Monday, March 30, 2009

Thursday, March 26, 2009

John Wooden: Coaching for people, not points


Thanks to Miguel for spotting this talk on TED!

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Related links:

Coach Wooden's Official Website

Pyramid of Success

Book mentioned in Poor Charlie's Almanack:

Be Quick But Don't Hurry

Monday, March 23, 2009

Influence in the Madoff Case

Before getting to the two articles below, consider this quote from Warren Buffett:

“An argument is made that there are just too many question marks about the near future; wouldn’t it be better to wait until things clear up a bit? You know the prose: “Maintain buying reserves until current uncertainties are resolved,” etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear and you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

Keep that in mind as you read through the articles and/or Robert’s Cialdini’s book, Influence. Uncertainty in investing can lead to attractive buying opportunities (per Buffett’s quote), but it is also a factor that leads to bad decision making, both on the conscious and subconscious level. That also reminds me of a quote from Ben Graham:

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

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You don’t have to be a Dupe to be Duped: Lessons from the Madoff Affair
By Dr. Robert Cialdini

The Power of Persuasion under Conditions of Uncertainty

Under conditions of uncertainty like those Madoff cultivated, a pair of principles of social influence gain special traction: Authority and Social Proof. Let’s take each in turn and examine how they were commissioned by Madoff to advance his persuasive success.

Authority. When people are uncertain of what to do, they don’t look inside themselves for answers; all they’ll see there is vexing ambiguity. Instead, they look outside. One prominent place they look is to the counsel of experts, credible authorities on the topic. And, by any measure, Bernard Madoff certainly had the look of a credible authority in financial matters. He possessed expert credentials from long years in the investment industry. After starting his firm in 1960, he grew it into a juggernaut that was reported to be the largest dealer in NYSE-listed stocks in the United States. His firm helped to develop the NASDAQ, where he served as Chairman of the Board of Directors and where Madoff Securities became the exchange’s largest market-maker. Beyond expertise, Madoff spent substantial time and money establishing a reputation for possessing the second element of credible authority—trustworthiness. He was active in an organization oriented to the self-regulation of the securities industry, the National Association of Securities Dealers, and even sat on its Board of Governors. Moreover, he was widely known for his good heart via multiple charitable and philanthropic involvements.

Against such a backdrop, we can begin to understand why so many knowledgeable and experienced financial professionals followed Mr. Madoff down the garden path. Under conditions of uncertainty, they did not look inside (to their own knowledge and experience) for direction. They looked outside to credible authorities on the topic. And, there were few on the murky topic of derivative-based hedge funds more credible than Bernie Madoff.

Social Proof. Besides authorities, do people seek any other source of external information when uncertain of how to choose? They do. They look to—and then follow—what most people just like them are doing. Here, the proof of a correct choice isn’t based on knowledge or logic or empirical evidence; it’s based on social evidence of what one’s peers and those in one’s social network have decided to do. For instance, if the evidence were clear that your friends and coworkers were flocking to a new restaurant for lunch, you’d likely follow suit. At developing, honing, and providing this kind of social evidence, the Madoff client recruitment program had few equals. Madoff is Jewish, and so, too, are the majority of his victims, who were often recruited at country clubs by Madoff’s lieutenants, who were also Jewish and also members of the same country clubs. Plus, new recruits knew and were similar to past recruits, who served as unwitting sources of social proof that an investment with Madoff must be a wise choice “for someone like me.” Of course, fraud of this sort is hardly limited to one ethnic or religious group. Called affinity schemes, these investment scams have always involved members of a group preying on other members of the group—Baptists on Baptists, Hispanics on Hispanics, Armenian-Americans on Armenian-Americans. Indeed, Charles Ponzi, who gave his name to the infamous Ponzi scheme that Madoff copied, was an Italian immigrant to the U.S. who fleeced other Italian immigrants to the U.S.

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The Bernard Madoff Case: Trust Takes Another Blow
Knowledge@Wharton

Knowledge at Wharton: Why is it that even sophisticated investors are being snookered in Ponzi schemes, still?

Maurice Schweitzer: The Madoff scandal is a story about several powerful influence principles working in concert. These are textbook principles. And in this case, you have four that are key. One is scarcity, where investors were told, "The fund is closed. But maybe I can get you in." It was exclusive, and there were some clients that got fired [because they asked too many questions]. The second key principle is authority. Madoff was somebody who in 1990 was the chair of NASDAQ. He pioneered electronic trading. He was a board member. He had this air of authority. And we know from the Milgram experiments and other studies that authority figures exert a huge amount of influence over us. Third, social proof. Everyone's doing it. From the Abu Dhabi Investment Authority to Line Capital of Singapore, to Stephen Spielberg and the owner of the New York Mets. You look around and everybody else is investing here. It seems like a reasonable thing to do. And fourth, the liking principle. We're influenced by people that we like. And here, social networks, meetings in country clubs, the charity events -- this is what brought people in. So you have in concert these four classic influence principles working together. And on the other hand, you have motivated reasoning. You have these investors who want to believe. They want to believe that they can earn the 10%, 11% interest, like clockwork. So they're willing to suspend their disbelief. And I think we failed to realize how powerful all of these factors are, when they work together.

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Adam Smith, Behavioral Economist

From the Journal of Economic Perspectives – Summer 2005

In The Wealth of Nations, published in 1776, Adam Smith famously argued that economic behavior was motivated by self-interest. But 17 years earlier in 1759, Smith had proposed a theory of human behavior that looks anything but self-interested. In his first book, The Theory of Moral Sentiments, Smith argued that behavior was determined by the struggle between what Smith termed the “passions” and the “impartial spectator.” The passions included drives such as hunger and sex, emotions such as fear and anger, and motivational feeling states such as pain. Smith viewed behavior as under the direct control of the passions, but believed that people could override passion-driven behavior by viewing their own behavior from the perspective of an outsider—the impartial spectator—a “moral hector who, looking over the shoulder of the economic man, scrutinizes every move he makes” (Grampp, 1948, p. 317)

The “impartial spectator” plays many roles in The Theory of Moral Sentiments. When it comes to choices that involve short-term gratification but long-term costs, the impartial spectator serves as the source of “self-denial, of self-government, of that command of the passions which subjects all the movements of our nature to what our own dignity and honour, and the propriety of our own conduct, require” (Smith, 1759 [1981], I, i, v, 26), much like a farsighted “planner” entering into conflict with short-sighted “doers” (Shefrin and Thaler, 1981). In social situations, the impartial spectator plays the role of a conscience, dispassionately weighing the conflicting needs of different persons. Smith (I, i, v, 29) recognized, however, that the impartial spectator could be led astray or rendered impotent by sufficiently intense passions: “There are some situations which bear so hard upon human nature that the greatest degree of self-government . . . is not able to stifle, altogether, the voice of human weakness, or reduce the violence of the passions to that pitch of moderation, in which the impartial spectator can entirely enter into them.”

Adam Smith’s psychological perspective in The Theory of Moral Sentiments is remarkably similar to “dual-process” frameworks advanced by psychologists (for example, Kirkpatrick and Epstein, 1992; Sloman, 1996; Metcalfe and Mischel, 1999), neuroscientists (Damasio, 1994; LeDoux, 1996; Panksepp, 1998) and more recently by behavioral economists, based on behavioral data and detailed observations of brain functioning (Bernheim and Rangel, 2004; Benhabib and Bisin, 2004; Fudenberg and Levine, 2004; Loewenstein and O’Donoghue, 2004). It also anticipates a wide range of insights regarding phenomena such as loss aversion, willpower and fairness (V. Smith, 1998) that have been the focus of modern behavioral economics (see Camerer and Loewenstein, 2004, for a recent review). The purpose of this essay is to draw attention to some of these connections. Indeed, as we propose at the end of the paper, The Theory of Moral Sentiments suggests promising directions for economic research that have not yet been exploited.

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Related books:

The Theory of Moral Sentiments

The Wealth of Nations

The Authentic Adam Smith: His Life and Ideas
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No Safety in Numbers - By Roger Lowenstein

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Thursday, March 19, 2009

GR-NEAM Reflections: Investing With Leviathan

The monthly publication written by John Gilbert, CIO, GR-NEAM (General Re-New England Asset Management).
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Link to past issues: HERE
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The Yellowstone Factor: Minimizing Downside Risk

Upon reading an article online about earthquakes at Yellowstone, I was reminded of the excellent article written by Mohnish Pabrai in 2004 - The Yellowstone Factor: Minimizing Downside Risk
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Excerpt:
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Yellowstone National Park is volcanic in nature, yet not one cone or caldera is visible. In the 1960s, this mystery was finally solved: The entire park -- 2.2 million acres -- is the caldera. It's the largest active supervolcano on Earth. Yellowstone started erupting about 17 million years ago, and it has a cycle of erupting roughly every 600,000 years. The last eruption was 630,000 years ago, so it's about 30,000 years past due on the next big one.

By 1984, Yellowstone's restless magma chamber caused the entire central region of the park -- several dozen square miles -- to be lifted 3 feet higher than it was in 1924. The area subsided by 8 inches in 1985, but it appears to be rising again. Although volcanic eruptions are very hard to predict, telltale signs of a forthcoming eruption are already there. Earthquakes are a precursor to volcanic activity, and there were 1,260 of them in the park in 2002 alone.

When Yellowstone awakens from its slumber, it's unlikely any humans within 700 miles of the park would survive. An area the size of New York State would have ash 67 feet deep. The aftermath probably would be worse, with no sunlight for years throughout the planet and much farmland rendered useless under mountains of ash. Humans have no memory of living through such devastation. (Thanks to Bill Bryson's A Short History of Nearly Everything for the data.)

Outliers

Yellowstone represents just one of the many ugly outlying events that have an extremely low probability of occurring, but that does not mean the odds are zero or that they can be ignored. Even the most seemingly resilient businesses are very fragile temporary creations by their nature, and it would take a lot less than Yellowstone's eruption to wipe them out. The Yellowstone Factor alone implies that there isn't a single business on the planet whose future is assured.

Minimizing downside risk is the first step toward being a successful investor. As Warren Buffett succinctly puts it:

Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1.

You always need to be cognizant of six sigma events that can have an ugly impact on your portfolio and account for the approximate probabilities. Whenever I look at any investment opportunity, I first fixate on what factors can cause the investment to result in a significant permanent loss of capital. Besides Yellowstone, there are the usual suspects: wars, terrorism, fraudulent financial statements, dishonest management, disruptive innovation, etc. But how can you figure out the probabilities for each one?
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Related books:
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Wednesday, March 18, 2009

The Washington Post: A Conversation With Nassim Nicholas Taleb

How do you define a Black Swan? If they're so unexpected, how can we prepare for them?

A Black Swan is an exception, like the bird. It is an event with massive consequences that is unexpected. My idea is not simply to say that these things happen. My idea has been to identify the vulnerabilities, the spots where people are driving the school bus blindfolded. In banking, I identified a huge amount of risk taking on the part of banks that were using bogus models to estimate their risks.

It was so painful to watch the banking system become so fragile to the Black Swans. Now there is wealth turning into air as we speak.

What do you see ahead? What do you make of the mainstream economists who predict that the economy will turn around later this year or next?

Look, globalization has created this interlocking fragility. At no time in the history of the universe has the cancellation of a Christmas order in New York meant layoffs in China. So for a while it created the illusion of stability, but it has created this devastating Black Swan.

Complex systems do not like debt. So it will proceed to destroy tens of trillions in debt until society rebuilds itself in an ultraconservative manner. We are in for a worse ride than people think.

People have the problem of denial. This is one of the things I learned in Lebanon. Everybody who left Beirut when the war started, including my parents, said, 'Oh, its temporary.' It lasted 17 years! People tend to underestimate the gravity of these situations. That's how they work.

Is this crisis going to last 17 years?

Unfortunately no, complex systems cascade much faster than that. However, the destruction will be deeper than people anticipate. It will bring down a lot of people.

My rosy scenario is that a better economic environment will develop, a low-debt, robust growth world, in which whatever is fragile will be allowed to break early and not late.

My nightmare scenario is that the government saves Citibank once again, as well as the other banks, and business resumes as usual. Then, the next time the system breaks, it breaks much, much bigger.
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Related books:
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The Black Swan: The Impact of the Highly Improbable (also available in an Audio Book)
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Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (also available in an Audio Book)
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Monday, March 16, 2009

WSJ: Bankers Need More Skin in the Game

Of all the causes of the financial meltdown of the past few years, the easiest to understand is that an irresponsible attitude toward risk led to terrible mistakes in judgment. But where did this casual approach to risk originate?

A major culprit, we believe, is a change in the way Wall Street financial institutions are organized. During the late 1970s and '80s, much of the responsibility for risk was transferred away from the people who made the financial decisions. As a result, leverage rose from 20-1 to 40-1 or higher, creating shaky towers of debt, which, as we know, eventually collapsed.

Of course, risk is not a bad thing. John Maynard Keynes identified the importance of "animal spirits," the naive optimism of entrepreneurs, to a robust economy: "The thought of ultimate loss which often overtakes pioneers . . . is put aside as a healthy man puts aside the expectation of death."

The trick is to find a way to encourage sensible risk-taking, while dampening the impulse to take chances that can throw an economy into recession and force taxpayers to bail out a banking system.

Can government accomplish this feat through rule-making and regulatory oversight? It is unlikely. As the Nobel Prize-winning economist Friedrich von Hayek correctly emphasized, no one -- not even a politician or a bureaucrat -- can gain the broad and deep knowledge necessary to make wise enough rules. Moreover, in a $14 trillion economy, you can't hire enough overseers to pore over everyone's books.

There is, however, a better solution: expose players in the financial game to greater personal loss if their risk-taking fails. When you worry that a mistake will cause you to lose your second home, your stocks and bonds and your club memberships, then you're less likely to take the kinds of risks that expose the rest of society to your failures.

A simple mechanism exists to achieve this purpose: the private partnership. Partners face liability that extends to their personal assets. They aren't protected by the corporate shield that limits losses to what the corporation itself owns (as well as the value of the stocks and bonds the corporation has issued). Unfortunately, the partnership is a legal form of business organization that was largely abandoned by banks over the past quarter-century. Our advice is to bring it back. In other words, don't nationalize; partnerize.

We know from Alfred Chandler, the great business historian, that "strategy determines structure." Similarly, structure determines behavior -- in this case, a healthier attitude toward risk. It is unlikely that a partnership will grow to the size of a Bank of America or Citigroup, but, while size can boost efficiency, it also poses systemic risk. As partnerships -- and corporations with partnership attributes -- replace behemoths, the current crisis will spawn structures for future success.
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Thursday, March 12, 2009

Dang Le's Notes From Buffett Meeting 2/6/2009

A big thanks to Dang Le for these notes!
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South Dakota:
You’ve recently invested in Goldman Sachs and GE. Is the financial sector a good buy right now?

Buffett:
No sector is a good buy unless you understand the business. However, I do believe that there is good value and great opportunity now in the financial sector because it is extremely unpopular. Sector’s themselves don’t make good buys, companies that are undervalued make good buys. You know how to value a business, you project the future cash flows discounted to present and buy with a margin of safety. The earnings prospects need to be greater than the current value. Anything that is unpopular is always great to look at. If I was getting out of school right now, I would take a look.

Creighton:
How much and how does risk factor into your investment decisions? Would you invest in emerging markets?

Buffett:
In general, emerging markets are not great for me because I need to put a lot of money to work. Risk does not equal beta. Risk comes around because you don’t understand things, not because of beta. There are normally 10 filters or so that I go through when I hear an idea. The first is can I understand the business and understand the downside not just today but five to ten years from now. There have been very few times that I’ve lost 1% of my net worth. I might be risk averse but I am not action adverse. Mrs. B saved $500 over the course of 16 years to start and build Nebraska Furniture Mart. Tom Watson Sr of IBM said, “I’m smart in spots and I stay in those spots.” I just stay within my circle of confidence. When I bought Nebraska Furniture Mart in 1983, Mrs. B took cash and not Berkshire stock. Why? She didn’t understand the value of stock. She understood cash and that is what she took. I need only need to be right a few times and can let thousands of ideas go by.

Ted Williams, who wrote the “Science of Hitting,” broke the strike zone into 92 ball shaped sections. He knew, if hit in his sweet spot, he’d hit 430, a little further out, and he’d hit 350. You have to know your sweet spot. The beautiful thing about investing is that it’s a “No called strike game” where unlike baseball the only strikes in investing are when you swing. I don’t have to swing.

When I do invest, I don’t care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2. Avoid debt. I decided early on that I never wanted to owe more than 25% of my net worth, and I haven’t… exept for in the very beginning. I like to play from a position of strength. I always try to have the odds in my favor. When I go to Vegas, I don’t go around putting $5 dollars on the blackjack tables. If someone wants to come to my room and put $5 on my bed, well that’s fine. I like those odds better.

Emory:
How do you think about value?

Buffett:
The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush. The keys are to only look at the bushes you like and identify how long it will take to get them out. When interest rates are 20%, you need to get it out right now. When rates are 1%, you have 10 years. Think about what the asset will produce. Look at the asset, not the beta. I don’t really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price. I don’t care if they close the NYSE for 5 years. I care more about the business than I do about events. I care about if there’s price flexibility and whether the company can gain more market share. I care about people drinking more Coke.

I bought a farm from the FDIC 20 years ago for $600 per acre. Now I don’t know anything about farming but my son does. I asked him, how much it cost to buy corn, plow the field, harvest, how much an acre will yield, what price to expect. I haven’t gotten a quote on that farm in 20 years.

If I were running a business school I would only have 2 courses. The first would obviously be an investing class about how to value a business. The second would be how to think about the stock market and how to deal with the volatility. The stock market is funny. You have no compulsion to act and a bunch of silly people setting prices all the time, it is great odds. I want the market to be like a manic depressive drunk. Graham’s Ch. 8, in the book Intelligent Investor, on Mr. Market is the most important thing I have ever read. Now think about the NYSE. You have thousands of companies to choose from. For me, that universe has shrunk because I need to put large dollar amounts to work. Attitude is much more important than IQ. You can really get into trouble with a high IQ, i.e. Long-Term Capital. You need to have the right philosophical temperament.


Emory:
You take great pride in keeping your schedule wide open. Do you believe that corporate America is overscheduled and overstretched?

Buffett:
[Showed his blank schedule book]. Bill Gates is overscheduled. I am extremely lucky and I can say no to anything because there isn’t an entity that can use economic pressure to make me do something. A lot of CEOs get into a lot of the rituals that are part of the job. I would rather deliver papers than be the CEO of GE. They have too much stuff to do that is a big pain. Don’t get me wrong, CEOs have it pretty good. I’d imagine that every CEO in the Fortune 500 would be willing to take the job for half of the money. The 76 or so CEOs that run companies at Berkshire don’t have to deal with bankers or lawyers. At Berkshire, we’ve never had a meeting for all of them anywhere. There are no presentations and no committees. They can be more productive, and it makes it attractive when they can do what they like to do best.

Kansas:
What are three traits of successful managers?

Buffett:
Passion is the number one thing that I look for in a manager. IQ is not really that important. They need to be able to work well with others and the ability to get people to do what you want them to do. I’d say intelligence, energy, integrity. If you don’t have the last one, the first two will kill you. All you have is a crook who works hard. If a person doesn’t have integrity, you want them dumb and lazy.

If you could put 10% of your future earnings on one of your classmates, you would pick the one that’s most effective at working with people. These are qualities that are elective. If you could pick one to sell short, it would be the person that no one wants to work with. You can elect to be the kind of person you want to be. Look at those qualities of the two people you’ve selected (one long and one short). They’re all qualities that you possess. It’s like marriage. If you want a marriage that’s going to last, look for someone with low expectations. Don’t keep score. Keeping score doesn’t build organizations, homes, etc. I have never had one fight with Charlie. When I took over Solomon I had to pick the best person to run it. I interviewed 12 people for 15 minutes each and I asked myself, “Who would I go into a foxhole with?” I never look at grades or where you went to school. When I picked Deryck Maughan, he never asked me about pay or options or indemnity. He went to work.

Chains of habit are too light to be felt until they’re too heavy to be broken. In terms of picking people how do you lead your life in a way that I’d pick you?
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Warren Buffett Interview on Bloomberg

Warren Buffett talks with Bloomberg's Betty Liu: VIDEO
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Jeremy Grantham: Reinvesting When Terrified

Apparently, posting Mr. Grantham's entire article yesterday wasn't very copyright friendly. I had posted the whole thing because 1) it was short, 2) I thought it was great advice that should be usable many times throughout an investment career, so I wanted to keep the words up in case the article is ever taken down, and 3) I think there are probably a few readers out there who may not be able to view a PDF file, so I wanted them to be able to read the excellent (in my opinion) and timely advice from Mr. Grantham. At any rate, here is the wording for and link to the article as posted on GMO's website, www.gmo.com:
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Jeremy Grantham's article,
Reinvesting When Terrified, (March 2009) offers some insight into reinvesting in the market during these current, very difficult times.
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Monday, March 9, 2009

Warren Buffett on CNBC's Squawk Box - Transcript & Video

Part 1 ---- Part 2 ---- Part 3
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Part 4 ---- Part 5 ---- Part 6 ---- Part 7
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How About Free? The Price Point That Is Turning Industries on Their Heads

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Related books:
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Article: "The Long Tail" by Chris Anderson
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Related links:
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Prem Watsa's 2008 Shareholder Letter - Fairfax Financial

Last year, I quoted Hyman Minsky who said that history shows that “stability causes instability”. He said that prolonged periods of prosperity lead to leveraged financial structures that cause instability – and did we see that in spades in 2008!!With SIVs, CDOs, CDOs squared, among many other structures, leverage on leverage was exposed in 2008. Private equity firms that could do no wrong in 2005/2006 were down 90% from their IPO price in 2007. While Madoff may be the biggest Ponzi scheme yet unearthed, what Mr. Minsky calls Ponzi financial structures, where interest and principal cannot be financed by internal operations, are being unmasked daily in the financial markets. Structured investments based upon consumer debt that we warned you about for some time took a real beating in 2008, as 47% of the original AAA ratings on U.S. residential mortgage-backed and various other asset-backed securities issued between 2005 and 2007 were downgraded. In fact, as of January 9, 2009, over 13% of those securities which had originally been rated as AAA had been downgraded to CCC+ or lower!

Last year, we quoted Ben Graham who said that only 1 in 100 of the investors who were invested in the stock market in 1925 survived the crash of 1929-32. Our experience has been the same. As shown in the table below, we incurred a significant cost annually from 2003 through 2006 because of our equity hedging and CDS exposures. Not shown, of course, is the cost of not reaching for yield in the same time period.


We think this recession is going to be long and deep and the only comparable data points are the debt deflation that the U.S. experienced in the 1930s and Japan experienced from 1989 to the present time. While the U.S. government has initiated a massive stimulus program and is providing up to $2 trillion for its Financial Stability Program, the effect of these programs will be diminished by the enormous deleveraging going on by businesses and individuals: government in the U.S. only accounts for less than 20% of GNP while the private sector accounts for more than 80%. The situation will have to be monitored carefully over the next few years. Of course, many of these negatives are being discounted in the stock market and credit markets as stock prices are down more than 50% and credit spreads are at record levels. We have not had as many opportunities in both markets in our investing career and we are busy!

Thursday, March 5, 2009

Howard Marks Memo: Will It Work?

The other day, my son Andrew – college senior and credit-analyst-to-be – asked whether I think Treasury Secretary Geithner is doing the right things. As has happened before, his question elicited a fatherly response that grew into this memo.

When you want a bridge built, you hire a civil engineer whose “calcs” will determine exactly how much concrete and steel should be used. Then it’ll be sure to hold the weight of the cars you expect to cross it. And if you have to perform a task in carpentry, you can employ specialized tools developed and tested expressly for the job: esoteric things like miter boxes, routers and extractors.

One of the most important things to bear in mind today is that economics isn’t an exact science. It may not even be much of a science at all, in the sense that in science, controlled experiments can be conducted, past results can be replicated with confidence, and cause-and-effect relationships can be depended on to hold. It’s not for nothing that economics is called “the dismal science.”

Solutions in economics aren’t nearly as dependable as engineers’ calculations, and there may not be a tool that’s just right for fixing an economy. Of course, the toolbox offers lots of possibilities, including interest rate reductions; quantitative easing; tax cuts, rebates and credits; stimulus checks; infrastructure spending; capital injections; loans, rescues and takeovers; regulatory forebearances and on and on. But no one should think there’s a “golden tool,” such that solving the problem is just a matter of figuring out which one it is and applying it. Anyone who holds the problem solvers to that standard is being unfair and unrealistic.
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Bubbles, Jobs and Investment Tips: Jeremy Grantham visits Wharton

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Where Mr. Grantham and the academics differ, however, is how these bubbles act when they pop. According to the market efficiency theory, all movements in the market are random and thus when a bubble pops, the market should follow a random walk (i.e. sometimes the market will go up, while other times the market will go down). But from Mr. Grantham's calculations, each of the 27 bubbles he studied "nose-dived back to the mean". The one exception, as noted above, was the tech bubble. When this bubble popped it did not revert back to the mean in 2003. Mr. Grantham claimed that this was due to two historic events, 9/11 and Alan Greenspan's decision to lower interest rates to the point where real rates were negative, which ultimately led to increased borrowing (surprise, surprise!). According to Mr. Grantham, these two events helped create "the biggest sucker rally in history".
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Related book: Manias, Panics, and Crashes: A History of Financial Crises
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Related previous post: GMO - Jeremy Grantham's 4Q 2008 Letter (Parts 1 & 2)
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Other, bubble-related books:
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A Short History of Financial Euphoria
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Tulipmania
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Panic of 1819
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The Panic of 1907
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The Great Crash of 1929
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The Go-Go Years
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Bull: A History of the Boom and Bust, 1982-2004
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Speculative Contagion
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Mr. Market Miscalculates
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Wednesday, March 4, 2009

Graham and Doddsville Newsletter - Winter 2009

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Excerpt (Thanks Linc!):
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Berkowitz: The amazing thing is that people just don’t seem to learn from history. Difficult times correct problems. Companies are tightening up, losing the fat, becoming more efficient, learning very tough lessons about leverage, and relearning about the sanctity of the balance sheet. They are learning that you should not play Russian roulette even if the gun may have a thousand chambers and only one bullet because if you hit that bullet, you are dead. Much of the probability and statistics work—for instance, Monte Carlo simulations—are based upon thousands and thousands of spins of the wheel. But if you kill yourself that one time, you can’t spin again. I don’t know where that is addressed in the statistical courses. Now we know it. Now we have books about black swans and fat tails, and we understand that a bad thing can happen more often than you think.

In life as in investing, what kills you is what you don’t know about and what you’re not thinking about. Today investors are focused on most of the ways in which you can die, which is a great signal for the future. It is when you’re not thinking about it that you get hurt. It is when you pay that optimistic price. It has always paid to be very greedy when everybody else is quite fearful of the environment, because that fear factor is priced in. You tend to get a relatively decent margin of safety based on the price you are paying for a given level of free cash flow. That is where we are today. What better time is there? If not now, when? Was it a better time to invest three years ago? Six years ago? And the answer is no. What is happening today, as in most bear markets, is that people either don’t have the cash or they don’t have the stomach—hence the low valuations.
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