Tuesday, April 27, 2010

Kirkland's: The importance of watching the insiders

Here are a few numbers from Kirkland’s (KIRK) to illustrate the importance of paying attention to what insiders are doing at companies:

Carl Kirkland:

  • 3,464,032 shares purchased on September 22, 2008 for $6,754,862 ($1.95 per share)
  • 2,639,900 shares sold since September 22, 2008 for proceeds of $30,742,256 (for an average sales price of $11.65 per share)
  • 824,132 shares from the September 2008 purchase still owned, for a current value (as of market close on 4/27) of $19,251,724 ($23.36 per share)

Total share sales plus current market value of shares bought in September of 2008 = $49,993,980 (or 7.4 times the initial investment)

Monday, April 26, 2010

Greenlight Capital Q1 2010 Letter

Among other things, David Einhorn discusses some statements that were made up by the Wall Street Journal.


Friday, April 23, 2010

Jeremy Grantham's Q1 2010 Letter: Playing with Fire (A Possible Race to the Old Highs)

Is there a new bubble on the horizon in the US? Having shot through GMO’s fair value estimate of 875, Jeremy Grantham's first quarter letter asks whether current policies and conditions are pushing the S&P to approach its old highs. Included in the letter is a link to a video of an interview about investment bubbles, done with Jeremy by the Financial Times on April 19. The Letters to the Investment Committee XVI is part one of a speech given by Jeremy discussing the Potential Disadvantages of Graham & Dodd-type Investing.

The best financial reform? Let the bankers fail - By James Grant

Found via My Investing Notebook.

The trouble with Wall Street isn't that too many bankers get rich in the booms. The trouble, rather, is that too few get poor -- really, suitably poor -- in the busts. To the titans of finance go the upside. To we, the people, nowadays, goes the downside. How much better it would be if the bankers took the losses just as they do the profits.

Happily, there's a ready-made and time-tested solution. Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors.

Of course, there are only so many mansions, Bugattis and Matisses to go around. And many, many such treasures would be needed to make the taxpayers whole for the serial failures of 2007-09. Then again, under my proposed reform not more than a few high-end sheriff's auctions would probably ever take place. The plausible threat of personal bankruptcy would suffice to focus the minds of American financiers on safety and soundness as they have not been focused for years.

Like one of those notorious exploding collateralized debt obligations, the American financial system is built as if to break down. The combination of socialized risk and privatized profit all but guarantees it. And when the inevitable happens? Congress and the regulators dream up yet more ways to try to outsmart the people who have made it their business in life not to be outsmarted. And so it is again in today's debate over financial reform. From the administration and from both sides of the congressional aisle come proposals to micromanage the business of lending, borrowing and market-making: new accounting rules (foolproof this time, they say), higher capital standards, more onerous taxes. If piling on new federal rules was the answer, we'd long ago have been in the promised land.

Until 1999, Goldman Sachs was a partnership, with the general partners bearing general and unlimited liability for the firm's debts. Today, Goldman -- like the vast majority of American financial institutions -- is a corporation. Its stockholders are liable only for what they invested, no more. And while there are plenty of sleepless nights, the constructive fear of financial oblivion is, for the senior executives, an all-too-distant nightmare.

The job before Congress is to bring the fear of God back to Wall Street. Not to stifle enterprise but quite the opposite: to restore real capitalism. By all means, let the bankers savor the sweets of their success. But let them, and their stockholders, pay dearly for their failures. Fair's fair.

Thursday, April 22, 2010

The Bernanke Put: Creating Tetrodoxin Investors - By Cliff W. Draughn

In the realm of academic sciences there sits at the top of the food chain the world of physics. The world according to Galileo, Pascal, and Newton can be quantified and the laws governing cause and effect put forth in intricate formulas and mathematical equations that hold true. Physics, according to Wikipedia, “is the natural science that involves the study of matter and its motion through space and time, as well as all applicable concepts, such as energy and force. More broadly, it is the general analysis of nature, conducted in order to understand how the world and universe behave.” In the world of mathematical physics, atomic physics, molecular physics, and quantum chemistry, one can define the universe in mathematical fashion. For example, as we all know from Newton’s laws of motion, to every action there is always an equal and opposite reaction. If I drop a ball of a specific size and density from a specified height, then based upon the physical aspects of the ball, the length traveled to the floor and the hardness of the surface it hits, a physicist can tell me mathematically how high the ball will bounce once it hits the floor. And not only once, but the height of all the subsequent bounces until it comes to rest on the floor.

In academia, somewhere below the world of physics lives the world of economics. Economists and investment professionals aspire to be physicists. The desire to quantify economic movement or behavior with formulas has become an obsession for the modern-day investor. The attempt to predict future outcomes based upon a given set of historical economic variables is the Holy Grail that we seek. However, there is one huge problem in quantifying the economic and investment world: you are dealing with human behavior that is often rational but at times can be completely irrational. For the purpose of argument, let’s use our above bouncing ball as a metaphor for today’s investor. If you take an investor and drop him from, say, a level of 1500 on the S&P to 700, then from a physics perspective one could project a rebound of returns. Given that humans are perfectly rational individuals who will always invest money to its highest and best utility with the least amount of risk, then one could employ mathematical formulas to draw conclusions as to how high the markets would recover. However, humans do not react to events as does mute physical matter: …we have the ability to be emotional, to rationalize, to anchor, and in many other ways make irrational decisions. For example, economists could apply the number-sequencing theory of Italian mathematician Fibonacci to the above example, and arrive at the conclusion that the investor should bounce to an S&P level of 1206. However, what if the investor behaves irrationally and, upon hitting the floor the first time, grabs an anchor for fear of bouncing again and again? Or what if he hits feet first and has the vertical jump of a Michael Jordan? Although there has developed a series of econometric laws using mathematical trend lines and what is commonly known as technical analysis, I question if we can actually measure human behavior. Are markets indeed efficient? Ben Graham once wrote:

Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from….Whenever calculus is brought in, or higher algebra, you could take as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the guise of investment.”

In my opinion, what Mr. Graham is trying to make you and me aware of is that critical thinking regarding financial markets is an underappreciated asset in this investment world. The trend is your friend, don’t fight the tape, let your herding instincts go with the flow – are all statements that reflect investors’ greed and fear of missing the next upward move in the market, regardless of valuations. Investment professionals have become consumed with sophisticated trade formulas, algorithms, and program trading and have forgotten how to apply common sense to the models. When events like 2008 occur (what the investment world terms as “fat tail” events and what Nassim Taleb referred to as “Black Swans”), the investment world dismisses the bursting of the bubble as a one-in-a-thousand occurrence. But why do investors get caught by these 3-sigma events, such as in 2008? In my opinion, it is a simple lack of critical thinking, where statistics, benchmarking, and status relative to your peers replace common sense. And that brings me back to the title of this newsletter. I am sure many of you are still wondering what the heck is a Tetrodotoxin Investor, and how does Fed policy create such?

Wednesday, April 21, 2010

Giverny Capital – 2009 Letter to Partners

What lessons have been learned from the crisis of 2008-2009?

We find it helpful to read historical writings in times of pessimism in order to keep current events in perspective. Abraham Lincoln wrote in 1859:

"It is said an Eastern monarch once charged his wise men to invent him a sentence to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: 'And this, too, shall pass away.' How much it expresses! How chastening in the hour of pride! How consoling in the depths of affliction!"

It is the nature of our civilization, for better or for worse, to have periods of both economic expansion and economic contraction. When we look at our scorecard, however, our civilization has made constant progress—progress towards a higher standard of living.

But one of the side effects of our system is that during periods of expansion, some participants try to hasten their journey towards greater wealth by using the lever of debt. This works for some time and the neighbor, who considers himself just as intelligent, concludes after considerable reflection: “Why not me?” This continues to work for a while… until a period of contraction presents itself, always without an official announcement. And those who were imprudent are punished. Unfortunately, during several quarters, all participants are punished whether they acted prudently or not.

Many people who have lost their jobs, for example, were forced to sell stock at abnormally low prices. But this wasn’t the case for everyone. Those who have the opportunity to wait for better days should remain emotionally immune against market drops. Because, at some point, the market will rise and reach new heights as the upward human quest for progress return to its historical road.

Economists who attempt to predict such cycles and the market in the short term fail to realize that they need to keep track of several hundred million factors which are the several hundred million human beings who participate in this vast activity. What’s involved here doesn’t just entail tracking a dozen economic indicators. Such economists remind me of the scientists from a thousand years ago who simplistically separated all the elements into four: earth, water, air, and fire.


But even such a sound philosophy isn’t enough to succeed in the market—another quality is necessary. In 1949, Ben Graham wrote the following in the conclusion to “The Intelligent Investor”:

"Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ." (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”

Another good debunking of the efficient market theory, CAPM, and the use of beta to measure risk

From Ned Goodman in the Dundee Corporation 2008 Annual Report (written about a year ago):

Benjamin Graham, the father of modern day security analysis, took time out in his later years to say: “Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concepts of risk. Price variability, yes; risk, no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.”

The stock market, like any auction market, is not efficient. Graham used to say, “price is what you pay, value is what you get.” As such, the translation of a bogus model and theory allowing journalists and accountants to easily calculate business valuation because the market knows all means that the market values are likely not to be correct. Markets and auctions have more to do with psychology than the calculation of intrinsic values.

The assumptions behind the CAPM and market efficiency are mostly foolish when studied carefully:

- No transaction costs

- No market movement because of buying or selling

- No taxes

- All investors are risk averse

- All investors share the same time horizon

- Volatility is risk and can be totally controlled by diversification

- All assets can be bought and sold freely

- Investors can all borrow at the best risk free rate

- All investors are aware of and use Markowitz Optimization tool which purports to allow an investor to calculate the required weight to give each stock in order to achieve the greatest return for a given level of risk chosen. Even Harry Markowitz did not totally use his tool for his own portfolio.

To make the whole situation even more ludicrous, Eugene Fama – the original creator of beta – i.e. risk equals volatility, has recently acknowledged its short comings.

So why is it that in spite of the likes of Jeremy Grantham who has recently said in blaming Alan Greenspan for the 2008 financial crisis: “An even bigger villain besides Greenspan was the general concept of rational expectations and the efficient market.” Keynes said “Politicians think they are all independent free thinkers. But it turns out they are invariably slaves to some defunct economic thinkers.” Today, we can add accountants as part of the political slavery to the nonsense of efficient markets.

Grantham went on to rant about Ben Bernanke – “His belief in market efficiency is so profound, that he does not believe that there could be a bubble – and therefore, despite the data before his eyes, he cannot see it. He (Bernanke) went on to say, ‘US house prices have never declined’; that’s why the Fed was so hopelessly wrong.”

So why, you may ask, have the regulators, journalists, and the accounting profession grasped on the efficiency of the markets when they created the Fair Value rule by putting “mark to market” with necessary accounting and regulatory usage.

The standard assumption in economics is that people make such good decisions that our choices are labelled optimal. Conventional investment advice from the Modern Portfolio theory is based on this underlying belief that people and financial markets are rational and sensible. In the real world, however, people are far from rational. We all know that the collective of people produces crazy irrationality.

Investment has not kept up with the cutting edge intellectual developments. While the science of irrational behaviour is quickly growing up, conventional wisdom still provides investment advice based on very outdated, bogus ideas of sensible sane people and rational stock markets. The extremes of human emotion prevent the stock market from spending much time in a rational state of fair valuation. The stock market has multiple personalities: extreme state of happiness to severe depression. The stock market rarely behaves in an average manner.

The creators of the Capital Asset Pricing Model (CAPM), Eugene Fama and Kenneth R. French wrote as recently as 2004 that : “The attraction of CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor – poor enough to invalidate the way it is used in applications.”

James Montier of Société Général and author of Behavioural Investing perhaps put it best – “that” CAPM is in actual fact Completely Redundant Asset Pricing (CRAP).

Charlie Munger as well said in April 1994, “I have a name for people who went to the extreme efficient market theory, which is “bonkers”. It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.”

It was my attitude on this subject that drove me away from the so-called consultants (or drove them away from me) who advise the major pension funds in our society. Consultants who have taken market efficiency to a religion. It is from that religion that we have index benchmarks, risk calculated by volatility (beta), indexing of portfolios. Clearly as the last ten years in the market has ended, the religion of efficient stock markets is more broadly recognized than those of us who agree with the Buffett-Munger agnosticism towards that “bonkers” theory.

Lawrence Summers, President Obama’s special economic advisor, in a prior position was part of the team brought in to unwind and bail out Long Term Capital Management. He stated on several occasions that the Efficient Market Theory is the worst thing that has ever happened to the investment process.

Nonetheless, like all religions, aspects of it take on a life of their own and today we have to live with:

- Regulators who want returns compared to benchmark indices.

- Regulators who want the risk of a mutual fund related to the fund’s beta

- Accountants who want to mark assets to market or if no market exists to a model that would replicate a market. This was the input that nearly took down the entire global banking system.

- Accountants who value option prices using the Black Scholes formula which uses beta as its key ingredient, negatively and unnecessarily reducing corporate earnings with a formula which has been proven incorrect.

With the gradual acceptance of the Efficient Market Theory by the accounting profession it means that as management we have no choice but to sit back and accept the silliness it creates of our financial statements. The bogus Efficient Market Theory has given accountants “negative goodwill”, “mark to market”, ‘impairment”, or “temporary impairment” and earnings and losses impact from equity accounting and share sales by subsidiary companies in excess of book value.

But not only must we accept the usual incomprehensible result, we must then sign a statement that we take full responsibility and agree with the resultant financial statements.

We recognize that accounting disciplines strive to provide information that is both relevant and verifiable. The evolution of accounting to “fair value” rather than “historical cost” means that current market prices have taken on a relevance that is just not acceptable to practiced and knowledgeable investment professionals. Ben Graham, the father of modern security analysis, stated that the stock market is not a “weighing machine”, it is a “voting machine” and the resulting prices that comes from the “voting” process is not likely or necessarily its value.

We have evolved from a system of objectivity and ability to verify to a system in which the market price of an asset is subject to debate between a company and its auditor, particularly during a period, such as recent, of economic stress and panic proportions of market price movements.

As a result, the accounting profession has become overly conservative in order to be prepared for the many instances of criticism that may come from management, shareholders and regulators. To quote Edward Lampert of Sears: “So much time and money ends up spent ensuring that the financial statements are immune from criticism that it can become much more of a distraction than a useful tool for investors and management.”

Link to: Dundee Corporation 2008 Annual Report

Jim Chanos on Fox Business

Monday, April 19, 2010

Steve Forbes Interview with Joel Greenblatt

Link to: Steve Forbes Interview with Joel Greenblatt


Related books:

The Little Book That Beats the Market

You Can Be a Stock Market Genius

Related links:

Magic Formula Investing

Formula Investing

FT Interview with Jeremy Grantham


William White, from the BIS, on failures in economic theory, politics and policy.

Found via Simoleon Sense.

Related previous post: THE MAN NOBODY WANTED TO HEAR

Hussman Weekly Market Comment: Earning More by Setting Aside Less

Meanwhile, it is notable that the "favorable" earnings reported by J.P. Morgan and Bank of America in the first quarter were due to reduced provisions for credit losses - charges that are largely discretionary. In the fourth quarter of 2009, J.P. Morgan charged $8.9 billion against earnings to provide for credit losses, but in the first quarter of 2010, it charged $7.0 billion. Thus $1.9 billion of the $3.3 billion in earnings reported by JPM reflected reduced provision for credit losses. Likewise, the main factor driving Bank of America's earnings was a reduction in loss reserves. Indeed, the provision for credit losses was $3.6 billion lower than it was a year ago (when delinquency rates and credit losses were running at a fraction of current levels).

The reduced provision for credit losses might be reassuring were it not for the fact that delinquencies, foreclosures, non-performing loans, commercial mortgage strains, and actual charge-offs reported by various sources have been either unchanged or accelerating. Bank of America, for example, reported that 30-day delinquencies on residential mortgages hit a new record of 8.5% in the first quarter (though the surging FHA-insured portion will allow them to pass some of the consequent losses off onto the American public). Moreover, provisions for credit losses are again falling short of net charge-offs, which is what we saw in 2008 before banks got into trouble (see the June 2, 2008 weekly comment: Wall Street Decides to Close Its Ears and Hum). For example, actual net charge-offs at Bank of America were $10.8 billion during the first quarter of this year (versus $6.9 billion a year ago), exceeding the provision of $9.8 billion that was deducted from earnings in the first quarter. In effect, the Bank reduced its reserve for future losses by about $1 billion, which had the effect of boosting reported earnings accordingly. This accounts for the entire improvement in earnings from the fourth quarter of 2009, and then some.

Overall, the current data presents at best a mixed picture of credit conditions. My impression is that investors should not be surprised by a significant second-wave of credit strains. Still, as we've anticipated for months, we have now entered the window where those strains would be expected to begin, so I won't maintain this view if the data don't increasingly support it. Some evidence is consistent with fresh deterioration, but not nearly to the extent that we would consider decisive. Meanwhile, indications of improvement are also extremely thin. It seems unwise for investors to celebrate variations of a few basis points in delinquency rates. It seems equally unwise to celebrate "favorable" bank earnings reports that are exclusively driven by reduced loan loss provisions, particularly when the volume of impaired loans has not declined proportionately. Keep in mind that Enron and Worldcom were able to report outstanding earnings for a while by adjusting the manner by which revenues and expenses were accrued. I suspect that the U.S. banking system has become a similar breeding ground for innovative accounting.

Friday, April 16, 2010

Tradewinds - David Iben’s March 2010 Commentary: Avatar

Thanks to Mike G. for passing this along.

The current investment environment is complex and challenging to say the least. Capitalism as we've known it is dead. The financial system is broken and the currencies are being debased. Should investors prefer common stocks, many of which that appear to be overpriced relative to fundamentals, cash—which is very expensive, yielding approximately zero and having lost 97% of its purchasing power over the past century, or bonds—which appear horribly overpriced. Bonds are, after all, an exchange of cash currently for the right to get that cash back sometime in the future when it arguably will have lost much of its purchasing power. In consideration of this risk, bonds pay a coupon. Current coupons are grossly insufficient compensation for the magnitude of this risk (in our humble opinion).

Amazingly, there is a silver lining in this otherwise bleak environment. It is still possible to exchange intrinsically depreciating currencies into goods that are much in demand and can be expected to become increasingly so. While history is littered with the battlefields resulting from mankind's efforts to secure food, water, gold and other metals, and energy; we currently need shed no blood. People will hand over these necessities of life in exchange for dollar bills! In exchange for bearing the business risk of owning common stocks, we can secure many of these same goods for a steep discount to their adjusted market value. Rather than complain about Chinese efforts to secure resources, we suggest that investors do the same. Tradewinds' team of investment professionals is scouring the globe looking for companies that own, process or transport scarce and valuable resources. Additionally, we still gravitate toward the stocks of the strong global franchises highlighted in the last Commentary.

Thursday, April 15, 2010

Singapore Prime Minister Lee Hsien Loong on Charlie Rose


Shiller PE charts

I thought these charts from Dylan Grice’s “What to do when there’s nothing to do?” piece from March 31st were worth passing along.

Global Debt Bomb

Kyle Bass has bet the house against Japan--his own house, that is. The Dallas, Texas hedge fund manager (no relation to the famous Bass family of Fort Worth) is so convinced the Japanese government's profligate spending will drive the nation to the brink of default that he financed his home with a five-year loan denominated in yen, which he hopes will be cheaper to pay back than dollars. Through his hedge fund, Hayman Advisors, Bass has also bought $6 million worth of securities that will jump in value if interest rates on ten-year Japanese government bonds, currently a minuscule 1.3%, rise to something more like ten-year Treasuries in the U.S. (a recent 3.4%). A former Bear Stearns trader, Bass turned $110 million into $700 million by betting against subprime debt in 2006. "Japan is the most asymmetric opportunity I have ever seen," he says, "way better than subprime."

Bass could be wrong on Japan. The world's second-largest economy has defied skeptics for so long that experienced traders call betting against it "the widowmaker." But he may be right on the bigger picture. If 2008 was the year of the subprime meltdown, 2010, he thinks, will be the year entire nations start going broke.

Most investors seem to believe, as the late Citibank chairman Walter Wriston put it, that "countries don't go bust." The opposite is true. "There was a massive default wave in 1980s and 1990s," says Reinhart. Investors may not have paid much attention since the defaults were mostly in emerging market countries like Guatemala and Romania. But the deadbeats included current investor favorites like Brazil, which defaulted in 1983, went through a bout of hyperinflation in 1990 and effectively defaulted again, for the same reason, in 2000. Reinhart and Rogoff show that, on average, nations add 86% to their debt loads within three years of a credit crisis. At the same time government revenue falls an average of 2% in the second year after the onset of the troubles (see timeline).

Wednesday, April 14, 2010

Congressional Oversight Panel: Commercial Real Estate Losses and the Risk to Financial Stability – February 10, 2010

Over the next few years, a wave of commercial real estate loan failures could threaten America’s already-weakened financial system. The Congressional Oversight Panel is deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nation’s mid-size and smaller banks, and that as the damage spreads beyond individual banks that it will contribute to prolonged weakness throughout the economy.

Commercial real estate loans are taken out by developers to purchase, build, and maintain properties such as shopping centers, offices, hotels, and apartments. These loans have terms of three to ten years, but the monthly payments are not scheduled to repay the loan in that period. At the end of the initial term, the entire remaining balance of the loan comes due, and the borrower must take out a new loan to finance its continued ownership of the property. Banks and other commercial property lenders bear two primary risks: (1) a borrower may not be able to pay interest and principal during the loan’s term, and (2) a borrower may not be able to get refinancing when the loan term ends. In either case, the loan will default and the property will face foreclosure.

The problems facing commercial real estate have no single cause. The loans most likely to fail were made at the height of the real estate bubble when commercial real estate values had been driven above sustainable levels and loans; many were made carelessly in a rush for profit. Other loans were potentially sound when made but the severe recession has translated into fewer retail customers, less frequent vacations, decreased demand for office space, and a weaker apartment market, all increasing the likelihood of default on commercial real estate loans. Even borrowers who own profitable properties may be unable to refinance their loans as they face tightened underwriting standards, increased demands for additional investment by borrowers, and restricted credit.

Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present “underwater” – that is, the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Increased vacancy rates, which now range from eight percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties.

The largest commercial real estate loan losses are projected for 2011 and beyond; losses at banks alone could range as high as $200-$300 billion. The stress tests conducted last year for 19 major financial institutions examined their capital reserves only through the end of 2010. Even more significantly, small and mid-sized banks were never subjected to any exercise comparable to the stress tests, despite the fact that small and mid-sized banks are proportionately even more exposed than their larger counterparts to commercial real estate loan losses.

A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American. Empty office complexes, hotels, and retail stores could lead directly to lost jobs. Foreclosures on apartment complexes could push families out of their residences, even if they had never missed a rent payment. Banks that suffer, or are afraid of suffering, commercial mortgage losses could grow even more reluctant to lend, which could in turn further reduce access to credit for more businesses and families and accelerate a negative economic cycle.

It is difficult to predict either the number of foreclosures to come or who will be most immediately affected. In the worst case scenario, hundreds more community and mid-sized banks could face insolvency. Because these banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery, and extend an already painful recession.

There are no easy solutions to these problems. Although it endorses no specific proposals, the Panel identifies a number of possible interventions to contain the problem until the commercial real estate market can return to health. The Panel is clear that government cannot and should not keep every bank afloat. But neither should it turn a blind eye to the dangers of unnecessary bank failures and their impact on communities.

The Panel believes that Treasury and bank supervisors must address forthrightly and transparently the threats facing the commercial real estate markets. The coming trouble in commercial real estate could pose painful problems for the communities, small businesses, and American families already struggling to make ends meet in today’s exceptionally difficult economy.


Related links about the above report:

FT Alphaville post

Albert Edwards: 19 February 2010 Weekly

Oak Value Fund: Investment Adviser’s Review – First Quarter 2010

“We are what we repeatedly do.” – Aristotle

In suggesting the importance of habits in the pursuit of excellence, Aristotle provided an instructive framework for investing. Successful companies, such as those we target for the Oak Value Fund (the “Fund”), tend to repeat effective activities or efforts that have been effective while minimizing or eliminating ineffective activities. It is no mere coincidence that these companies are very profitable and produce high returns on capital (and do so without the use of significant financial leverage) while demonstrating the ability to grow both domestically and abroad. Through the years, their leaders have consistently made the decisions to repeat those activities that produce and reinforce successful outcomes. The benefits of these habits have been most apparent in recent years. While many of their competitors were retrenching, these companies were generally improving their business models, expanding their product offerings and market positions, and investing shareholder capital to take advantage of long-term growth opportunities.

Grant's Prospectus Issue - March 5, 2010

I'm not sure if the person who posted this issue of Grant's online is following proper copyright laws, but here's the link to the issue (while it lasts):


Jim Chanos on Charlie Rose

James Chanos, President, Kynikos Associates. He is the man who predicted the Enron downfall and is now predicting a housing bubble in China.

Link to: Jim Chanos on Charlie Rose


Related previous post: Jim Chanos' Presentation on China

Tuesday, April 13, 2010

Popular Delusions - 23 March 2010: When to sell gold - by Dylan Grice

Having a medium of exchange makes life easier than under barter economy and societies have always organised themselves around the best monetary standard they could find. Until industrialisation of the paper printing process, that happened to be gold, which is small, malleable, portable and with no tendency to tarnish. Crucially, it's also relatively finite and this particular characteristic (in combination with the others) can be very useful in environments characterised by monetary mischief.

I view it primarily as insurance against such environments. It’s a lump of metal with no cash flows and no earnings power. In a very real sense it's not intrinsically worth anything. If you buy it, you're forgoing dividend or interest income and the gradual accumulation over time of intrinsic value since a lump of cold, industrially useless metal can offer none of these things. That forgone accumulation of wealth is like the insurance premium paid for a policy which will pay out in the event of an extreme inflation event.

Is there anything else which will do that? Some argue that equities hedge against inflation because they are a claim on real assets, but most of the great bear market troughs of the 20th century occurred during inflationary periods. A more obvious inflation hedge is inflation linked bonds, but governments can default on these too. More exotic insurance products like sovereign CDSs, inflation caps, long-dated swaptions or upside yield curve volatility all have their intuitive merits. But they all come with counterparty risk. Physical gold doesn’t. Indeed, during the “6000 year gold bubble” no one has defaulted on gold. It is the one insurance policy which will pay out when you really need it to.

There is nothing mystical about gold and I don't consider myself a gold bug. In fact, I'm not sure I'd even classify gold as an ‘investment’ in the strictest sense of the word. Well chosen equities (not indices) will act as wealth-compounding machines and are likely to make many times the initial outlay in real terms over time. These are ‘investments’ because so long as the economics of each business remain firm, you don’t want to sell. As they say in the textbooks, you ‘buy to hold.’ But gold isn't like that. Like all commodities, it's intrinsically speculative because you only buy it to sell it in the future.

The reason I own gold is because I'm worried about the long-term solvency of developed market governments. I know that Milton Friedman popularised the idea that inflation is “always and everywhere a monetary phenomenon” but if you look back through time at inflationary crises - from ancient Rome, to Ming China, to revolutionary France and America or to Weimar Germany - you'll find that uncontrolled inflations are caused by overleveraged governments which resorted to printing as the easiest way to avoid explicit default (whereas inflation is merely an implicit default). It’s all very well for economists to point out that the cure for runaway inflation is simply a contraction of the money supply. It’s just that when you look at inflationary episodes you find that such monetary contractions haven't been politically viable courses of action.

Economists, we find, generally don’t understand this because economists look down on disciplines which might teach them it, such as history, because they aren’t mathematical enough. True, historians don’t use maths (primarily because they don’t have physics envy) but what they do use is common sense, and an understanding that while the economic laws might hold in the long run, in the short run the political beast must be fed.


Related link: Passport Capital's Rationale For Owning Physical Gold Versus Proxies

The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going - by Jesse Eisinger and Jake Bernstein

In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates. Subprime mortgage company shares were falling. Investors began to balk at buying complex mortgage securities. The housing bubble, which had propelled a historic growth in home prices, seemed poised to deflate. And if it had, the great financial crisis of 2008, which produced the Great Recession of 2008-09, might have come sooner and been less severe.

At just that moment, a few savvy financial engineers at a suburban Chicago hedge fund helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages.

When the crash came, nearly all of these securities became worthless, a loss of an estimated $40 billion paid by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers.

Yet the hedge fund, named Magnetar for the super-magnetic field created by the last moments of a dying star, earned outsized returns in the year the financial crisis began.

How Magnetar pulled this off is one of the untold stories of the meltdown. Only a small group of Wall Street insiders was privy to what became known as the Magnetar Trade. Nearly all of those approached by ProPublica declined to talk on the record, fearing their careers would be hurt if they spoke publicly. But interviews with participants, e-mails, thousands of pages of documents and details about the securities that until now have not been publicly disclosed shed light on an arcane, secretive corner of Wall Street.

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations -- CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.


Related books:

ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism

The Big Short: Inside the Doomsday Machine

Monday, April 12, 2010

Albert Edwards: Global Strategy Weekly - 16 March 2010

Ultimately, as my colleague Dylan Grice writes, I think we head back to double-digit inflation rates as governments opt to default. I certainly again expect to see CPI inflation above 25% in the UK and indeed in most developed nations in my lifetime – I have happy memories of the three-day week and doing my homework by candlelight. In the near term, however, the deflationary quicksand will suck us ever lower until we suffocate. A key driver for underlying inflation remains unit labour costs. While unit labour costs decline at an unprecedented rate, they are sucking us inevitably into a Fisherian, debt-deflation spiral. Only then will we see how far policymakers are willing to go to debauch the currency. Last year saw them cross the Rubicon. Monetisation is now the policy lever of first resort.

Don’t Bet the Farm on the Housing Recovery - By Robert J. Shiller

THE question now is whether a strong case has been built for a new bull market since the home-price turning point in May 2009. Though there is no way to be precise, I don’t believe it has.

Since that turning point, most public discourse on housing has not been about a new long-term view of the market. Instead, it focused initially on whether the recession was over and on the extraordinary measures the government was taking to support the housing market.

Now we’re shifting into a new phase. The recession is generally viewed as being over, and those extraordinary measures are being lifted.

On March 31, the Federal Reserve ended its program of buying more than $1 trillion of mortgage-backed securities, and the homebuyer tax credit expires on April 30.

Recent polls show that economic forecasters are largely bullish about the housing market for the next year or two. But one wonders about the basis for such a positive forecast.

Momentum may be on the forecasts’ side. But until there is evidence that the fundamental thinking about housing has shifted in an optimistic direction, we cannot trust that momentum to continue.

Leucadia 2009 Letter to Shareholders

Even in good times, it is difficult to make estate wineries profitable. The entire industry suffers from a lack of discipline. The sheer number of brands combined with owners willing to sell out last year’s vintage at (or below) cost are a constant anchor on price. Estate wineries have high fixed costs and require large marketing dollars, making volume the key profit driver. We have a great management team led by Erle Martin and Patrick DeLong who have streamlined our operations while improving our wines. We now need more volume.

Having started one estate winery from scratch we have seen that planting quality vineyards increases land value and may provide an inflation hedge. Durable annual cash flows may be difficult to achieve, thus the ultimate judgment on our investment will have to wait until it is eventually sold.


The Future

Most of our assets are tied to a recovery in the world’s economy. In 2009, we have seen the baby steps of recovery. We hope the baby does not flop back on its bottom. In the current recessionary environment, earnings from our operating businesses and investments do not cover our overhead and interest. We have cash, liquid investments and securities and other assets that should carry us through these difficult times. We are energetically cutting costs. We have talented managers and employees working hard every day.

Out of prudence we take a pessimistic view as to when this recession will end. To think otherwise would be a gamble that we are unwilling to make.

In these troubled times there are sure to be opportunities for investment and we will remain on the hunt. The acquisition by Berkadia is the first fruition of that hunt. We recognize a good deal when we see one and will strive to execute.

We intend to resist what we consider “financial bets.”