Monday, February 28, 2011

The Madoff Tapes - By Steve Fishman

One evening, my home phone rang. “You have a collect call from Bernard Madoff, an inmate at a federal prison,” a recording announced. And there he was.

John Mauldin: When Irish Eyes Are Voting

Most of the world is focused on the Middle East and Libya, and rightly so. We will look at that in a minute. And I agree the Middle East is important. But my eyes are focused on what I think is the far more important event of the day, and that is the election going on in Ireland.

I have written about Ireland before, but we need to once again focus on what are not smiling Irish eyes. Ireland was once the envy of Europe, with one of the highest growth rates in the world. It was not long ago that Ireland could borrow money at lower rates than Germany. Now rates are 6% and likely to rise with the new government. Let’s look at a few data points from a brilliantly written article by Michael Lewis, who ranks as one of my favorite writers.


Irish taxpayers are being asked to pay French, German, and British bond banks and the ECB, which bought that debt. It is 30% of their GDP, along with the rest of the debt. At 6% interest, that means it will take 10% of their national income just to pay the interest. It guarantees that Ireland will be in a poverty cycle for decades. The ECB and the IMF seem to think the solution for too much debt is more debt. And in order to pay the ECB, the Irish must take on an austerity program that guarantees even worse recessions and higher unemployment.

The government that agreed to take on the bank debts is going to be voted out in spectacular fashion today. Whether one party can win or has to form a coalition government is not yet clear, but the mandate is to renegotiate the Irish debt. Both the ECB and the Germans have said that is not possible, that deals have been made. But asking Irish voters, you don’t get the sense they feel the same obligation.


Related previous post: When Irish Eyes Are Crying - By Michael Lewis

Bloomberg Video: Howard Buffett Says Dad Aims to Keep Berkshire Culture

Thanks to Matt for passing this along.

Link to: Howard Buffett on Bloomberg

Hussman Weekly Market Comment: Cash and Credit - Implications for the Financial Markets

So what is the effect of creating an extra $600 billion dollars of monetary base by having the Fed purchase $600 billion dollars of Treasury debt? The same thing that happens anytime any security is issued. Somebody has to hold it, and the returns on all other assets have to shift by just enough to make everyone in the economy happy, at the margin, to hold the outstanding quantity of all of the securities that have been issued. In practice, the only way you can get people to willingly hold $2.4 trillion in non-interest bearing cash is to depress the return on all close substitutes to next to zero. So short-term Treasury bill yields have been pressed to nearly nothing.

Of course, people also look at risky assets and ask whether they might be able to get higher risk-adjusted returns by holding those instead. In order to make people happy to hold the outstanding quantity of zero return cash, the prospective returns on other risky securities have also collapsed (securities are a claim to future cash flows - as investors pay a higher price, they implicitly agree to accept a lower long-term return). In my view, this has gone on to an extent far beyond what is likely to be sustained, but thanks to eager speculation, the S&P 500 is now priced, by our estimates, to achieve annual returns of just 3.25% over the coming decade.

Likewise, all of those securities yielding zero or nearly zero returns have to compete with commodities. Here, the markets have responded to the massive deficits of world governments by increasing their expectations regarding inflation. Now, if you're looking at a zero nominal return on money-market instruments, as well as expected inflation over time, it's natural to start hoarding commodities. See, if you expect your dollars to buy fewer goods and services in the future, and you're not earning interest to make up for it, you'd prefer to stockpile goods right now. This, of course, has created terrible problems for people in less-developed countries, who are experiencing soaring prices for food and fuel, but commodity hoarding was a predictable outcome of QE2.

The real question is how high commodity prices have to rise until people are indifferent between holding non-interest bearing cash, and commodities that are elevated in price. The basic answer is that commodity prices have had to "overshoot" the expected future level of broad consumer prices by enough that both cash and commodities can now be expected to suffer a negative real return as measured against a broad basket of consumer goods. This sort of overshoot is necessary to make people indifferent between holding one versus another, and it restores equilibrium in the face of the negative real return available on money market securities. As with stock prices, I believe that this has already gone too far, but the civil unrest in the Middle East has certainly worsened the situation over the short-term.

This is a critical point - commodity prices tend to swing by a much greater amount than consumer prices. You can easily get periods where general consumer prices are advancing, yet commodities prices are advancing slower or even falling. In my view, QE2 has provoked an "overshooting" advance in commodities prices, which has been necessary because the Fed is holding real interest rates at negative levels. In the face of moderately higher consumer price inflation, coupled with short-term interest rates at zero, the only way to get people to be comfortable holding that much cash is to make the prospective returns on every possible alternative just as bad.

If investors don't understand that this is how QE2 is "working," they are likely to be as blindsided by the coming decade of weak investment returns as they've been over the past decade.


Having discussed QE2, let's move on to the broader subject of "credit." Here also, there is a lot of confusion about how credit creation is related to real economic activity. My hope is that the following discussion will clarify some of these relationships. As usual, the best way to evaluate the merit of somebody's analysis is if they show you the data, so I'll also show you the data.

Santangel’s Review: David Einhorn Financial Crisis Inquiry Commission Interview Transcript

A BIG thanks to Steve F. for passing this along.

We’re in the business of identifying and evaluating great “undiscovered” investors. How do we know what to look for? In part, by studying great “discovered” investors, like David Einhorn of Greenlight Capital. A November 2010 interview with the Financial Crisis Inquiry Commission reveals just how, in a period of great chaos and uncertainty, Einhorn synthesized information and pieced together various puzzles. In the interview, Einhorn details his thinking in the fall of 2008 step by step and stock by stock; he saw what was coming and acted to short several major financial institutions.

We thought it was such an insightful and candid interview that we transcribed it for our readers. We hope you like it, too.


Link to audio MP3: HERE

Saturday, February 26, 2011

Warren Buffett's 2010 Shareholder Letter

Link to: Warren Buffett's 2010 Letter to Shareholders



The highlight of 2010 was our acquisition of Burlington Northern Santa Fe, a purchase that’s working out even better than I expected. It now appears that owning this railroad will increase Berkshire’s “normal” earning power by nearly 40% pre-tax and by well over 30% after-tax. Making this purchase increased our share count by 6% and used $22 billion of cash. Since we’ve quickly replenished the cash, the economics of this transaction have turned out very well.

A “normal year,” of course, is not something that either Charlie Munger, Vice Chairman of Berkshire and my partner, or I can define with anything like precision. But for the purpose of estimating our current earning power, we are envisioning a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006. Using these assumptions, and several others that I will explain in the “Investment” section, I can estimate that the normal earning power of the assets we currently own is about $17 billion pre-tax and $12 billion after-tax, excluding any capital gains or losses. Every day Charlie and I think about how we can build on this base.


There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.

This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.


Our second advantage relates to the allocation of the money our businesses earn. After meeting the needs of those businesses, we have very substantial sums left over. Most companies limit themselves to reinvesting funds within the industry in which they have been operating. That often restricts them, however, to a “universe” for capital allocation that is both tiny and quite inferior to what is available in the wider world. Competition for the few opportunities that are available tends to become fierce. The seller has the upper hand, as a girl might if she were the only female at a party attended by many boys. That lopsided situation would be great for the girl, but terrible for the boys.

At Berkshire we face no institutional restraints when we deploy capital. Charlie and I are limited only by our ability to understand the likely future of a possible acquisition. If we clear that hurdle – and frequently we can’t – we are then able to compare any one opportunity against a host of others.

When I took control of Berkshire in 1965, I didn’t exploit this advantage. Berkshire was then only in textiles, where it had in the previous decade lost significant money. The dumbest thing I could have done was to pursue “opportunities” to improve and expand the existing textile operation – so for years that’s exactly what I did. And then, in a final burst of brilliance, I went out and bought another textile company. Aaaaaaargh! Eventually I came to my senses, heading first into insurance and then into other industries.

There is even a supplement to this world-is-our-oyster advantage: In addition to evaluating the attractions of one business against a host of others, we also measure businesses against opportunities available in marketable securities, a comparison most managements don’t make. Often, businesses are priced ridiculously high against what can likely be earned from investments in stocks or bonds. At such moments, we buy securities and bide our time.

Our flexibility in respect to capital allocation has accounted for much of our progress to date. We have been able to take money we earn from, say, See’s Candies or Business Wire (two of our best-run businesses, but also two offering limited reinvestment opportunities) and use it as part of the stake we needed to buy BNSF.

Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.

To start with, the directors who represent you think and act like owners. They receive token compensation: no options, no restricted stock and, for that matter, virtually no cash. We do not provide them directors and officers liability insurance, a given at almost every other large public company. If they mess up with your money, they will lose their money as well. Leaving my holdings aside, directors and their families own Berkshire shares worth more than $3 billion. Our directors, therefore, monitor Berkshire’s actions and results with keen interest and an owner’s eye. You and I are lucky to have them as stewards.

This same owner-orientation prevails among our managers. In many cases, these are people who have sought out Berkshire as an acquirer for a business that they and their families have long owned. They came to us with an owner’s mindset, and we provide an environment that encourages them to retain it. Having managers who love their businesses is no small advantage.


A lot has happened at GEICO during the last 60 years, but its core goal – saving Americans substantial money on their purchase of auto insurance – remains unchanged. (Try us at 1-800-847-7536 or In other words, get the policyholder’s business by deserving his business. Focusing on this objective, the company has grown to be America’s third-largest auto insurer, with a market share of 8.8%.

When Tony Nicely, GEICO’s CEO, took over in 1993, that share was 2.0%, a level at which it had been stuck for more than a decade. GEICO became a different company under Tony, finding a path to consistent growth while simultaneously maintaining underwriting discipline and keeping its costs low.

Let me quantify Tony’s achievement. When, in 1996, we bought the 50% of GEICO we didn’t already own, it cost us about $2.3 billion. That price implied a value of $4.6 billion for 100%. GEICO then had tangible net worth of $1.9 billion.

The excess over tangible net worth of the implied value – $2.7 billion – was what we estimated GEICO’s “goodwill” to be worth at that time. That goodwill represented the economic value of the policyholders who were then doing business with GEICO. In 1995, those customers had paid the company $2.8 billion in premiums. Consequently, we were valuing GEICO’s customers at about 97% (2.7/2.8) of what they were annually paying the company. By industry standards, that was a very high price. But GEICO was no ordinary insurer: Because of the company’s low costs, its policyholders were consistently profitable and unusually loyal.

Today, premium volume is $14.3 billion and growing. Yet we carry the goodwill of GEICO on our books at only $1.4 billion, an amount that will remain unchanged no matter how much the value of GEICO increases. (Under accounting rules, you write down the carrying value of goodwill if its economic value decreases, but leave it unchanged if economic value increases.) Using the 97%-of-premium-volume yardstick we applied to our 1996 purchase, the real value today of GEICO’s economic goodwill is about $14 billion. And this value is likely to be much higher ten and twenty years from now. GEICO – off to a strong start in 2011 – is the gift that keeps giving.

One not-so-small footnote: Under Tony, GEICO has developed one of the country’s largest personal-lines insurance agencies, which primarily sells homeowners policies to our GEICO auto insurance customers. In this business, we represent a number of insurers that are not affiliated with us. They take the risk; we simply sign up the customers. Last year we sold 769,898 new policies at this agency operation, up 34% from the year before. The obvious way this activity aids us is that it produces commission revenue; equally important is the fact that it further strengthens our relationship with our policyholders, helping us retain them.

I owe an enormous debt to Tony and Davy (and, come to think of it, to that janitor as well).


Let me emphasize again that cost-free float is not an outcome to be expected for the P/C industry as a whole: In most years, industry premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue. Berkshire’s outstanding economics exist only because we have some terrific managers running some unusual businesses.

At bottom, a sound insurance operation requires four disciplines: (1) An understanding of all exposures that might cause a policy to incur losses; (2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) The willingness to walk away if the appropriate premium can’t be obtained.

Many insurers pass the first three tests and flunk the fourth. The urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by a testosterone-driven CEO to accept shrinking volumes has led too many insurers to write business at inadequate prices. “The other guy is doing it so we must as well” spells trouble in any business, but none more so than insurance.


Manufacturing, Service and Retailing Operations

This group of companies sells products ranging from lollipops to jet airplanes. Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12-20%. Unfortunately, a few have very poor returns, a result of some serious mistakes I have made in my job of capital allocation. These errors came about because I misjudged either the competitive strength of the business I was purchasing or the future economics of the industry in which it operated. I try to look out ten or twenty years when making an acquisition, but sometimes my eyesight has been poor.


Home ownership makes sense for most Americans, particularly at today’s lower prices and bargain interest rates. All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.) For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come.

But a house can be a nightmare if the buyer’s eyes are bigger than his wallet and if a lender – often protected by a government guarantee – facilitates his fantasy. Our country’s social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford.



In our reported earnings we reflect only the dividends our portfolio companies pay us. Our share of the undistributed earnings of these investees, however, was more than $2 billion last year. These retained earnings are important. In our experience – and, for that matter, in the experience of investors over the past century – undistributed earnings have been either matched or exceeded by market gains, albeit in a highly irregular manner. (Indeed, sometimes the correlation goes in reverse. As one investor said in 2009: “This is worse than divorce. I’ve lost half my net worth – and I still have my wife.”) In the future, we expect our market gains to eventually at least equal the earnings our investees retain.

* * * * * * * * * * * *

In our earlier estimate of Berkshire’s normal earning power, we made three adjustments that relate to future investment income (but did not include anything for the undistributed earnings factor I have just described).

The first adjustment was decidedly negative. Last year, we discussed five large fixed-income investments that have been contributing substantial sums to our reported earnings. One of these – our Swiss Re note – was redeemed in the early days of 2011, and two others – our Goldman Sachs and General Electric preferred stocks – are likely to be gone by yearend. General Electric is entitled to call our preferred in October and has stated its intention to do so. Goldman Sachs has the right to call our preferred on 30 days notice, but has been held back by the Federal Reserve (bless it!), which unfortunately will likely give Goldman the green light before long.

All three of the companies redeeming must pay us a premium to do so – in aggregate about $1.4 billion – but all of the redemptions are nevertheless unwelcome. After they occur, our earning power will be significantly reduced. That’s the bad news.

There are two probable offsets. At yearend we held $38 billion of cash equivalents that have been earning a pittance throughout 2010. At some point, however, better rates will return. They will add at least $500 million – and perhaps much more – to our investment income. That sort of increase in money-market yields is unlikely to come soon. It is appropriate, nevertheless, for us to include improved rates in an estimate of “normal” earning power. Even before higher rates come about, furthermore, we could get lucky and find an opportunity to use some of our cash hoard at decent returns. That day can’t come too soon for me: To update Aesop, a girl in a convertible is worth five in the phone book.

In addition, dividends on our current common stock holdings will almost certainly increase. The largest gain is likely to come at Wells Fargo. The Federal Reserve, our friend in respect to Goldman Sachs, has frozen dividend levels at major banks, whether strong or weak, during the last two years. Wells Fargo, though consistently prospering throughout the worst of the recession and currently enjoying enormous financial strength and earning power, has therefore been forced to maintain an artificially low payout. (We don’t fault the Fed: For various reasons, an across-the-board freeze made sense during the crisis and its immediate aftermath.)

At some point, probably soon, the Fed’s restrictions will cease. Wells Fargo can then reinstate the rational dividend policy that its owners deserve. At that time, we would expect our annual dividends from just this one security to increase by several hundreds of millions of dollars annually.

Other companies we hold are likely to increase their dividends as well. Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

Overall, I believe our “normal” investment income will at least equal what we realized in 2010, though the redemptions I described will cut our take in 2011 and perhaps 2012 as well.


John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it “anomalies.” (I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.)

Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination. For that matter, so does the academic’s inclination to dwell on the valuation of options. You can be highly successful as an investor without having the slightest ability to value an option. What students should be learning is how to value a business. That’s what investing is all about.


Life and Debt

The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.

Charlie and I have no interest in any activity that could pose the slightest threat to Berkshire’s wellbeing. (With our having a combined age of 167, starting over is not on our bucket list.) We are forever conscious of the fact that you, our partners, have entrusted us with what in many cases is a major portion of your savings. In addition, important philanthropy is dependent on our prudence. Finally, many disabled victims of accidents caused by our insureds are counting on us to deliver sums payable decades from now. It would be irresponsible for us to risk what all these constituencies need just to pursue a few points of extra return.

We keep our cash largely in U.S. Treasury bills and avoid other short-term securities yielding a few more basis points, a policy we adhered to long before the frailties of commercial paper and money market funds became apparent in September 2008. We agree with investment writer Ray DeVoe’s observation, “More money has been lost reaching for yield than at the point of a gun.” At Berkshire, we don’t rely on bank lines, and we don’t enter into contracts that could require postings of collateral except for amounts that are tiny in relation to our liquid assets.

Furthermore, not a dime of cash has left Berkshire for dividends or share repurchases during the past 40 years. Instead, we have retained all of our earnings to strengthen our business, a reinforcement now running about $1 billion per month. Our net worth has thus increased from $48 million to $157 billion during those four decades and our intrinsic value has grown far more. No other American corporation has come close to building up its financial strength in this unrelenting way.

By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

Friday, February 25, 2011

Eddie Lampert's Letter to Sears Shareholders

If one owns 10% of a company, or 1% of a company or .0000001% of a company, what matters is how that investment fares over time. A company worth $1 billion that doubles in value to $2 billion only doubles an owner’s investment if the number of shares outstanding remains constant. Merging with another company with a $1 billion market capitalization and issuing shares to effect that merger would leave the 10% owner of a $1 billion company with a 5% stake in a $2 billion market value company. In both cases, the value of that investment is $100 million. Taking that logic down to the lowest possible unit, 1 share, serves to demonstrate and emphasize the logic of focusing on per share value as the key measure for shareholders.

At Sears Holdings, we seek to create long-term value for our shareholders. Like Apple, we seek to do so by improving our operating performance, innovating, and delighting customers. In this area, we have fallen far short of our goals and what we aspire to do in the future. On the second dimension of capital allocation, I believe that our behavior and focus has served our shareholders well over the past eight years and will magnify the value creation when our operating performance improves. We built cash when we felt that it was the right decision for our shareholders, and we delivered cash to those who elected to sell their shares when we felt that it was the right thing to do.

Share repurchases are not a panacea, nor are they a singular strategy. Yet, they are more than just the return of capital to shareholders. They represent an investment by the non-selling shareholders in the future of the business and the company. By repurchasing shares from selling shareholders, the remaining shareholders increase their ownership stake, thereby taking the additional risk and additional upside potential based upon future performance. When coupled with outstanding operating performance, share repurchases magnify returns. When the price paid is attractive relative to future performance, share repurchases magnify returns. As a form of discipline on alternative capital allocation strategies, share repurchases can magnify returns. But, at the wrong price, with poor future performance, share repurchases can harm returns.

Thursday, February 24, 2011

GuruFocus Interview With Prof. Bruce Greenwald

Back to your comment, what’s the best way, do you think, to distinguish the ones that are temporarily sick from the ones that are terminally ill?

The first judgment that you have to make is that is it a franchise business or is it not. And the reason that judgment is so important is, that if this is a franchise business, then the growth is valuable, and temporary slow growth may give you a bargain. If it’s not a franchise business, you don’t care what the growth is, the growth neither creates nor destroys value, and that, too, will give you a view into where the opportunities are, because if it’s been growing and now it’s stopped growing, and people are upset about that, because the growth in the long run doesn’t create value, you don’t care about that at all. So the first thing you have to understand is, is this a Buffett franchise type business? And the answer to that is that typically, they’re going to dominate niche markets, and if it’s not a franchise business, you’re crazy to pay for the growth, and you only are going to get the earnings in the asset value. So if it’s not a franchise business, you look at the earnings, you look at the asset value, and if the earnings value is close to the asset value, and there are some other filters that you can look at, and this is not a destructive management, and together that average value is way below what the company is trading below in the marketplace, then that’s a company where the disease is not coming. So then if it’s a franchise business, the nature of the terminal disease is different. If it’s a franchise business, the terminal disease is where the franchise is either shrinking or going away, by competition. And the newspapers are an example, I think Apple (AAPL) is going to be an example of that, so I think in that case whether the disease is terminal or not is if the company continues to enjoy the standard competitive advantages. Do they dominate their particular local markets in geography, do they have customer captivity, or is that going away, and if they have propriety technology.

Okay. This comment makes lots of sense, but it’s kind of different from what Warren Buffett said. Warren Buffett said “I’d rather buy a good company at fair price, than a fair company a good price.”

Our only variable is what Warren Buffett thinks of is a fair price. His idea of a fair price, by the way, is a price that gets him a return going forward on that investment without any improvement in the multiple of somewhere between 13 and 15%. By normal standards, when the average market return is 7-8%, that’s a really good price, he’s looking for a very good price. They call it a fair price because the multiple may be fairly rich, it may be 13, 14 times earnings. But the value of the growth may bring his return up to 13-15%. So when he says a fair price he’s talking in terms of normal value metrics, and there the reason that you prefer that to a poor company at a really good price is that because the good company can grow through reinvestment and things like same-store sales growth, your return will come in the form of capital [gain], not distributive income, and that, after tax, is much more valuable.

Moving on to another topic, back to 2008, we know that many famed value investors lost lots of money, some lost about 50% of their fund. Why do you think this happened?

I think that there are two reasons why this happened. One is that some of them were not careful about what were franchises and what were not. So they looked at the financials and they said “look at how much money these guys are making” and they ignored the fact that none of them were dominating any particular market, and they bought them because they were cheap but not on a sustainable earnings basis, they were cheap on a temporary earnings basis that wasn’t going to continue.

A perfect example of this is banking. There are three basic activities that banks are involved in. They do backoffice processing, and that’s a big competitive market, no one’s got any advantages there. Second thing is that they deploy assets in public markets, and they do investment banking operations. There are no competitive advantages in that, there are lots of smart people competing, and when they stretch to get extra returns from that they almost invariably do it by taking those outside risks, and they almost always pay for it later. But they don’t really make money there, even though in good times it looks like they’re making money there.

The real way they make money is that they dominate local markets, like M&T Bank (MT) up in Buffalo, and they have better information about local borrowers. That’s the way to make money, and people forgot that, and everyone forgot that. All these banks, like AIG (AIG), looked like they were making money by superior performance in financial markets, and we know that that’s not sustainable. And so the first thing is that they made a mistake by overestimating the earnings power of a lot of businesses, that they shouldn't have, and that’s one big source of loss.

A second source of loss is that you can convert a temporary loss into a permanent loss. Many went bankrupt, and they never had a chance to recover. So, I think it’s those two things that got people in trouble. Where they were careful about assets, and Buffett got in trouble, and he’ll admit it, on the Irish banks and the oil companies.

So you think that because these investors don’t think long term or long business cycles?

Right, I wouldn’t even say long business cycle, I would say that they look at earnings that are not really sustainable without a franchise, and they bought companies that they thought were franchise companies, on the theory that those earnings were sustainable, when I think when they looked carefully they would have seen that they weren’t. And they bought companies that did come back, and as a lot of you know, a lot of companies did come back, but some went bankrupt before they could.

Do you think that [macro] factor[s] should play a [role] here in value investing? Some value investors after the 2008 crash put more attention on [macro]-economic environment.

I think that in terms of doing macro forecast, all the evidence is that no one does that well, and you’re not going to make money by forecasting the economy. But, if you want to worry about risk, you certainly should have a sense on when the macro environment is very uncertain, like it is now and in 2007, and when the macro environment is much more stable. And there, I think, you should make a judgment. I don’t think that people should look at macro as a way to make money, but if they consider their risk posture, I think they’ve got to buy more insurance or be more careful in a macro environment that’s dangerous. That’s what they want to assess, not if the market is up or down, just if there’s a high level of uncertainty or not. And typically, the most dangerous kind from a macro perspective are not just when the market is all high and all expensive, but also when you look at the implied volatilities and the derivatives they’re incredibly low, so no one thinks there’s going to be any problems. Like housing was going to go up forever. And I think you’re not going to make money on a bet, unless you’re lucky, that housing is going to plant. But in that environment you know that sooner or later you’re going to get into trouble with the market, and insurance in a former derivative is being sold quite cheaply.

So if we cannot predict the [macro] economic trend, but what about the overall market valuations? Warren Buffett uses the ratio of total market cap over GNP, which is the single most important indicator of the market. Also we know that Professor Shiller used an adjusted P/E ratio.

Any of these measures will do fine. They’ll tell you when markets are out of the normal range of where they are because profits are characteristically over a very long period of time get a constant portion of GDP, and therefore the value of those profits should bear a constant relationship to GDP, and therefore P/E levels of those profits should be roughly stable, which is Shiller’s point, and therefore you can compare profit to GDP or you can use Shiller’s P/E and you’re going to come up with similar answers. And because Shiller also uses the average earnings over many years, it would be constant relative to GDP. I think that’s certainly something you want to worry about, but again, you’re not going to predict one year ahead using that, but I think what you will be able to predict is when there’s a higher probability you’re going to get into trouble, and there you should take a more defensive posture.

So we can use this as a long term indicator of market valuation, maybe make some strategic change on portfolios?

Yes, I think that’s right. And derivatives, the VIX is pretty low at the moment, this is a slightly scary moment.


Another question, for your personal portfolio, what sector/industries do you hold?

Let me give you one stock when I think about what’s the obvious industry to look at: health insurers in the United States. You want the health insurer with the strongest competitive advantage, which is related to local economies. Most locally concentrated company is Wellpoint (WLP), and it’s traded for a very good price.

Do you have it in your personal portfolio?


You think that the reason you own it is because it has a strong local position?

It has a powerful local position, only in 17 states. The management buys back a ton of stock, that they sold their sub-scale subscription drugs service at a very good price to the industry leader and distributed most of the money to shareholders. It’s a cheap price, and you can’t do better than that in an industry that sooner or later is going to grow.

The P/E ratio is only at 10.

It’s actually a lot lower than that because they have a lot of cash embodied in the balance sheet.

Captive Gorillas Succumbing to Human Disease

Found via Hunter-Gatherer.

Life for humans is much easier than for animals in the wild. On a day-to-day basis, we generally do not have to worry about being eaten or starving to death. Depending on the individual's job, some can get by just fine by sitting around all day. However, this lifestyle brings forth its own set of health issues such as diabetes and heart disease, illnesses rarely found in the wild. These "human" diseases have spread to gorillas that are raised in captivity.

The only species of gorilla kept at North American zoos is the Western Lowland Gorilla. The number one killer of males in captivity is heart disease, much like humans. After a 21 year old gorilla named Brooks died of heart failure at Cleveland Metroparks Zoo in 2005, a group of researchers decided to examine how the gorilla’s lifestyle affect their health. The team was led by Elena Hoellein Less, a PhD candidate in biology at Case Western Reserve University.

The researchers believe that heart disease can be stopped by switching captive gorillas back to their natural diets in the wild. For decades, zoos have fed gorillas bucket loads of high vitamin, high sugar, and high starch foods to make sure their got all their nutrients. At the Cleveland zoo, they have started feeding food such as romaine lettuce, dandelion greens, endives, alfalfa, green beans, flax seeds, and even tree branches which they strip of bark and leaves. To top it off, they give the gorillas three Centrum Silver multivitamins inside half a banana.

Going back to this natural diet has changed gorilla behavior. Before, gorillas only ate during a quarter of their day because the food was so packed with nutrients. Now at Cleveland, they spend 50-60 percent of their day eating which is the same amount as in the wild. With all this extra eating, the gorillas have doubled their caloric intake, yet at the same time have dropped 65 pounds each. This brings their weight more in line with their wild relatives.

"We're beginning to understand we may have a lot of overweight gorillas," said Kristen Lukas, an adjunct assistant professor of biology at Case Western Reserve and chair of the Gorilla Species Survival Plan®. "And, we're just recognizing that surviving on a diet and being healthy on a diet are different. We've raised our standards and are asking, are they in the best condition to not only survive but to thrive?"

Less and her crew are continuing their studies of captive gorillas by measuring the fat on their backs to create a gorilla body mass index. This can be used to gauge healthy weight for gorillas much as it is used for humans. The next step, says Less, is to exercise gorillas at the zoo to get their muscles to a similar level as their wild relatives.


For how (and why) us humans may be able to get the same benefit, check out Art De Vany’s book: The New Evolution Diet

TED Talk: Deborah Gordon digs ants



Related books:

Tuesday, February 22, 2011

Robert Shiller on Fox Business

Link to video: Yale's Shiller on the Future of Housing

The Secret of Memory

Found via Simoleon Sense and Farnam Street.

When I first set out to train my memory, the prospect of learning these elaborate techniques seemed preposterously daunting. One of my first steps was to dive into the scientific literature for help. One name kept popping up: K. Anders Ericsson, a psychology professor at Florida State University and the author of an article titled “Exceptional Memorizers: Made, Not Born.”

Ericsson laid the foundation for what’s known as Skilled Memory Theory, which explains how and why our memories can be improved, within limits. In 1978, he and a fellow psychologist named Bill Chase conducted what became a classic experiment on a Carnegie Mellon undergraduate student, who was immortalized as S.F. in the literature. Chase and Ericsson paid S.F. to spend several hours a week in their lab taking a simple memory test again and again. S.F. sat in a chair and tried to remember as many numbers as possible as they were read off at the rate of one per second. At the outset, he could hold only about seven digits at a time in his head. When the experiment wrapped up — two years and 250 mind-numbing hours later — S.F. had increased his ability to remember numbers by a factor of 10.

When I called Ericsson and told him that I was trying to train my memory, he said he wanted to make me his research subject. We struck a deal. I would give him the records of my training, which might prove useful for his research. In return, he and his graduate students would analyze the data in search of how I might perform better. Ericsson encouraged me to think of enhancing my memory in the same way I would think about improving any other skill, like learning to play an instrument. My first assignment was to begin collecting architecture. Before I could embark on any serious degree of memory training, I first needed a stockpile of palaces at my disposal. I revisited the homes of old friends and took walks through famous museums, and I built entirely new, fantastical structures in my imagination. And then I carved each building up into cubbyholes for my memories.

Cooke kept me on a strict training regimen. Each morning, after drinking coffee but before reading the newspaper or showering or getting dressed, I sat at my desk for 10 to 15 minutes to work through a poem or memorize the names in an old yearbook. Rather than take a magazine or book along with me on the subway, I would whip out a page of random numbers or a deck of playing cards and try to commit it to memory. Strolls around the neighborhood became an excuse to memorize license plates. I began to pay a creepy amount of attention to name tags. I memorized my shopping lists. Whenever someone gave me a phone number, I installed it in a special memory palace. Over the next several months, while I built a veritable metropolis of memory palaces and stocked them with strange and colorful images, Ericsson kept tabs on my development. When I got stuck, I would call him for advice, and he would inevitably send me scurrying for some journal article that he promised would help me understand my shortcomings. At one point, not long after I started training, my memory stopped improving. No matter how much I practiced, I couldn’t memorize playing cards any faster than 1 every 10 seconds. I was stuck in a rut, and I couldn’t figure out why. “My card times have hit a plateau,” I lamented.

“I would recommend you check out the literature on speed typing,” he replied.

When people first learn to use a keyboard, they improve very quickly from sloppy single-finger pecking to careful two-handed typing, until eventually the fingers move effortlessly and the whole process becomes unconscious. At this point, most people’s typing skills stop progressing. They reach a plateau. If you think about it, it’s strange. We’ve always been told that practice makes perfect, and yet many people sit behind a keyboard for hours a day. So why don’t they just keeping getting better and better?

In the 1960s, the psychologists Paul Fitts and Michael Posner tried to answer this question by describing the three stages of acquiring a new skill. During the first phase, known as the cognitive phase, we intellectualize the task and discover new strategies to accomplish it more proficiently. During the second, the associative phase, we concentrate less, making fewer major errors, and become more efficient. Finally we reach what Fitts and Posner called the autonomous phase, when we’re as good as we need to be at the task and we basically run on autopilot. Most of the time that’s a good thing. The less we have to focus on the repetitive tasks of everyday life, the more we can concentrate on the stuff that really matters. You can actually see this phase shift take place in f.M.R.I.’s of subjects as they learn new tasks: the parts of the brain involved in conscious reasoning become less active, and other parts of the brain take over. You could call it the O.K. plateau.

Psychologists used to think that O.K. plateaus marked the upper bounds of innate ability. In his 1869 book “Hereditary Genius,” Sir Francis Galton argued that a person could improve at mental and physical activities until he hit a wall, which “he cannot by any education or exertion overpass.” In other words, the best we can do is simply the best we can do. But Ericsson and his colleagues have found over and over again that with the right kind of effort, that’s rarely the case. They believe that Galton’s wall often has much less to do with our innate limits than with what we consider an acceptable level of performance. They’ve found that top achievers typically follow the same general pattern. They develop strategies for keeping out of the autonomous stage by doing three things: focusing on their technique, staying goal-oriented and getting immediate feedback on their performance. Amateur musicians, for example, tend to spend their practice time playing music, whereas pros tend to work through tedious exercises or focus on difficult parts of pieces. Similarly, the best ice skaters spend more of their practice time trying jumps that they land less often, while lesser skaters work more on jumps they’ve already mastered. In other words, regular practice simply isn’t enough. To improve, we have to be constantly pushing ourselves beyond where we think our limits lie and then pay attention to how and why we fail. That’s what I needed to do if I was going to improve my memory.

Clay Shirky on How Social Media is Changing the Middle East

Also, be sure to check out the disagreement between Shirky and Malcolm Gladwell on this topic HERE.

Bruce Berkowitz Interview with Advisor Perspectives

In last year’s interview, you said that one should never play Russian roulette no matter how good the odds, but given the dependence of the financial system now on government support both here and abroad, aren't you playing Russian roulette with approximately 80% of the Fairholme Fund’s holdings in the financial sector?

We stayed away until we thought the Russian roulette element was over. The Russian roulette part was at the initial stage of the financial crisis, before the government became involved. That part ended once it was clear that capital would be given to the banks and what the objectives of the Fed and the Treasury were, and once enough time went by. By enough time, I'm referring to the further seasoning of potential bad loans, most of which originated in the 2007-2008 period.

At that time, you no longer could kill the companies, but there was still a question as to how much they could make in a more normal time. You really can't kill all of them or you would kill the entire economy.

John Mauldin's Outside the Box: Stay Out of the ROOM - by Ed Easterling

One of my favorite analysts is Ed Easterling of Crestmont Research. We used to get together a whole lot more when he lived in Dallas, but he has since moved to the wilds of Oregon. Ed’s first book, Unexpected Returns, is a classic work that I think is a must-read for all stock market investors.

And now he favors us with yet another book, called Probable Outcomes: Secular Stock Market Insights, in which he takes on the mostly silly research, done by so many analysts, that purports to show what an investor can expect to make from his retirement portfolio over time. I can’t tell you how disastrous this simplistic analysis can be for retirees.

This week’s Outside the Box is an excerpt from this latest book.


Related books:

Unexpected Returns

Probable Outcomes

Monday, February 21, 2011

Jean-Marie Eveillard on King World News

Hussman Funds 12/10 Semi-Annual Report

For the third time in a decade, the Federal Reserve has embarked on a policy that addresses structural economic problems by provoking speculation in asset prices. The first two attempts were ultimately followed by stock market declines greater than 50% each. As we enter 2011, the stock market remains in what we view as an already strenuously overvalued advance, which has driven our estimates for S&P 500 Index total returns to less than 3.2% annually over the coming decade. My expectation is that this attempt to create what the economist Ludwig von Mises called “illusory prosperity” will end no better than it has in the past. As von Mises wrote in 1931, before the worst portion of the Great Depression:

“Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not a real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth [i.e. the accumulation of savings made available for productive investment]. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent that this economic situation is built on sand.”

None of this, however, implies that a severe market downturn should be expected over the near term. Though it is not possible to rule out a substantial decline in market valuations, our main reason for defensiveness as we enter 2011 is that the market environment is characterized by a syndrome of elevated valuations, overextended price trends, overbullish investor sentiment, and rising interest rates. This combination of conditions typically does not persist for more than a few months, but when the complete set has been observed, the stock market has often been vulnerable to abrupt losses that can erase weeks or months of gains in a few trading sessions.

Wednesday, February 16, 2011

BCA Interviews David Sokol

Found via My Investing Notebook.

BCA: Buffett told shareholders, "I failed you in letting NetJets descend into this condition." But what could he have done differently? Nobody saw a downturn of this magnitude coming.

Sokol: At Berkshire, we let the management team run the business. But that means sometimes when that team doesn't make the transitions it should, we will be slower to step in.

Starting in late 2006, 2007, you could see that the capital being expended was exceeding the returns coming with it. There were commitments to acquire too many airplanes when you'd already seen a leveling off in the industry — things that a pure entrepreneur often won't see, because they tend to want to grow the business forever no matter what.

I think Warren saw those things, but wanted to give them a chance to figure it out. Then the fall of '08 happened, and there still wasn't enough reaction to that, and I think he felt: Time.

Of Berkshire's 40 acquisitions in the last 20 years, 38 have outperformed any expectations, and two have stumbled a little bit. That's a pretty good track record.

You want to err on the side of giving the management team the opportunity, and I think he meant he probably gave it more than he should.

BCA: So NetJets didn't pull back quickly enough?

Sokol: That's right.

BCA: What was the other business that stumbled?

Sokol: Dexter Shoes.

UNLV president’s somber warning on budget cuts moves faculty to tears

Found via the Mises Blog. To repeat Sir John Templeton’s 2005 prediction: “Most of the methods of universities and other schools, which require residence, have become hopelessly obsolete. Probably, over half of the universities in the world will disappear as quickly in the next 30 years.”

In what must have been one of his most painful tasks in office, UNLV President Neal Smatresk warned faculty leaders Tuesday to prepare for a budget catastrophe — news that left some in tears.

Smatresk at times sounded almost in mourning as he spoke to the Faculty Senate, saying he had instructed his provosts to start planning for more cuts in staff, departments and programs.

The faculty was angry and indignant.

“I’m sick we are destroying much of what we’ve built,” said Cecilia Maldonado, an educational-leadership professor and chairwoman of the Senate.

“This amounts to foreclosure,” said Greg Brown, a history professor and president of the Nevada Faculty Alliance, a professor group.

Michael Bowers, UNLV’s provost, noted that UNLV is 54 years old and that he has worked there 27 years. “I never thought this day would come, but we have to plan,” he said.

The emotional display was unprecedented, Bowers said after the meeting, “because we’ve never had a situation like this before.”

Kyle Bass on CNBC

Video: Sayonara Japan

Video: Europe's Day of Reckoning

Video: Muni Meltdown

Video: Bass: China Inflation Could Hit 10 Percent Next Quarter


Related previous post: Hayman Capital Letter: The Cognitive Dissonance of it All - By Kyle Bass