedness. This is equivalent to your property insurer saying you cannot use your year-end bonus to add stronger locks and a better sprinkler system to your house.

The consequence was that bank loan loss reserves as a percentage of current nonperforming loans -- a rough measure of reserve adequacy -- fell to less than 100% recently. Clearly the reported bank earnings of the last few years benefited from the low reserve set-asides, and thus those earnings were of lower quality than in years past. And when loan losses took a sudden -- and predictable -- turn up last year and this, banks had to suddenly add significant reserves. Right when confidence in the banking industry is fragile and the credit cycle is at least in a cyclically weak period, banks have had to report big earnings reductions due to increased bad loans, given the lack of a reserve cushion to dip into.

As Forbes notes, something here does not add up. Addressing the issue abstractly, it provides more encouragement -- as if more were needed -- to focus on the short term at the expense of the long. Or, as Brave New World put it: "Was and will make me ill. I take a gram and only am." The outcome there was achieved by taking tablets of "soma", rather than the financial regulators' joy juice. Similar outcome.

When the history of the 2008 financial crisis is written, a decade-old Securities & Exchange Commission campaign to force banks to reduce their loan loss reserves may go down as one of the prime policy screwups that made things worse.

In 1998 the SEC forced SunTrust Banks to restate three years of financials by claiming it had used overly generous loan loss reserves as a cookie jar to smooth earnings. The crackdown effectively prompted financial institutions to limit reserves to one year's worth of expected losses, says Zach Gast, an analyst with RiskMetrics. It also set off a decadelong decline in reserves, which left banks with a record low reserve-to-loan ratio of 1.21% at the end of 2006 -- just in time for the housing bust to hit. Starting from a skimpy level, banks doubled loss reserves last year to $68 billion, but bad debt rose even faster (see chart).

Federal Deposit Insurance Corp. Chairman Sheila Bair told Congress in March that accounting rules do not permit banks to build reserves in a benign economic environment, forcing them to increase them when things turn bad. Notice to regulators: Something is cockeyed here.


In a tour de force of analysis and exposition, Sean Corrigan eviscerates the modern banking industry and justifiably lays at its doorstep the current financial markets crisis, as well as the unnecessary boom/bust cycles of times past. The banking business by its very nature is a government protected flim flam game that would not survive in a voluntary free market system. Ergo, claims that today's crisis is due to "market failure" is wrong to the core. (This is not to say that regulators could not be more intelligent about keeping the flim flam game operating in a less malign manner, per the posting immediately above. But that is a second-order consideration.)

With a certain weary inevitability, the cries of pain emanating from those seeing their aspirations ground to dust amid the current upheaval in financial markets have been interspersed with the shrill descant of those all too eager to proclaim a "crisis of capitalism." The implication that it is now time for those far-seeing, disinterested Solons in government to step forward once more and to put right what mere "market forces" have again so woefully failed to correct.

High finance, we are told, has become a business of "privatizing profit and socializing losses," a thoroughly inequitable mechanism which the state now has a duty to redress by erecting a whole new framework of Do's and Don'ts in order to rein in the 21st century's version of the Robber Barons.

With a breathtaking degree of effrontery, we are even being asked to take seriously the idea that the very institution which has been one of the most culpable in laying the groundwork for the disaster -- the Federal Reserve of pre-ordained, baby-step rate rises and skyscraper-ledge rate reductions -- should, henceforth, be accorded unparalleled powers of oversight and direction over every facet of our everyday business!

While the initial diagnosis is fairly unexceptionable -- since the game of "heads-I-win-tails-you-lose" is precisely what financial market institutions have long been conditioned to play -- the corollary is not. Nor is this just because politically opportune Witchfinders General tend to be more guilty of fighting the last war than even the most hidebound of generals; nor because the analogy is decidedly unfair to the original Robber Barons, many of whom grew rich by creating genuine wealth and not simply by living, often obscenely high on the hog, off that generated by others.

No, the whole concept of a "market failure" is a hoary old canard which it is vitally important to dispel for fear that an eager Leviathan will again exploit its subjects' understandable present anxieties in order permanently to increase its power over their lives and liberties.

If the basic tenets of free-market "capitalism" include the full recognition of property rights, the sanctity of voluntary contract, and the relegation of government to a minimalist role as arbiter -- and, reluctantly, as enforcer -- of last resort, it can hardly be argued that we have ever actually lived under such a regime. Indeed, the roots of today's woes -- as of those suffered innumerable times in the past -- lie not in whether this or that regulation was sufficiently well-crafted or implemented, but rather go deeper into the issue of whether banking as currently instituted is -- in any way, shape, or form -- an activity consonant with such principles.

If the very act of asking such a question sounds insupportably radical to modern ears, we would say, in our defence, that we are only following in an honorable, republican tradition which stretches all the way from Jefferson and Jackson to Ron Paul.

Not to mention it follows the path trod by many members of the much-vilified "conspiracy theorist" class, who so often place central banking at the center of the nexus of evil.

Firstly, the ability of banks to create money simply by making a book entry in favor of a borrower, without first asking whether anyone else would be willing to place their previously earned cash at the latter's disposal, is nothing other than a legalized act of counterfeiting or, if you prefer, an act of "watering" the stock of claims upon the totality of private property; of diluting the existing "shareholders" rights to the social product without their prior consent.

That such a practice of issuing monetary substitutes willy-nilly is the fons et origo of inflation (at least in countries where similarly forcing government liabilities into circulation does not predominate) should need little explanation. What might bear emphasis, though, is that if one considers the state's indulgence in such crude coin-clipping as a "tax" -- i.e., as a legal, if unethical (and often unconstitutional), act of expropriation, one is forced to conclude that the banking equivalent is nothing less than an unauthorized expropriation -- in other words, a theft.

Such a crime is no less worthy of outrage simply because it has long been officially sanctioned, even encouraged. Nor is it pardonable because there is no one, single, identifiable victim, for the truth is that we all suffer from such depredations -- or, at least, all of us excluding the initial borrower (able to spend the new money before the rest of us realize it should buy fewer goods than it does) and the issuing bankers themselves.

Secondly, the fact that depositors are led to believe that they do not relinquish any rights over the funds they entrust to the banks -- when, in fact, they are no more than the unsecured creditors of a commingled holding -- leads to the reprehensible business of promising demand account customers instant access to "their" cash, while being fully aware that such a promise is wholly fraudulent since the bulk of this "cash" will be rapidly deployed to "fund" any number of the long term, potentially illiquid ventures being undertaken by the bank's lending department.

That this "cash" can therefore only be repaid by luring other dupes into the scheme means that the whole businesses has its foundations in a further falsehood, one which seeks to make profit from what is little more than a typically lucrative, if undeclared, actuarial subterfuge. The fact is that, by some twisted thread of history, banks have been accorded the unjust privilege of being allowed to ignore the absolutely crucial lines of demarcation between four, wholly beneficial, but utterly distinct, roles.

Monies given into their possession in their guise as "giro", or transmission, agents, or as the custodians of what are, today, largely virtual safety deposit-boxes, are one thing: quite another are the resources entrusted to them in their equally laudable function as asset managers whose job is profitably to invest their customers' term deposits in a range of what are presumed to be creditworthy ventures.

A third -- individually irreproachable -- business is that of facilitating the raising and transfer of capital between customers; mobilizing savings, large and small, in order to fund entrepreneurial attempts at wealth creation, whether through arranging trade finance or by bringing issues to the bond and stock markets.

Finally, there is no intrinsic demerit to bankers speculating either with their own capital or, indeed, with that of those clients who are fully cognizant of the fact that their money will be used to bankroll an attempt to outguess other traders and to preempt changes in the valuation of securities, currencies, or commodities.

The underlying problem is that banks have been granted the right indiscriminately to mix all four of these often incompatible activities. This gives rise to an unhealthy promiscuity, corrupting their fiduciary duties, introducing irreconcilable conflicts of interest, and opening up countless opportunities for a wholly legal embezzlement which has a small, but significant, chance of going horribly awry -- as today's events have once more forcibly brought home.

Moreover, this is a world in which banking "capital" is a veritable Cheshire Cat of insubstantiality (since banks are unique in having little but their own debauched "money" on both sides of the balance sheet). That "capital" is most easily increased by means of the notional profit booked on a deal -- a profit which is often no more than a deliberately optimistic, upfront reckoning of many future years’ prospective income and, so, is one which is subject to a whole array of possibly unjustified, "modeling" assumptions.

As ethereal as this gain might turn out to be, the fact is that, for as long as this fiction can be maintained, it strongly induces banks to lend and relend against the collateral afforded by the very same assets which have most appreciated under the influence of their original loans, thus ensuring that they re-attain the maximum permissible degree of leverage and hence most flatter their returns on equity.

This powerful positive feedback -- one whose underlying fuel is the banks' unnatural ability to create money, simply by granting loans -- means that they are rewarded (at least while things are in the upswing) for reinforcing any resulting instabilities. Thus, they frequently find themselves turning the most innocuous of convective puffs into a raging hurricane of wasteful malinvestment.

What this implies is that fractional reserve banking not only gives rise to a fall in the value of money, per se, but it is also the well-spring of that thoroughly avoidable and widely destructive bipolar disorder we know as the business cycle, i.e., the boom and the bust itself, and so gives the main impulse to those periodic, lemming-like waves of folly which so mar the history of material progress.

While this indictment would seem to suggest that -- as those now waving pitchforks and mattocks on the intersections of Wall St. are noisily demanding -- banks should be subject to an unusually strict scrutiny in place of the rather lax regime prevalent of late, the truth is that no special rules whatsoever are necessary: on the contrary, all that is needed is for the same basic principles of law to apply to banks as to any other commercial enterprise, in a manner that they have never done heretofore.

Those who would deny the validity of this last contention might reflect upon the fact that the very existence of legal tender laws, government-administered deposit insurance schemes, and -- a fortiori -- public sector "lenders of last resort" reveals the inherent invalidity of the banks' logical, economic, and jurisprudential position, despite centuries of positivist legal precedent and state-sanctioned privilege.

It should be obvious by now that none of this has anything to do with "capitalism," properly defined, but rather is something more common to the practice of rent-seeking despots -- whether those of the ancien regime, or of our modern elective dictatorships.

Without the honest money which presupposes a system of 100% specie reserve, free banking with no second recourse -- should bankruptcy still occur -- to its victims' property via forced taxpayer restitution or compensatory central bank inflation, there can be no truly free market and hence no "capitalism" to let us down so badly. Instead, what we are suffering is yet another demonstration of the perils of state intrusion into the sphere of private relations, with all the perverse disincentives it entails and with all the faulty signals it gives off to businessmen and consumers alike.

In fine, what we are having to endure is the latest example of the many crises brought on by financial corporatism -- a sorry situation which will neither be remedied nor prevented from reoccurring in future by succumbing to the panic and taking measures which will only serve to strengthen the stranglehold already exerted upon our lives by a voracious, interventionist bureaucracy; measures which would only come at the expense of that genuine freeing of the economic realm which would most rapidly heal our present hurts and so assure our continuing prosperity.


The IMF is threatening to sell gold in order to finance its own operations and to support the dollar. Those will long memories will recall the during the 1970s, IMF gold sales did nothing to hold back the gold bull market. It seemed more like (there is always a strong element of interpretation in retrospectively analyzing why the market did what it did, of course) that every time the market absorbed the gold sales, it fed the bull as the market gained confidence. Time for a repeat?

What a busy week for the International Monetary Fund! And it is just over halfway through. ... Rumors were that finance ministers from Europe, Japan, the U.K., Canada, and, of course, the U.S. wanted to chew over joint intervention in the currency market -- buying dollars to support the U.S. currency, easing the surge in commodity prices, and helping export-dependent economies avoid a race to debase as they try to stay competitive. But could they really be so dumb?

On Monday, the IMF's managing director, Dominique Strauss-Kahn, called for concerted crossborder intervention and regulation by national governments to stem the ongoing global banking crisis. On Tuesday, the IMF laid out plans to reorganize its own finances, selling 400 tonnes of gold reserves to help cover a $400 million deficit in its $1 billion budget. Tuesday night saw the IMF warn that total write-downs (i.e., balance sheet losses) due to the collapse of subprime U.S. mortgage lending may reach $945 billion.

"It is now widely acknowledged that public measures are needed in a number of areas," claimed the IMF -- established at the end of World War II to help keep the world's financial system in check with the U.S. dollar newly crowned as king of world currencies. "In particular, there may be a need to shore up the prices of various types of securities to prevent fire sales."

And then, on Wednesday, the IMF cut its forecast for world economic growth in 2008 to 3.7%, from the 4.2% it had predicted only three months before. "Further," says the head office of analysis and advice for 185 member nations, "world growth would achieve little pickup in 2009, and there is a 25% chance that the global economy will record three percent or less growth in 2008 and 2009, equivalent to a global recession."

Pretty much the entire globe has been downgraded by the IMF's chief economist, Simon Johnson, starting with a "mild recession" in the U.S. Which leaves him, oddly enough, scratching his head at the collapse of the U.S. dollar. "The effect of the financial turmoil in the United States has been to lower the prospects of growth," he said in Wednesday's 2008 World Economic Outlook, "but somewhat paradoxically, it has also increased oil prices, metal prices, and, of course, food prices."

Plunging property prices tend to go hand in hand -- squeezing tight like a child in a crowd -- with a falling exchange rate. Just ask British consumers about their 1990-92 slump in real estate prices. Or ask them again, jabbing a thumb in their eye, about what has happened to sterling since the latest house price slump began in late summer 2007. That is why the sudden surge in the dollar of last August presented investors and savers with such a fantastic opportunity to get ahead of the curve and defend their wealth.

The initial surge in the dollar -- which pushed the euro down from $1.38 to $1.34 by the start of September -- came thanks to a dash for cash by the world's biggest banks. The U.S. dollar being the world's #1 money, cash equaled greenbacks. And selling everything else to raise money -- for settling lost trades and client redemptions -- the panic marked what might prove a last chance (during this dollar bear market, at least) to swap dollars for gold below $700 per ounce.

And now? The very week that the IMF said it is going ahead with a gold sale of 400 tons (pending U.S. approval, which looks a dead certainty)? "It seems that dealing with the risks stemming from the behavior of private sector financial institutions may be the big focus for this coming weekend's G-7 meeting in Washington," noted John Hardy at Saxo Bank. ... But the growing call for panglobal financial meddling looks sure to create a "Reverse Plaza Accord" sometime soon in the future.

"In view of the present and prospective changes in fundamentals," said the communique of September 22, 1985, issued by the rich G-5 nations from the Plaza Hotel in New York, "some further orderly appreciation in the main nondollar currencies against the dollar is desirable."

Together, therefore, the big guns of the global economy "[stood] ready to cooperate more closely to encourage this when to do so would be helpful." Put another way -- which was entirely the point -- the G-5 would start selling dollars and buying non-U.S. currencies to cut down the looming "super dollar" that towered over the global economy. (Those changing fundamentals, by the way, were that the United States had become a net debtor for the first time in 70 years. It has barely looked back ...)

What now might cause "close cooperation" in reversing this strategy, buying the dollar to increase its value, and thus aiding non-dollar countries struggling to bear the costs of the dollar's 6-year decline? "There is now agreement in the eurozone about the fact that the depreciation of the dollar is a problem," said an unnamed French official ... back in December. The finance wonks attending the next G-7 meeting "have to pass the same message to the market," he went on. But so far ... it has been ignored.

Of course, it is not in the United States' interest to see the dollar go higher. If you owed $9 trillion and you owned the printing press, would you not be just fine with the idea of your debt being inflated away? But the other G-7 cronies, not to mention the poor Asian and Middle Eastern economies that continue to pile up greenbacks and T-bonds every time they do business ... might they want to see some kind of "Reverse Plaza" enacted -- and soon! -- to support their stockpile of dollars? And with the IMF standing ready to sell 400 tons of gold over the next couple of years, would it not make a great deal for the central banks of Beijing and Japan?

As the GFMS consultancy here in London points out, China holds barely 1% of its foreign currency reserves in gold at the moment. The rest, pretty much, is in dollars. The Japanese do little better, with a 2% gold holding. They just broke the $1 trillion mark in U.S. dollars, on the other hand.

If this swap -- the West's gold for Asia's dollars -- comes off sometime soon, you will not have to simply stand by and watch this transfer of wealth as if helpless. You could join the big switch -- out of dollars and into truly hard currency ... Or you could wait for that communique from the Beijing Plaza Hotel.


Shorting is the most conceptually straightforward method of profiting from a financial instrument -- a stock or futures contract, for example -- whose price is falling. It does not involve, as with a put option, paying a premium whose value deteriorates with time, and so having to consider that complexity is avoided.

However, the conceptual simplicity can give way to complications in practice. Shorting a futures contract will only present a problem in disorderly markets, i.e., almost never. But shorting individual stocks can be problematic if a lot of other people are also trying to short the same stock. This article supplies a simple introduction to the arena.

Short selling is one of the most effective ways to make money on a stock that is losing money for its investors, but the fact of the matter is that most investors do not have any experience with shorting. Here is the long and short of shorting stocks ...

Shorting is one of the best ways to profit from the downside of an investment. Anyone can make money when the market is doing well, but profiting from a plummeting stock market seems foreign to most investors. If done well, you can increase your wealth no matter what the market is doing. So, how do shorts work? Ask our resident short selling expert, Dan Amoss, CFA:

"When you short a stock, the process involves borrowing it from your broker's inventory and selling it immediately. You are acting under the assumption that you will buy it back [known as covering] at a lower price in the future and pocket the difference between the sale and the purchase ... You must pay interest on whatever amount of money you borrow, but the idea is that the stock falls much more in percentage terms than the cost of your loan."

In other words, instead of the "buy low, sell high," philosophy most investors are used to, you want to sell high first, then buy the stock back later when it is cheap. ...

The first thing you will need to short stocks is a margin account -- a special account that you can use to borrow money from your broker. To open a margin account, regulators require you to deposit at least $2,000 to start off, and use 50% margin.

But just because you want to short a particular stock does not mean you will be able to every time ... "Depending on you brokerage, it may or may not be able to 'locate' shares for you to sell short. If so, the brokerage will notify you that it has a restriction on selling short when you try to enter your order," says Amoss. Usually, this does not happen. If it does, Amoss suggests calling up your broker to see if they can locate shares of the stock for you to borrow.

Shorting can sometimes have a noticeable effect on the share price of a stock, depending on how much short interest, or the total number of shorted shares out there, exists. You can find a stock's short interest by going to any stock research website and checking out the key stats section. Lots of investors see high short interest as a sign of two possible things -- one, that there is not a lot of investor confidence in the stock, and two that the price is due to rise. So, how would investors shorting a stock make the share price rise?

Because of a thing called a short squeeze. In a short squeeze, more and more investors want to short a stock, increasing the demand for the stock and increasing the price. As the price rises, more and more of those short sellers get nervous and cover (or are forced to cover), and end up buying back enough shares that they keep pushing that price on up. ...

[S]horting stocks does not come without its risks (like the short squeeze I just mentioned). Chief among them is the risk that the stock's price will actually go up instead of down. When you buy a stock hoping it will go up ... your biggest risk is that it will fall in value. If you are long a stock, the lowest it can go is $0.

If you are shorting a stock, on the other hand, there is theoretically no limit to how high its price can go. If you short a $5 stock that rockets up to $25, you will be out a ton of money. But, that does not mean that you have got unlimited risk when you short stocks.

You see, the chances of that $5 stock shooting up to $25 before you get a chance to cover your short are slim to none. Because most stocks typically do not fluctuate by huge percentages in one day, you are not facing potential destruction when you short -- if you have done your homework, that is.

In other words, if you have an exit strategy to cut your losses like a mental or actual buy stop loss order in place, this theoretically catastrophic loss is easily avoided. If you indeed cut your losses. A legendary instance of where an investor failed to do this was when hedge fund operator Robert Wilson shorted Atlantic City gambling casino operator Resorts International in the late 1970s. Mr. Wilson's tribulations are described in exquisite detail in John Train's classic The Money Masters. The stock eventually did tank, but not before Wilson was forced to cover his short position at a $10 million loss -- a lot of money back then.


The blood of the world’s economic circulatory system.

With the price of oil topping $110 a barrel, Christopher Hancock suggests that it is a good time to look at investing in refiners.

For one moment, forget about stock markets as divine measures of prosperity. Focus on the lives of ordinary citizens. We read that 28 million Americans will subside on food stamps this year -- the most since Congress enacted the program in the 1960s. A typical trip to the grocery store will cost the American consumer 9% more today than it did just one year ago.

Have you picked up a 5-pound bag of flour or a dozen eggs lately? Both staples are up more than 40% since January 2007 -- among the worst price hikes. In effect, your paycheck must increase 10% just to keep as much food on the table in 2008 as you had in 2007. Of course, that is assuming there is a paycheck to spend. ...

If that were not enough, oil has topped $110. Prices at the pump hit $3.28, another all-time high. Meanwhile, the nation's truckers prepare to strike. According to reports, many truckers are operating at a loss when diesel prices rise above $4 per gallon. To protest rising fuel costs, a group of big rig operators engineered a massive traffic jam on the New Jersey Turnpike. They monopolized all lanes, geared down to 20 mph and crept from the Big Apple like floats in a holiday parade. Similar protests clogged Chicago and Atlanta. It feels, dear reader, like an emotionally debilitating chapter from Atlas Shrugged.

We take these protests very seriously. After all, the health of the American economy rests on the ability to move goods to and fro. Like shipping, trucking still serves as the world's economic circulatory system. This business connects the world in ways high-tech never will. Trucking is, and will remain, irreplaceable on the world stage. We cannot live without it. ...

Truckers will demand higher wages to offset higher costs. Higher wages will require the goods they haul to be sold at higher prices. You get the idea. And this scenario discounts a major disruption to world oil supplies. A militant group truly determined to thwart the American dream would not have to leave the Middle East. Ask policymakers which asset they covet more: The Green Zone or Saudi oil production?

Treasury notes and bonds yielding 3-4% may appear a safe haven in today's market environment, but they are a long-term investment I would strongly advise you to avoid. It is better to own a diversified portfolio of stocks -- especially stocks that have the ability to pass through price increases and those levered to long-term investment cycles, like energy, natural resources and infrastructure stocks. They might be rocky in the short term, but they should far outpace bonds over the next 5-10 years. Therefore, we argue that it never hurts to hold a major refiner.

America's limited refining capacity ensures tight supplies. It is no secret that the U.S. has not built a new refinery since 1976. Why? ... [M]any industry executives remain wary of risking the billions in capital investment needed for such expansions. Even as gas prices soar, companies wonder: What about 5 years from now? What about 10 years down the line? How will alternative energy affect the demand for petroleum products?

Others argue that tangible growth in offshore refining capacity can offset a lack of U.S. expansion. Maybe so. Or maybe Southeast Asian growth will absorb any and all extra supply. Maybe a decrepit old American refinery will explode or succumb to fire, restricting capacity even more. And maybe sound judgment will prevail, and the illogical, economically unfeasible solution better known as corn-based ethanol will lose its proverbial steam.

Whatever holds for 20-40 years down the road, our present situation remains inescapable: The world consumes about two barrels of oil for every new barrel it finds. To think this can continue in perpetuity is delusional, a naiveté of convenience and nothing more. No amount of rationalization can convince a sober mind that one plus one equals three. If and when carbon-based fuels are replaced, we think the substitute will be just about anything but ethanol. But for now, the world still runs on oil.

But the real problem, dear reader, is not the absence of oil. It is the absence of cheap oil.

Valero: More Upside Than Downside

Here is an example of standard Wall Street analysis, in this case covering the major refiner Valero Energy. Refinery stocks tend to rise and fall with the rise and fall of their "crack spread" -- a measure of proceeds realized per barrel of refined product output vs. the refiner's crude stock costs. This means the stocks are volatile. If the case made for refiners above by Christopher Hancock is correct -- basically that refinery industry capacity is tight and will continue that way -- then the average spread achieved by refiners should be good going forward and dips in the stocks due to dips in the current spread would be buy opportunities.

Oil refiner Valero Energy (VLO) does not extract its own oil. As the price of oil has risen, its margins have been pummeled, and so have its shares, down 30% year-to-date to $48. It recently projected Q1 EPS of $0.10-0.35, way below Street forecasts of $0.91.

Barron's says that despite the gloom, crack spreads (the difference between the price of gas and crude) have bottomed and are widening; after going negative a few weeks ago, they are back to $7.43/barrel. Analysts say that a $10 spread is sustainable.

Citi analysts say Valero's downside is limited to about $43.80 -- and that assumes worst-case earnings and its historical lowest P/E multiple. It also trades at a sizeable discount to the replacement value of its refineries; CEO Bill Klesse has said he wants to sell four of its 17 refineries, and there are rumors Petrobras (PBR) is stalking its Aruba refinery. With the proceeds, Valero plans to pay down debt and repurchase shares. Valero's refineries are also equipped to refine the lowest quality crudes, which few others can do.

Wall Street analyst "worst case" earnings/multiple projections are often optimistic, but in this case do not appear unreasonable. And replacement values are a sensible basis for value analysis only if the assets are actually worth replacing. But, again, given tight refinery capacity one could see the desirability of Valero's assets in the eyes of multiple buyers.

Analyst Paul Sankey of Deutsche Bank think shares have more than 60% upside.


Modern value investing legend Seth Klarman gave a talk at M.I.T. earlier this year on the suject of -- not surprisingly -- the virtues of the value approach to investing. The keepers of the "Gone to the Dogs" blog -- which is "dedicated to the discipline of value investing" -- were kind enough to transcribe and share the talk. What the talk lacks in Buffettesque waggishness it more than makes up for in substance.

Looking at today's systemic financial system misfire, Klarman's basic point is that it is the consequence of a mass failure of market participants to consider the risk part of the risk/reward equation when committing their funds. He is not just belaboring the obvious. The ignoring of risk is (or was) instrinsic to the conventional investing culture -- not merely a miscalculation, it was more analogous to the colorblind person who cannot distinguish red. Plainly, if everyone had insisted on some modicum of Benjamin Graham's "Margin of Safety" in mind before they put any cash on the line, the world would look very different today. (Klarman authored a book titled Margin of Safety in the early 1990s. Now out of print, it is offered used on Amazon for well over $1000.)

Klarman concludes his talk with this advice: "Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred." That would serve well as a mantra for every investor. Repeat it to yourself every day ... or every half hour, depending on market conditions.

Recent financial market events, including subprime loan losses, hedge fund and quant fund woes, and the bailout or takeover of numerous financial institutions and structured vehicles, that are suddenly strapped for cash, highlight the extreme risk taking and leverage that have lately permeated our financial system. The current distress will likely create opportunities for patient investors, but while proper investing requires a disciplined and long-term perspective, few market participants are able to ignore short-term phenomena. The daily blips of the market are, in fact, noise -- noise that is very difficult for most investors to tune out.

Investors unfortunately face enormous pressure -- both real pressure from their anxious clients and their consultants and imagined pressure emanating from their own adrenaline, ego and fear -- to deliver strong near-term results. Even though this pressure greatly distracts investors from a long-term orientation and may, in fact, be anathema to good long-term performance, there is no easy way to reduce it. Human nature involves the extremes of investor emotion -- both greed and fear -- in the moment. It is hard for most people to overcome and act in opposition to their emotions. Also, most investors tend to project near-term trends -- both favorable and adverse -- indefinitely into the future. Ironically, it is this very short-term pressure to produce -- this gun to the head of everyone -- that encourages excessive risk taking which manifests itself in several ways: a fully invested posture at all times; for many, the use of significant and even extreme leverage; and a market-centric orientation that makes it difficult to stand apart from the crowd and take a long-term perspective.

Right at the core, the mainstream has it backwards. Warren Buffett often quips that the first rule of investing is to not lose money, and the second rule is to not forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance. For 25 years, my firm has strived to not lose money -- successfully for 24 of those 25 years -- and, by investing cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio -- and with risk comes losses. Some investors target specific returns. A pension fund, for example, might target an 8% annual gain. But if the blend of asset classes under consideration fails to offer that expected result, they can only lower the goal -- which for most is a non-starter -- or invest in something riskier than they would like. Pressure to keep up with a peer group renders decision making even more difficult. Then, there is no assurance whatsoever that the incurrence of greater risk will actually result in the achievement of higher return. The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.

When the herd is single-mindedly focused on return, prices are frequently bid up and returns driven down. This is particularly so when leverage is used. Leverage does not have to be dangerous. Non-recourse debt on an asset can serve to make a large purchase more affordable. Taking out a non-recourse loan on an already owned asset can actually reduce risk, since the borrowed funds become yours, while the risk of loss is transferred to the lender.

But recourse debt is something else entirely. If you purchase some investments, and then borrow with recourse debt to buy more, you are now vulnerable to mark-to-market losses in what you own. Depending on the precise terms of the debt, a decline in the value of your holdings could force you either to put up more collateral -- which you may not have -- or to sell off some of the investments you purportedly like to meet margin calls. By borrowing, you have ceased to be the master of your own fate and allowed the lender -- or actually the market -- to be. How ironic to allow the market, which has dished up your current portfolio of opportunity, to dictate to you the need to sell your attractive holdings in order to survive.

The availability and use of margin or recourse debt is especially pernicious. Had you purchased an investment without leverage that declined in price, you could have used any available cash to buy more. Alternatively, you could sell another investment that did not decline or declined less to afford more of the now better bargains. This, in fact, is a healthy discipline, forcing you to choose among investments to own the ones you like best, and necessitating that you carefully decide when to hold onto cash and when to put it to work. Recourse leverage changes this equation, as you can seemingly own all the investments you want simply by borrowing to buy them. There is no healthy portfolio discipline enforced by the desire to make new purchases or the anticipation that you may want to. There is also a bit of a slippery slope in that if a little leverage is good, why is more leverage not better? When do you stop?

One way that vast leverage has been introduced into the financial markets has been through Wall Street's securitization engine. In the late 1970s, to help financial institutions achieve diversification and -- at least arguably -- liquidity, Wall Street began to pool mortgages (and more recently corporate and other consumer debt) and then sliced and diced these aggregations into new tranches of debt securities that offered varying degrees of risk and return. In recent years, many of these tranches were again pooled and retranched into still more finely calibrated and opaque financial instruments. These transactions were blessed by remarkably unworried rating agencies, who granted their investment grade imprimatur to some quite dubious underlying collateral.

So long as the underlying assets performed well, these securities were well bid for in ample size, and investors were satisfied. Appetite for securitization fodder grew and grew, and loan originators were pressed to lower standards to generate product. A steadily rising housing market erased fears of credit risk, since one's credit really does not matter if the collateral -- in this case houses -- is only going up in value. There is a soothing circularity to the easy credit conditions and the steadily rising home prices that no one noticed or chose to worry about. At the extreme, loans were eagerly granted to borrowers who lied -- and who were encouraged to lie -- on their loan applications for no-documentation loans -- also known in the trade as liar's loans. One survey showed 95% of those who applied for such loans apparently did misstate their income or net worth.

Like many Wall Street innovations, these subprime mortgage-backed securities were not created with bad times in mind. When housing prices slipped and refinancing assumptions proved faulty, the models that most traders and investors used to value and analyze these securities became less and less applicable, and market conditions became increasingly chaotic as losses mounted. Liquidity declined to almost zero, and holders had difficulty valuing what they held when the financial musical chairs came to an end. What we are seeing in the debt markets is the end result of this financial innovation gone wrong.

We live in an era of leverage not just on Wall Street but on Main Street. For two generations, credit has become much more widely available and acceptable. In our grandparent's era, there were no credit cards, home equity or subprime loans, or CDOs. People paid cash for what they purchased, and worked hard to earn that cash. The sequencing of that mattered, too: first you worked hard, then you bought what you wanted. Even the federal government was expected -- except in times of war -- to run a balanced budget.

But during our parents' lifetimes and our own, credit has become increasingly available and standards increasingly lax, to the point where credit cards and checks backed by credit lines arrive unrequested in the mail, where your house can be used as an ATM, where people with dismal credit histories are eagerly sought after to provide them with loans, where investors flock to buy junk bonds and shaky companies seek to issue them, and where investment funds are offered the opportunity to enhance their return through structured products, derivatives and exotic financings, all of which embed high amounts of leverage.

The moral imperative of repaying the banker -- your neighbor -- who granted you the loan across his imposing desk has been replaced by the moral vacuum of anonymous lenders using credit scoring -- who quickly resell your loan to someone you will never meet -- and who are actually comfortable with the actuarially determined probability that you may default. Credit rating agencies have embraced the debt orgy with lax standards and naive models, brewing conflicts of interest and accepting healthy fees to label toxic waste as investment grade.

A similar risk exists as a result of the burgeoning increase in capital allocated to alternative investments -- venture capital, private equity and hedge funds. While return-starved endowments and pension funds have looked to alternatives to add excess return and diversification, they are hardly a panacea. Some alternative managers have historically added considerable value, while for others, the jury is out.

For alternatives in their entirety, high management and performance fees truncate upside potential. Increased competition has forced many alternative managers to incur greater risk to achieve their accustomed returns. For some, this involves incurring greater credit risk, while for others, this means utilizing considerable amounts of leverage. The pendulum may be starting to turn -- as recent developments in the mortgage and hedge fund markets suggest. Because the scale of today's leverage so greatly exceeds historical levels, it seems possible that we are only in the early stages of a credit contraction. Not surprisingly, it may take time to work off the excesses.

Intervention by the Federal Reserve -- as we recently had -- seems likely to give license to further speculation while failing to address -- and perhaps exacerbating -- the underlying problem of lax lending standards, poor credit quality and excessive use of leverage. Indeed, many market participants believe the solution to today's problem of over-leverage and bad credit is more debt. Recently, many funds have been formed to make leveraged purchases of loans that are expected to trade in the mid to high-90s instead of par, with 5 times leverage or more bringing the yield to a 15 to 20% return. It seems unlikely that the debt crisis can be near an end when the solution offered -- more debt -- is in fact what caused the problem in the first place.

Many investors lack a strategy that equips them to deal with a rise in volatility and declining markets. Momentum investors become lost when the momentum wanes. Growth investors -- who pay a premium for the fastest growing companies -- do not know what to do when the expected growth fails to materialize. Highly leveraged investors, like some quant funds in the headlines, were recently forced to sell regardless of value when their methodology produced losses rather than gains. Counting on a government bailout for every market crisis seems a dicey proposition, especially when supposedly impossible events happen on Wall Street every few years.

By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before problems hit, precisely because no one can accurately predict the future direction of the stock market or economy. Value investing, the strategy of buying stocks at an appreciable discount from the value of the underlying businesses, is one strategy that provides a road map to successfully navigate not only through good times but also through turmoil. Buying at a discount creates a margin of safety for the investor -- room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies. Following a value approach will not be easy for everyone, especially in today's media-dominated, short-term oriented markets, in that it requires deep reservoirs of patience and discipline. Yet it is the only truly risk averse strategy in a world where nearly all of us are, or should be, risk averse.

My friend and fellow value investor, Chris Browne, President of Tweedy Browne, describes what value investors do by telling this story. He was interviewing a new trader and after the interview, walked them through the Tweedy Browne offices. At the elevator on their way out, the trader commented, "At other Wall Street firms, just by walking through the office you can tell if the market is up or down. At Tweedy Browne, you cannot even tell if the market is open!" This really does highlight the difference between most of today's frenzied, decision-a-minute firms and the behavior of a truly long-term oriented investor.

As value investors, our business is to buy bargains that financial market theory says do not exist. We have delivered great returns to our clients for a quarter century -- a dollar invested at inception in our largest fund is now worth over 94 dollars, a 20% net compound return. We have achieved this not by incurring high risk as financial theory would suggest, but by deliberately avoiding or hedging the risks that we identified. In other words, there is a large gap between standard financial theory and real world practice. Modern financial theory tells you to calculate the beta of a stock to determine its riskiness. In my entire professional career, now 25 years long, I have never calculated a beta. This theory urges you to move your portfolio of holdings closer to the efficient frontier. I have never done so, nor would I know how. I have never calculated the alpha or beta of my firm's investment performance, which is how some people would determine whether or not we have done a good job.

Some people stick to elegant theories long after it is apparent that the theories do not explain reality. The Chicago School of Economics has said the financial markets are efficient. They conveniently explain away Warren Buffett's incredible investment record as aberrational. The second richest man in the country is a value investor. He built his net worth gradually over nearly 50 years of successful investing. And his net worth continues to grow handsomely! 50 billion dollars are a lot of aberrations! Rather than abandon their theorizing to study Buffett exhaustively to see what lessons could be learned, too many people cannot bear to reexamine their faulty theories.

It turns out that this inflexibility of thinking is nothing new. Witness the insights of a brilliant man who might well have been an exceptional value investor had he not had something more important to do one century ago. This man was Wilbur Wright, whose aeronautical accomplishments are recounted in To Conquer the Air, by James Tobin. Wright contrasted his and Orville's hands-on approach to learning to fly with the more cerebral of Samuel Pierpont Langley, the Secretary of the Smithsonian in that era, who was the Wright brothers' most formidable competitor in manned flight. Wright compared man's first steps toward flight with the more ordinary challenge of riding a horse. He declared (To Conquer the Air, p. 122):
There are two ways of learning how to ride a fractious horse; one is to get on him and learn by actual practice how each motion and trick may be best met; the other is to sit on a fence and watch the beast a while, and then retire to the house and at leisure figure out the best way of overcoming his jumps and kicks. The latter system is the safest; but the former, on the whole, turns out the larger proportion of good riders. It is very much the same in learning to ride a flying machine; if you are looking for perfect safety, you will do well to sit on a fence and watch the birds, but if you really wish to learn, you must mount a machine and become acquainted with its tricks by actual trial.
So, too, for the stock market. It is easy to peruse stock tables from the comfort of your office or living room and declare the market efficient. Or you can invest other people's capital for a number of years and learn that it is not. What is amazing to me is that, as with the Wrights, the burden of proof somehow is made to fall on the practitioner to demonstrate that they have accomplished something that so-called experts said could not be done (and even then find yourself explained away as aberrational). Almost none of the burden seems to fall on the academics, who cling to their theories even in the face of strong evidence that they are wrong.

When Benjamin Graham first developed the principles of value investing in the 1920s, he could not have imagined the changes the investment world would undergo over the next 80 years: the wondrous technological advances, the vast accumulation of wealth, the institutionalization of investing, the new financial instruments. Because so much is so very different, I am sure he would be especially pleased to find that value investing is, in many ways, the leading investment discipline being practiced today. Yes, there are other approaches -- growth, momentum, black box computer programs. But there is only one approach -- one discipline -- that is simple enough for anyone to follow, logical and commonsensical to anyone who pays attention and incontrovertibly proven to work.

Value investing involves the purchases of bargains, the proverbial dollars for 50 cents. Unlike speculators, who think of securities as pieces of paper that you trade, value investors evaluate securities as fractional ownership of, or debt claims on, real businesses. They are evaluated as one would evaluate the purchase of an interest in a business or of the entire business. Buying such bargains confers on the investor a margin of safety, room for imprecision, error, bad luck, or the vicissitudes of economic and business forces. Value investing is a long-term orientated investment approach -- never to be confused with short-term speculation -- that requires considered patience, discipline and rigor.

Value investing lies at the intersection of economics and psychology. Economics is important because you need to understand what assets or businesses are worth. Psychology is equally important because price is the critically important component in the investment equation that determines the amount of risk and return available from any investment. Price, of course, is determined in the financial markets, varying with the vicissitudes of supply and demand for a given security.

It is crucial for investors to understand not only what value investing is, and that it works, but why it is a successful investment philosophy. At the very core of its success is the recurrent mispricing of securities in the marketplace. Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong. If, on the one hand, securities can become undervalued or overvalued, which I believe to be incontrovertibly true, value investors will thrive. If, on the other hand, all securities at some future date become fairly and efficiently priced, value investors will have nothing to do. It is important, then, to consider whether or not the financial markets are efficient.

Institutional constraints and market inefficiencies are the primary reasons that bargains develop. Investors prefer businesses and securities that are simple over those that are complex. They fancy growth. They enjoy an exciting story. They avoid situations that involve the stigma of financial distress or the taint of litigation. They hate uncertain timing. They prefer liquidity to illiquidity. They prefer the illusion of perfect information that comes with large, successful companies to the limited information from companies embroiled in scandal, fraud, unexpected losses or management turmoil.

Institutional selling of a low-priced small-capitalization spinoff, for example, can cause a temporary supply-demand imbalance. If a company fails to declare an expected dividend, institutions restricted to owning dividend-paying stocks may unload shares. Bond funds allowed to own only investment-grade debt would dump their holdings of an issue immediately after it was downgraded below BBB by the rating agencies. Market inefficiencies, like tax selling and window dressing, also create mindless selling, as can the deletion of a stock from an index. These causes of mispricing are deep-rooted in human behavior and market structure, unlikely to be extinguished anytime soon.

My firm's approach is to seek situations where there is urgent, panicked or mindless selling. As Warren Buffett has said, "If you are at a poker table and can't figure out who the patsy is, it's you." In investing, we never want to be the patsy. So rather than buy from smart, informed sellers, we want to buy from urgent, distressed or emotional sellers. This concept applies to just about any asset class: debt, real estate, private equity, as well as public equities.

As the father of value investing, Benjamin Graham, advised in 1934, smart investors look to the market not as a guide for what to do but as a creator of opportunity. The excessive exuberance and panic of others generates mispricings that can be exploited by those who are able to keep their wits about them. For three quarters of a century, this advice has helped a great many value investors become very rich, not quickly, but relentlessly, in good markets and in bad.

After 25 years in business trying to do the right thing for our clients every day, after 25 years of never using leverage and sometimes holding significant cash, we still are forced to explain ourselves because what we do -- which sounds so incredibly simple -- is seen as so very odd. When so many other lose their heads, speculating rather than investing, riding the market's momentum regardless of valuation, embracing unconscionable amounts of leverage, betting that what has not happened before will not ever happen, and trusting computer models that greatly oversimplify the real world, there is constant and enormous pressure to capitulate. Clients, of course, want it both ways, too, in this "What have you done for me lately?" world. They want to make lots of money when everyone else is, and to not lose money when the market goes down. Who is going to tell them that these desires are essentially in conflict, and that those who promise them the former are almost certainly not those who can deliver the latter?

The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions. Success in the market leads to excess, as bystanders are lured in by observing their friends and neighbors becoming rich, as naysayers are trounced by zealous participants, and as the effects of leverage reinforce early successes. Then, eventually, and perhaps after more time than contrarians would like, the worm turns, the last incremental buyer gets in, the last speculative dollar is borrowed and invested, and someone decides or is forced to sell. Things quickly work in reverse, as leveraged investors receive margin calls and panicked investors dump their holdings regardless of price. Then, the wisdom of caution is once again evident, as not losing money becomes the watchword of the day.

Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.