Wednesday, August 31, 2011

GR-NEAM Reflections: 08/30/2011 - Solving For the Kiss of Death

Thanks to Matt for passing this along.

The Eurozone financial crisis is approaching a potential flashpoint. Yields on Spanish and Italian sovereigns are near, or at, the level at which their debt loads will eventually be unsustainable. The reaction of the German government will determine the outcome.


Important picture from the piece:

Why Are Finland's Schools Successful?

Found via Simoleon Sense.

It was the end of term at Kirkkojarvi Comprehensive School in Espoo, a sprawling suburb west of Helsinki, when Kari Louhivuori, a veteran teacher and the school’s principal, decided to try something extreme—by Finnish standards. One of his sixth-grade students, a Kosovo-Albanian boy, had drifted far off the learning grid, resisting his teacher’s best efforts. The school’s team of special educators—including a social worker, a nurse and a psychologist—convinced Louhivuori that laziness was not to blame. So he decided to hold the boy back a year, a measure so rare in Finland it’s practically obsolete.

Finland has vastly improved in reading, math and science literacy over the past decade in large part because its teachers are trusted to do whatever it takes to turn young lives around. This 13-year-old, Besart Kabashi, received something akin to royal tutoring.

“I took Besart on that year as my private student,” Louhivuori told me in his office, which boasted a Beatles “Yellow Submarine” poster on the wall and an electric guitar in the closet. When Besart was not studying science, geography and math, he was parked next to Louhivuori’s desk at the front of his class of 9- and 10-year- olds, cracking open books from a tall stack, slowly reading one, then another, then devouring them by the dozens. By the end of the year, the son of Kosovo war refugees had conquered his adopted country’s vowel-rich language and arrived at the realization that he could, in fact, learn.

Years later, a 20-year-old Besart showed up at Kirkkojarvi’s Christmas party with a bottle of Cognac and a big grin. “You helped me,” he told his former teacher. Besart had opened his own car repair firm and a cleaning company. “No big fuss,” Louhivuori told me. “This is what we do every day, prepare kids for life.”

This tale of a single rescued child hints at some of the reasons for the tiny Nordic nation’s staggering record of education success, a phenomenon that has inspired, baffled and even irked many of America’s parents and educators. Finnish schooling became an unlikely hot topic after the 2010 documentary film Waiting for “Superman” contrasted it with America’s troubled public schools.

WSJ: The Halo Effect: How It Polishes Apple's and Buffett's Image - By Jason Zweig

Found via Simoleon Sense.

This week, the stock market sported a couple of halos.

Steve Jobs, the co-founder of Apple universally regarded as a visionary who saved the company, stepped down as chief executive—and his cool glow still clung to Apple. In Thursday's falling market, its stock outperformed the Nasdaq index by 1.3 percentage points. On Friday, Apple closed up nearly 3%, again beating the Nasdaq.

Also Thursday, Bank of America announced a $5 billion investment from Berkshire Hathaway. That vote of confidence from Berkshire's chairman, Warren Buffett, not only sent Bank of America's stock up by $18 billion at its high for the day; it may have added billions more to the market value of the shares of other banks like Citigroup and Wells Fargo (also a Buffett holding).

In both cases, what psychologists have christened the "halo effect" was at work. In this quirk of the human mind, one powerful impression spills over onto our other judgments of a situation.

But halos also can lead investors astray. As management professor Phil Rosenzweig points out in his book "The Halo Effect," a soaring stock price can lead investors to regard the company's managers as focused, disciplined and passionate—while, in the negative halo of a falling stock price, the same executives will now seem stubborn, unimaginative and resistant to change.

Investors think, at either time, that they are evaluating the stock and the managers independently, but one opinion inevitably colors the other, often leading investors to be too bullish on the upside and too bearish on the downside. The managers haven't changed; our perceptions of them have.

The trick, then, is to recognize that halos can be valuable without letting them hijack your determination of value.

You can adapt a procedure described by the Nobel Prize-winning psychologist Daniel Kahneman—who is widely admired for his insights into decision-making—in his forthcoming book, "Thinking, Fast and Slow." Start by identifying a handful of objective factors that you believe can predict superior returns. You might, say, include low debt as a percentage of total capital, stable earnings growth, high return on equity, low price relative to earnings and a history of raising prices without losing customers.

For any prospective investment, rate each of these financial factors on an identical scale—say, from 0 at the bottom to 5 at the top. Then add a final, subjective factor: your overall intuitive impression of each company and its management, rating them on the same scale. Finally, total all the scores and divide by the number of factors; the company with the highest average is the one you should favor.

This way, even while acknowledging the warm glow that a company throws off, you won't let yourself be completely dazzled by the halo.


Related books:

The Halo Effect

Thinking, Fast and Slow

Tuesday, August 30, 2011

Apple’s Creative Destruction of Competitors

Via The Big Picture.

One of the things that seems to have gotten lost in the avalanche of Steve Jobs coverage has been the impact he has had on technology investors. I refer not to the entire technology sector as an investable asset, but rather, the utterly crushing effect Apple has had on specific competitors as Jobs remade entire industries.

It is creative destruction writ large.

Starting with the iPod, consider the companies and franchises that the Apple juggernaut has demolished in its wake. Yes, we know the original Mac was hugely influential, ripped off by Microsoft. AAPL was marginalized as a PC player, only kept alive by a $150m MSFT investment in the a 1990s so as to retain a weakened competitor in the OS space.

Today, the triple threat of iPod/iPhone/iPad has left behind a wake of confounded business models, overwhelmed managements, and bereft shareholders. Let’s look at who has been hurt — and helped — by the elegant interface monster from Cupertino:

Bill Gross – September 2011 Investment Outlook: New-Fangled Love Songs

In many ways the global economic crisis is like a marriage gone bad. As the Three Dog Night sang years ago, global economies have functioned harmoniously for many years, but suddenly the love songs have become strident and cacophonous, the policy coordination morphing into a war of the roses as opposed to a giving of them. Instead of three-part harmony we are now experiencing, at a minimum, tri-party disharmony, teetering on the brink of “divorce,” which in economic parlance means a possible “developed economy” recession – a downturn from which reconciliation may be difficult due to a lack of policy options and cooperation. But I get ahead of myself. Let’s first ring the wedding bells, then take you through an explanation of three separate global marriages and how each of the partners have grown apart.

Monday, August 29, 2011

TED Talk - Dan Ariely: Beware conflicts of interest


Steven Romick interview with Barron’s

Barron's: What were you up to the past couple of weeks?

Romick: We've been buyers of stocks in the last couple of weeks. Back in 2008, we had a ton of cash we drew down, flexing up our portfolio with distressed debt and high yield, taking it from roughly 5% to 34% four to five months later. Our strength isn't in being a macro investor and trading currencies or foreign bonds. But we think it's important to have a macro backdrop to invest against. Just as importantly, it will drive us away from things we should avoid, which can be as important as the things you own. At times, it limits catastrophic risk. From 2005 to 2007, when we worried about unsustainable home prices and the overlevered consumer and overlevered financial institutions, we didn't own banks, even if they looked cheap at 11 times earnings. Earnings were overstated.

What's worrying you these days?

The thing that Standard & Poor's got right in downgrading our country's debt is that they recognized that fiscal policy is inextricably linked to political process. Nothing about this political process really invites confidence. We think economic growth at best will be slow. Growth expectations for the U.S. were overstated, because if you look at the stimulus, there was no way to know what the permanent benefits would be. My partner Bob Rodriguez calls it Red Bull economics. When we look at a business, we look for companies to make good decisions for the long term, even if it negatively impacts the short term.

The U.S. government doesn't do that. They end up putting parks in that make constituents happy, but don't replace the pipes underneath the roads, because you don't see that. Our political process has been hijacked so that elected representatives and appointed officials are tempted to rewrite economic law based on political need rather than common sense.

What scares us: We continue to borrow from ourselves and from different sovereign nations to live beyond our means. So the biggest fear is this artificially low level of interest rates. Quantitative easing has allowed the government to push the back end of the yield curve down. If you are a lender, why the heck would you lend to the U.S. for a decade at a little over 2%, or for 30 years at 3.5%? One of our big concerns is that rates go up despite the economy—that we don't have complete control of our destiny.

Unlike Japan, we are borrowing from others. If rates jumped 5%, our interest expense as a percentage of our federal budget would jump from its current 6% to the high teens. How much spending would be crowded out because of that?

Sunday, August 28, 2011

Jon Stewart vs Warren Buffett's Conservative Critics

Thanks to Will for passing this along.



Hussman Weekly Market Comment: A Reprieve from Misguided Recklessness

An immediate note on market conditions. Last week's market advance cleared out the "predictable" expectation for constructive returns that briefly emerged from the recent market selloff. That doesn't mean that the market can't advance further, but given that the expected return/risk profile of stocks has now shifted hard negative again, any such advance would be a random fluctuation rather than a predictable one. Strategic Growth and Strategic International Equity have shifted from a briefly constructive position back to a full hedge. Our principal investment position in Strategic Total Return remains a 20% allocation to precious metals shares, where the ensemble of conditions remains very favorable on our measures, despite what we view as a welcome correction in the spot price of physical gold. The Fund has a duration of only about 1.5 years in Treasury securities, mostly driven by a modest exposure in 3-5 year maturities.

It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that is always and only observed during or immediately prior to U.S. recessions. These include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but the evidence we observe at present has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full setof these conditions is during or just prior to U.S. recessions). This doesn't mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that "this time is different."

While the reduced set of options for monetary policy action may seem unfortunate, it is important to observe that each time the Fed has attempted to "backstop" the financial markets by distorting the set of investment opportunities that are available, the Fed has bought a temporary reprieve only at the cost of amplifying the later fallout.


Historically, the typical bull-bear market cycle has produced a range of 10-year prospective returns in a band between about 7.5% and 13%. That band presently corresponds to a range for the S&P 500 index between 600 and 1000. A 10% prospective return is right in the middle, at about 800 on the S&P. Once you recognize that profit margins are in fact cyclical, that range is about right, as uncomfortable as it may be to contemplate. Jeremy Grantham of GMO estimates that fair value is "no higher than 950." A tighter norm for prospective return between 9-11% maps to an S&P 500 between 750 and 850.

Finally, while I certainly would not expect it in the absence of extreme macroeconomic upheaval, major secular undervaluation as we observed in 1950, 1974 and 1982 would presently map to about 400 on the S&P 500. When you think of "once in a generation" valuations and "secular bear market lows" - that number, not anything near present levels, should be what crosses your mind. I am well aware that even discussing numbers like these, given the present mindset of investors, is likely to be dismissed as utterly ridiculous. Frankly, I would rather risk the ridicule of those who pay lip-service to research, cash flows, fundamentals, and value than to pretend these outcomes are impossible, when the historical record (and even the experience of the past decade) strongly indicates otherwise.

As Howard Marks of Oaktree Capital has noted, "We hear a lot about 'worst-case' projections, but they often turn out to be not negative enough.. most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that'll be the case; if it didn't, people wouldn't make risky investments. But it can't always work that way, or else risky investments wouldn't be risky. And when risk bearing doesn't work, it really doesn't work, and people are reminded what risk's all about."

John Mauldin: The End of the World, Part 1

It’s not really the end of the world, but to read some of the analysis and data over the past week, it’s hard not to wonder if it’s not the beginning of the Endgame at the very least. There is more to cover than I can really do justice to, but we will just start. We HAVE to look at the US data first (briefly) and then on to Europe, where it will may be the end of the euro experiment, depending on two voting populations. Can you spell “Banking Crisis,” gentle reader? A nod to Bernanke’s finger-pointing speech, some links on the scourge of high-frequency trading, and we end on a positive note about the Boomer generation growing older. And, I answer the question that is burning in your brain: “How many years of US corn production will China’s dollar reserves buy?” Write your answer down now. This letter may print out longer than usual, as there are plenty of charts. Let’s skip the “but firsts” and jump right in.

Friday, August 26, 2011

WSJ: Disney, Walton, Ford, Gates: Tales of When Legends Leave

The founder of a successful corporation steps down. Then what?

At Ford Motor Co. and Walt Disney Co., long periods of stagnation or decline, followed by renewal. At Wal-Mart Stores Inc., continued success for a time, then new challenges.

Now it is Apple Inc.'s turn, following Steve Jobs's resignation as CEO on Wednesday.

Tim Cook, Apple's new CEO, gets high marks for running the company during Mr. Jobs's two medical leaves in recent years. "Apple has done a better job than most to prepare for this," says Jeffrey Pfeffer, a professor at Stanford University's Graduate School of Business, who knows several Apple executives.

But history suggests it will not be a smooth ride.


Steve Jobs' 2005 Stanford Commencement Address is always worth going back and watching from time to time.


My favorite quote from the speech:

"When I was 17 I read a quote that went something like "If you live each day as if it was your last, someday you'll most certainly be right." It made an impression on me, and since then, for the past 33 years, I have looked in the mirror every morning and asked myself, "If today were the last day of my life, would I want to do what I am about to do today?" And whenever the answer has been "no" for too many days in a row, I know I need to change something. Remembering that I'll be dead soon is the most important thing I've ever encountered to help me make the big choices in life, because almost everything--all external expectations, all pride, all fear of embarrassment or failure--these things just fall away in the face of death, leaving only what is truly important. Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart."

Brevan Howard capitalises on turmoil

Brevan Howard, the world’s largest macro hedge fund, has made close to $1.5bn over the past three weeks on the back of turmoil in the global markets.

In a month in which equity markets worldwide have seen declines of more than 10 per cent, the gain comes as a vindication for the $32bn London-based fund manager, which for more than a year – like many of its peers – has struggled to make headway in volatile conditions.

The fund has been “positioned for a global slowdown” since earlier this summer, said a senior employee of the firm – a strategy that has begun to reap serious rewards.

The recent gains mean Brevan’s flagship Master Fund, which for much of the year has been flat, is now up by just over 11 per cent, an investor told the Financial Times on condition of anonymity.


Related book: Expected Returns: An Investor's Guide to Harvesting Market Rewards

Related previous post: Introduction to "Expected Returns: An Investor's Guide to Harvesting Market Rewards" - By Antti Ilmanen

Thursday, August 25, 2011

Mohamed El-Erian on CNBC and FT Op-Ed


Link to Op-Ed in the Financial Times: “Bernanke must not push QE3 at Jackson Hole”

Video: Fed's Hoenig on Monetary Policy, U.S. Economy

Aug. 25 (Bloomberg) -- Federal Reserve Bank of Kansas City President Thomas Hoenig talks with Bloomberg's Michael McKee about the Fed's ability to help the U.S. economy. Hoenig says there's a limit to how much more the central bank can do and that the focus should now be on solving the country's fiscal problems. Hoenig also discusses the Fed's mandate, the outlook for monetary policy and business sentiment. They speak at the Fed's annual symposium in Jackson Hole, Wyoming.

Lemarne update

Back in March, I posted a brief write-up on Lemarne, a company with a capital allocation philosophy familiar to value investors. For those still interested, they just released their results for the fiscal year-ended June 30th. The results were about as expected. Here are the key points:


· Profit before tax totalled $5.15 million.

· Profit after tax totalled $3.72 million.

· Sales revenue totalled $54.8 million [up 13%]

· Shareholder funds $31.4 million at 30 June 2011 with cash on deposit totalling $19.8 million.

· Earnings per share 43.2 cents per share.

· Net tangible asset backing per share was $3.62

Throughout the year, Lemarne has actively pursued a number of strategic opportunities with companies in Europe, USA and Australia. We will comment on Lemarne’s strategic opportunities and dividends at the Annual General Meeting.

The stock closed at (AUD) $3.45, which puts it trading at 0.95x tangible book value and about 8x earnings.

Disclosure: I am a portfolio manager at Chanticleer Advisors and the fund Chanticleer manages owns shares in Lemarne Corporation Limited. It may in the future buy or sell shares and it is under no obligation to update its activities. This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

Berkshire Hathaway to Invest $5 Billion in Bank of America

CHARLOTTE, N.C.--(BUSINESS WIRE)-- Bank of America Corporation announced today that it reached an agreement to sell 50,000 shares of Cumulative Perpetual Preferred Stock with a liquidation value of $100,000 per share to Berkshire Hathaway, Inc. in a private offering. The preferred stock has a dividend of 6 percent per annum, payable in equal quarterly installments, and is redeemable by the company at any time at a 5 percent premium.

In conjunction with this agreement, Berkshire Hathaway will also receive warrants to purchase 700,000,000 shares of Bank of America common stock at an exercise price of $7.142857 per share. The warrants may be exercised in whole or in part at any time, and from time to time, during the 10-year period following the closing date of the transaction. The aggregate purchase price to be received by Bank of America for the preferred stock and warrants is $5 billion in cash.


Related link: Buffett's comments to CNBC

Wednesday, August 24, 2011

Finance News Network interviews Steve Keen

Lelde Smits: Hello, I’m Lelde Smits for the Finance News Network. Joining me today to cast some light on the global debt situation is Associate Professor of Economics and Finance, Steve Keen. Steve, welcome back to FNN. Now debt has been in the headlines and it certainly seems the US and Europe are drowning in it. How did we get into this situation and how is it different to the Global Financial Crisis of 2008?

Steve Keen: Well it isn’t different; it’s the continuation of exactly the same crisis, because we began accumulating too much private debt - not public - private debt. Gambling on rising asset prices all around the world, everything from the madness of the dotcom and the internet bubble of the nineties. Before that the eighties bubble which Australia was also caught up in. Real estate bubbles are all over the globe, of course the subprime but also in Australia and England and Spain, and God knows what. That private debt stopped growing in about 2007/2008 because the private sector had taken on far too much for this gamble. When it stopped growing that caused the crisis and now we are in the period where people are reducing their debt, and that’s what is causing the continued slump. And this particular experience now is just a case of people realising, ‘Hey, we’re not going to get growth back anymore’.

Lelde Smits: So it’s nothing different, it is the continuation of the GFC?

Steve Keen: It’s the continuation. This won’t be over for ten to fifteen years.


Related book: Debunking Economics - Revised and Expanded Edition: The Naked Emperor Dethroned?

Grant's Interest Rate Observer: Summer Break Issue

This anthology of Grant's pieces, both ancient and modern, is not only for you, but also for your friends--and co-workers, clients, classmates, shipmates, brothers-in-law and maids-of-honor, too. Please pass it along, with our compliments, to any and all prospective members of the greater Grant's family.

7 in 10 Students Have Skipped Buying a Textbook Because of Its Cost, Survey Finds

Found via John Hawks.

For many students and their families, scraping together the money to pay for college is a big enough hurdle on its own. But a new survey has found that, once on a campus, many students are unwilling or unable to come up with more money to buy books—one of the very things that helps turn tuition dollars into academic success.

In the survey, released on Tuesday by the U.S. Public Interest Research Group, a nonprofit consumer-advocacy organization, seven in 10 college students said they had not purchased a textbook at least once because they had found the price too high. Many more respondents said they had purchased a book whose price was driven up by common textbook-publishing practices, such as frequent new editions or bundling with other products.

"Students recognize that textbooks are essential to their education but have been pushed to the breaking point by skyrocketing costs," said Rich Williams, a higher-education advocate with the group, known as U.S. PIRG. "The alarming result of this survey underscores the urgent need for affordable solutions."

Party Ends at For-Profit Schools

Thanks to Will for passing this along.

For-profit colleges are facing a tough test: getting new students to enroll.

New-student enrollments have plunged—in some cases by more than 45%—in recent months, reflecting two factors: Companies have pulled back on aggressive recruiting practices amid criticism over their high student-loan default rates. And many would-be students are questioning the potential pay-off for degrees that can cost considerably more than what's available at local community colleges.

"People are just frozen or deferring, delaying decisions to go to school," said DeVry Inc. Chief Executive Daniel Hamburger in a conference call earlier this month. "The average person in the U.S. has become much more risk-averse and cautious when it comes to spending or committing to anything. It's unrealistic for us to think that education would be immune from this."


Related previous posts:

Bad Education

Steve Eisman's Ira Sohn Conference Presentation and Speech

Paper: William D. Hamilton’s Work in Evolutionary Game Theory


William D. Hamilton’s impact on contemporary views of evolution has been nothing short of revolutionary, and his contributions to our reasoning on kin selection, genomic conflicts, parasitism and costs of sex dominate these fields. He also had an important, if somewhat less obvious, influence on evolutionary game theory. This field, which by now is well-established both in biology and economics, is usually (and rightly) attributed to John Maynard Smith: the canonical references are his brief joint paper with George Price, and his book ‘Evolution and the Theory of Games’. But W.D. Hamilton played an important, and indeed pioneering role in the development of this field.


Related papers:

The Evolution of Cooperation

Extraordinary sex ratios. A sex-ratio theory for sex linkage and inbreeding has new implications in cytogenetics and entomology

Related books:

The Selfish Gene

Evolution and the Theory of Games

The Evolution of Cooperation

Related Stanford course: Robert Sapolsky: Human Behavioral Biology – Spring 2010

Ed Easterling on fair value

From Probable Outcomes:

“The concept of fair value relates to the appropriate value for the stock market given existing economic and market conditions. For example, when the inflation rate is in the mid-range, then bond yields should be in the mid-range to compensate for that level of inflation. Likewise, since stocks are financial assets, the stock market’s valuation level should reflect the conditions of inflation. As a result, fair value is a relative concept, not an absolute one. Valuation is relative to the inflation rate; it is not a level that is arbitrarily anchored to a long-term average.”

And a graph from Crestmont’s site showing the relationship:

Tuesday, August 23, 2011

Born, and Evolved, to Run

Among his academic peers, Daniel Lieberman, 47, is known as a “hoof and mouth” man.

That’s because Dr. Lieberman, an evolutionary biology professor at Harvard, spends his time studying how the human head and foot have evolved over the millenniums. In January, Harvard University Press published his treatise, “The Evolution of the Human Head.”

We spoke in a Cambridge hotel room for three hours last winter and then again on the telephone in June. An edited and condensed version of the two conversations follows.

Alexander Roepers of Atlantic Investment Management to Present at the 7th Annual New York Value Investing Congress

Alexander Roepers of Atlantic Investment Management is scheduled to present at the 7th Annual New York Value Investing Congress. In his February 2007 interview with Value Investor Insight, he described his investment philosophy:

I realized early on from watching people like Warren Buffett and some of the early private-equity players that if I was going to stand out, I needed to concentrate on my highest-conviction ideas, in a well-defined set of companies that I knew very well. As a result, I limit my universe inside and outside the U.S. in a variety of ways. I want liquidity, so I don’t look at anything below $1 billion in market cap. I want to have direct contact with management and to be a top-ten shareholder in my core holdings, so anything above a $20 billion market cap is out.

Because five or six unique holdings make up 60-70% of each of my portfolios, I also exclude companies with idiosyncratic risk profiles that I consider unacceptable in such a concentrated portfolio. That means I exclude high-tech and biotech companies with technological obsolescence risk, tobacco or pharmaceutical companies with big product-liability risks, utilities and other regulated companies where the government can change the rules of the game, and companies that lack sufficient transparency, like banks, brokerages and insurance companies.

Then we boil it down further into potential “core” longs and “other” longs. Core longs are those in which we can own 2-7% of the company and have a close, constructive relationship with management. Overall, the potential universe of core holdings has around 170 companies in the U.S. and about 180 outside the U.S. These are the stocks that drive our performance – we’ve made our record by finding our share of big winners among these core longs while avoiding almost any losers.

Readers of Value Investing World are eligible for a $1,700 discount to attend the New York Value Investing Congress on October 17 & 18. To qualify for the discount, please use the link below and the discount code N11VIW6. The discount expires on August 31, 2011. Disclosure: Value Investing World receives a referral fee for registrations generated through the link.

Click to register for the 7th Annual New York Value Investing Congress

Monday, August 22, 2011

Howard Marks and the economic cycle

This is a long excerpt from Howard Marks’ November 2001 Memo “You Can't Predict. You Can Prepare.” I think it is an important topic/mental model to keep in mind, both for today’s investing environment and for future ones. Especially since interest rates today are being kept artificially low, profit margins are still near all-time highs and Wall Street estimates for corporate earnings are based on, to quote John Hussman, the “assumption that profit margins will achieve and indefinitely sustain the highest profit margins observed in U.S. history.”

How can non-forecasters like Oaktree best cope with the ups and downs of the economic cycle? I think the answer lies in knowing where we are and leaning against the wind. For example, when the economy has fallen substantially, observers are depressed, capacity expansion has ceased and there begin to be signs of recovery, we are willing to invest in companies in cyclical industries. When growth is strong, capacity is being brought on stream to keep up with soaring demand and the market forgets these are cyclical companies whose peak earnings deserve trough valuations, we trim our holdings aggressively. We certainly might do so too early, but that beats the heck out of doing it too late.

The Credit Cycle

The longer I'm involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.

The process is simple:

- The economy moves into a period of prosperity.

- Providers of capital thrive, increasing their capital base.

- Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.

- Risk averseness disappears.

- Financial institutions move to expand their businesses – that is, to provide more capital.

- They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.

At the extreme, providers of capital finance borrowers and projects that aren't worthy of being financed. As The Economist said earlier this year, "the worst loans are made at the best of times." This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.

When this point is reached, the up-leg described above is reversed.

- Losses cause lenders to become discouraged and shy away.

- Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.

- Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers.

- Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.

- This process contributes to and reinforces the economic contraction.

Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.

I stated earlier that cycles are self-correcting. The credit cycle corrects itself through the processes described above, and it represents one of the factors driving the fluctuations of the economic cycle. Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.

In "Genius Isn't Enough" on the subject of Long-Term Capital Management, I wrote "Look around the next time there's a crisis; you'll probably find a lender." Overpermissive providers of capital frequently aid and abet financial bubbles. There have been numerous recent examples where loose credit contributed to booms that were followed by famous collapses: real estate in 1989-92; emerging markets in 1994-98; Long-Term Capital in 1998; the movie exhibition industry in 1999-2000; venture capital funds and telecommunications companies in 2000-01. In each case, lenders and investors provided too much cheap money and the result was over-expansion and dramatic losses. In "Fields of Dreams" Kevin Costner was told, "if you build it, they will come." In the financial world, if you offer cheap money, they will borrow, buy and build – often without discipline, and with very negative consequences.

The credit cycle contributed tremendously to the tech bubble. Money from venture capital funds caused far too many companies to be created, often with little in terms of business justification or profit prospects. Wild demand for IPOs caused their hot stocks to rise meteorically, enabling venture funds to report triple-digit returns and attract still more capital requiring speedy deployment. The generosity of the capital markets let companies sign on for huge capital projects that were only partially financed, secure in the knowledge that more financing would be available later, at higher p/e's and lower interest rates as the projects were further along. This ease caused far more capacity to be built than was needed, a lot of which is sitting idle. Much of the investment that went into it may never be recovered. Once again, easy money has led to capital destruction.

In making investments, it has become my habit to worry less about the economic future – which I'm sure I can't know much about – than I do about the supply/demand picture relating to capital. Being positioned to make investments in an uncrowded arena conveys vast advantages. Participating in a field that everyone's throwing money at is a formula for disaster.

We have lived through a long period in which cash acted like ballast, retarding your progress. Now I think we're going into an environment where cash will be king. If you went to a leading venture capital fund in 1999 and said, "I'd like to invest $10 million with you," they'd say, "Lots of people want to give us their cash. What else can you offer? Do you have contacts? Strategic insights?" I think the answer today would be different.

One of the critical elements in business or investment success is staying power. I often speak of the six-foot-tall man who drowned crossing the stream that was five feet deep on average. Companies have to be able to get through the tough times, and cash is one of the things that can make the difference. Thus all of the investments we're making today assume we'll be going into the difficult part of the credit cycle, and we're looking for companies that will be able to stay the course.

The Corporate Life Cycle

As indicated above, business firms have to live through ups and downs. They're organic entities, and they have life cycles of their own.

Most companies are born in an entrepreneurial mode, starting with dreams, limited capital and the need to be frugal. `Success comes to some. They enjoy profitability, growth and expanded resources, but they also must cope with increasing bureaucracy and managerial challenges. The lucky few become world-class organizations, but eventually most are confronted with challenges relating to hubris; extreme size; the difficulty of controlling far-flung operations; and perhaps ossification and an unwillingness to innovate and take risks. Some stagnate in maturity, and some fail under aging products or excessive debt loads and move into distress and bankruptcy. The reason I say failure carries within itself the seeds of success is that bankruptcy then permits some of them to shed debt and onerous contracts and emerge with a reborn emphasis on frugality and profitability. And the cycle resumes . . . as ever.

The biggest mistakes I have witnessed in my investing career came when people ignored the limitations imposed by the corporate life cycle. In short, investors did assume trees could grow to the sky.

Do You Suffer From Decision Fatigue?

Found via Simoleon Sense.

Three men doing time in Israeli prisons recently appeared before a parole board consisting of a judge, a criminologist and a social worker. The three prisoners had completed at least two-thirds of their sentences, but the parole board granted freedom to only one of them. Guess which one:

Case 1 (heard at 8:50 a.m.): An Arab Israeli serving a 30-month sentence for fraud.

Case 2 (heard at 3:10 p.m.): A Jewish Israeli serving a 16-month sentence for assault.

Case 3 (heard at 4:25 p.m.): An Arab Israeli serving a 30-month sentence for fraud.

There was a pattern to the parole board’s decisions, but it wasn’t related to the men’s ethnic backgrounds, crimes or sentences. It was all about timing, as researchers discovered by analyzing more than 1,100 decisions over the course of a year. Judges, who would hear the prisoners’ appeals and then get advice from the other members of the board, approved parole in about a third of the cases, but the probability of being paroled fluctuated wildly throughout the day. Prisoners who appeared early in the morning received parole about 70 percent of the time, while those who appeared late in the day were paroled less than 10 percent of the time.

Why Software Is Eating The World - By Marc Andreessen

Thanks to Will for passing this along.

This week, Hewlett-Packard (where I am on the board) announced that it is exploring jettisoning its struggling PC business in favor of investing more heavily in software, where it sees better potential for growth. Meanwhile, Google plans to buy up the cellphone handset maker Motorola Mobility. Both moves surprised the tech world. But both moves are also in line with a trend I've observed, one that makes me optimistic about the future growth of the American and world economies, despite the recent turmoil in the stock market.

In short, software is eating the world.


Related article: Software eats part of the world (read Andreessen article first)

Wall Street Aristocracy Got $1.2 Trillion From Fed

Citigroup Inc. (C) and Bank of America Corp. (BAC) were the reigning champions of finance in 2006 as home prices peaked, leading the 10 biggest U.S. banks and brokerage firms to their best year ever with $104 billion of profits.

By 2008, the housing market’s collapse forced those companies to take more than six times as much, $669 billion, in emergency loans from the U.S. Federal Reserve. The loans dwarfed the $160 billion in public bailouts the top 10 got from the U.S. Treasury, yet until now the full amounts have remained secret.

Fed Chairman Ben S. Bernanke’s unprecedented effort to keep the economy from plunging into depression included lending banks and other companies as much as $1.2 trillion of public money, about the same amount U.S. homeowners currently owe on 6.5 million delinquent and foreclosed mortgages. The largest borrower, Morgan Stanley (MS), got as much as $107.3 billion, while Citigroup took $99.5 billion and Bank of America $91.4 billion, according to a Bloomberg News compilation of data obtained through Freedom of Information Act requests, months of litigation and an act of Congress.

“These are all whopping numbers,” said Robert Litan, a former Justice Department official who in the 1990s served on a commission probing the causes of the savings and loan crisis. “You’re talking about the aristocracy of American finance going down the tubes without the federal money.”

Foreign Borrowers

It wasn’t just American finance. Almost half of the Fed’s top 30 borrowers, measured by peak balances, were European firms. They included Edinburgh-based Royal Bank of Scotland Plc, which took $84.5 billion, the most of any non-U.S. lender, and Zurich-based UBS AG (UBSN), which got $77.2 billion. Germany’s Hypo Real Estate Holding AG borrowed $28.7 billion, an average of $21 million for each of its 1,366 employees.

The largest borrowers also included Dexia SA (DEXB), Belgium’s biggest bank by assets, and Societe Generale SA, based in Paris, whose bond-insurance prices have surged in the past month as investors speculated that the spreading sovereign debt crisis in Europe might increase their chances of default.

The $1.2 trillion peak on Dec. 5, 2008 -- the combined outstanding balance under the seven programs tallied by Bloomberg -- was almost three times the size of the U.S. federal budget deficit that year and more than the total earnings of all federally insured banks in the U.S. for the decade through 2010, according to data compiled by Bloomberg.

EconTalk: O'Donohoe on Potato Chips and Salty Snacks

Brendan O'Donohoe of Frito-Lay talks with EconTalk host Russ Roberts about how potato chips and other salty snacks get made, distributed, and marketed. The interview follows an hour-long tour of a local supermarket where O'Donohoe showed Roberts some of the ways that chips and snacks get displayed and marketed in a modern supermarket. The conversation is a window into a world that few of us experience or are even aware of--how modern producers and retailers make sure the shelves are stocked and their products get noticed.

John Mauldin: The Recession of 2011?

It was relatively easy for me to forecast the recessions of 2001 and late 2007 over a year in advance. We had an inverted yield curve for 90 days at levels that have ALWAYS heralded a recession in the US. Plus there were numerous other less accurate (in terms of consistency) indicators that were “flashing red.” (For new readers, an inverted yield curve is where long-term rates go below short-term rates, a [thankfully] rare condition.)

And since stocks drop on average more than 40% in a recession, suggesting that you get out of the stock market was not such a challenging call. Although, when Nouriel Roubini and I were on Larry Kudlow’s show in August of 2006, we got beaten up for our bearish views. And you know what? The stock market then proceeded to go up another 20% in the next six months. Ouch. That interview is still on YouTube at Timing can be a real, um, problem. There is no exact way to time markets or recessions.

My view then was based on the inverted yield curve (as an article of faith) and, not much later in 2006, my growing alarm as I realized the extent of the folly of the subprime debt debacle and how severe a crisis it would become. I changed my assessment from a mild recession to a serious one in early 2007 as my research revealed more and more fault lines and the damning interconnection of the global banking system (which has NOT been fixed, only made worse since then). I should note that my early views were rather Pollyannaish, as I thought (originally) that losses to US banks would only be in the $400 billion range. I keep telling people that I am an optimist.

With the Fed artificially holding down rates on the short end of the curve, we are not going to get an inverted yield curve this time, so we have to look for other indicators to come up with a forecast for the US economy. We grew at less than 1% in the first half of the year. That is close to stall speed. And that was with a full dose of QE2! So now, let’s look at a series of charts that cause me to be very concerned about the near-term health of the economy. Then we turn to Europe and problems compounding there.

Hussman Weekly Market Comment: Whack-A-Mole

As of last week, the S&P 500 has declined to the point where we now expect 10-year total returns averaging about 5.7% annually on the index. This is certainly higher than the 3.4% prospective return we observed earlier this year, but is still a prospective return more characteristic of market peaks than of long-term buying opportunities. Wall Street analysts continue to characterize stocks as cheap on the basis of completely specious approaches like "forward operating earnings times arbitrary P/E multiple," or worse, "forward operating earnings yield divided by 10-year Treasury yield." Unfortunately, despite a few anecdotal successes, there is no correlation between "valuation" on these measures and actual subsequent market returns.

There are numerous reasons why these toy models based on forward operating earnings are misguided, but the four most important ones today are 1) forward operating earnings presently carry the embedded assumption that profit margins will achieve and indefinitely sustain the highest profit margins observed in U.S. history; 2) the duration of a 10-year Treasury bond is only about 8 years, while the duration of the S&P 500 is about 42, meaning that any given yield increase implies 5 times more loss for stocks than it does for bonds, and there is no reason in the world why investors should treat those risks as equivalent; 3) the current conformation of evidence strongly suggests the likelihood of an oncoming U.S. recession, and forward earnings expectations tend to be stunningly off-base in those instances, and; 4) the norms typically applied to forward operating earnings are artifacts of the recent period of bubble valuations, and use norms for "trailing net" as if they are equally applicable to "forward operating." In fact, the correlation between forward operating P/Es and other normalized P/Es having far longer history suggests that a forward multiple of even 12 is quite rich.

As it happens, forward operating earnings, when used properly, can actually be very informative about prospective market returns (see Valuing the S&P 500 Using Forward Operating Earnings ). However, the phrase "used properly" can't be emphasized enough. Here and now, our forward operating earnings model delivers nearly identical prospective return estimates for the S&P 500 as our standard methodology. Stocks are emphatically not undervalued here on any reasonably long-term horizon.

Friday, August 19, 2011

Bob Rodriguez on CNBC

He comes on around 3:20.


Thursday, August 18, 2011

Terra Nova Royalty Corporation (TTT)

A good article/write-up on Seeking Alpha of a company and manager with a great track record. The conference calls can be accessed HERE. (Neither I nor the fund I co-manage have a position in TTT at the time of this post)

Before the end of the year, Terra Nova plans to distribute to shareholders about $100m in assets that the management thinks should not be part of the “new” MFC. My guess is this will mainly be the real estate situated in Dessau and Stendal (which has no synergies with the supply chain management operations) along with some other assets or excess cash which still have to be announced. This will reduce the net worth of the company to about $450m, an amount that the company is comfortable with to achieve further growth.

From the financial standpoint, shareholders really have nothing to complain about. Based on the management’s valuation (which we have to trust since there is little transparency about the assets), the book value of the company is $8.91 per share, and the company earned $0.38 per share in the first half (if the share-based compensation expensed in Q1 is backed out). The royalty rate on the Wabush Mine increased compared to last year, but shipments or iron ore pellets from the mine are still below the historical average (see my previous article for details about the royalty asset). If production ramps up again after maintenance and repairs, and iron ore prices stay favourable, the royalty could earn the company an extra $0.20 per share as Mr. Smith indicated in the telephone conference yesterday. If this materializes, and the rest of the business performs in-line with the first half, the new MFC Industrial could earn $1 per share this year. So at about eight times earnings, a discount to book value, lots of cash on the balance sheet ($413.8m, or $6.62 per share) and a $1.63 special dividend or spin-off distribution coming later in the year, the valuation is not demanding.

From Ice Age to hyper-inflation with SocGen bear

(Reuters) - Three months ago, with the Federal Reserve nearing the end of its second major stimulus program and inflation pressures on the rise, Albert Edwards' bond market view stood out from the crowd.

Societe Generale's famously bearish analyst, in contrast to most, did not see 10-year Treasury yields rising above 3 percent just because the Fed was going to stop buying bonds. Instead, he predicted they would fall below 2 percent.

So far, Edwards -- who predicted the Asian financial crisis of 1997-98, the U.S. housing implosion and who sees China's economy suffering a hard landing -- has been closer than most on his debt call. Last week, yields tested their record low of 2.04 percent.

Investors, however, should hope he's not as accurate on his next call: Edwards sees Treasury yields falling further because, he says, the economy will weaken. He is targeting benchmark rates at around 1.50 percent in the next six months.

Be sure to lock in a low-rate mortgage while you can, though. After that, says Edwards, a period of hyper inflation will push bond yields into double digits and send the S&P 500 stock index tumbling to 400, only a third of its current value.

"On a 10-year view I think government bonds are a horrible investment," Edwards told Reuters in an interview. "My view is that the end game for all this is monetization and trade war and very rapid inflation."

Fed Eyes European Banks

In one sign of how European banks may be having trouble getting dollar funding, an unidentified European bank on Wednesday borrowed $500 million in one-week debt from the European Central Bank, according to ECB data. The bank paid a higher cost than what other banks would pay to borrow dollars from fellow lenders. It was the first time for that type of borrowing since Feb 23.

WCAM: The Bubble Network: Deflating the Social Media Frenzy

In the Facebook movie, The Social Network, one of the original investors asks the question, “A million dollars isn’t cool, you know what’s cool? … A billion dollars.” Now, less than a decade after inception, Facebook is looking very cool indeed with a projected public offering in the neighborhood of $100 billion and perhaps the most anticipated IPO since Google.

The internet music company Pandora and the professional networking site LinkedIn each had IPOs this spring at nearly $3 billion and $9 billion valuations respectively. In addition to Facebook’s expected IPO in 2012, Groupon, Living Social, and Zynga have all filed paperwork declaring their intentions to make a public offering in the near future. Despite high national unemployment and a ubiquitous sense of economic gloom, the prospect of public investment in the internet social media movement has resulted in a frenzy of excitement not seen since, well, the last internet bubble.

While bubble speculators debate whether or not there is a bubble, entrepreneurial investors let the logic of fundamental analysis guide them to temper hysteria and identify sound investment opportunities. Each new internet company must be evaluated in the same way any potential investment is evaluated; on its own merits. In that way, the current frenzy looks less like a bubble, and more like a handful of potentially over valued companies. Rather than one giant industry-wide bubble, like we have experienced in the past with housing or the internet, this social media phenomenon appears to be closer to what one might witness when watching children play with bubbles on the playground; many individual bubbles will pop on their own with little or no economic reverberations, while a few float away.

Wednesday, August 17, 2011

Is the SEC Covering Up Wall Street Crimes? - By Matt Taibbi

Imagine a world in which a man who is repeatedly investigated for a string of serious crimes, but never prosecuted, has his slate wiped clean every time the cops fail to make a case. No more Lifetime channel specials where the murderer is unveiled after police stumble upon past intrigues in some old file – "Hey, chief, didja know this guy had two wives die falling down the stairs?" No more burglary sprees cracked when some sharp cop sees the same name pop up in one too many witness statements. This is a different world, one far friendlier to lawbreakers, where even the suspicion of wrongdoing gets wiped from the record.

That, it now appears, is exactly how the Securities and Exchange Commission has been treating the Wall Street criminals who cratered the global economy a few years back. For the past two decades, according to a whistle-blower at the SEC who recently came forward to Congress, the agency has been systematically destroying records of its preliminary investigations once they are closed. By whitewashing the files of some of the nation's worst financial criminals, the SEC has kept an entire generation of federal investigators in the dark about past inquiries into insider trading, fraud and market manipulation against companies like Goldman Sachs, Deutsche Bank and AIG. With a few strokes of the keyboard, the evidence gathered during thousands of investigations – "18,000 ... including Madoff," as one high-ranking SEC official put it during a panicked meeting about the destruction – has apparently disappeared forever into the wormhole of history.

Under a deal the SEC worked out with the National Archives and Records Administration, all of the agency's records – "including case files relating to preliminary investigations" – are supposed to be maintained for at least 25 years. But the SEC, using history-altering practices that for once actually deserve the overused and usually hysterical term "Orwellian," devised an elaborate and possibly illegal system under which staffers were directed to dispose of the documents from any preliminary inquiry that did not receive approval from senior staff to become a full-blown, formal investigation. Amazingly, the wholesale destruction of the cases – known as MUIs, or "Matters Under Inquiry" – was not something done on the sly, in secret. The enforcement division of the SEC even spelled out the procedure in writing, on the commission's internal website. "After you have closed a MUI that has not become an investigation," the site advised staffers, "you should dispose of any documents obtained in connection with the MUI."

S&P 500 2012 EPS Estimates

Wall Street says about $104.

Compared to Crestmont's normalized EPS of about $70 (p.16).


Related book: Probable Outcomes

Monday, August 15, 2011

Eric Hoffer and "The True Believer"

A great paragraph to conclude the preface of The True Believer:

It is perhaps not superfluous to add a word of caution. When we speak of the family likeness of mass movements, we use the word "family" in a taxonomical sense. The tomato and the nightshade are of the same family, the Solanaceae. Though the one is nutritious and the other poisonous, they have many morphological, anatomical and physiological traits in common so that even the non-botanist senses a family likeness. The assumption that mass movements have many traits in common does not imply that all movements are equally beneficent or poisonous. The book passes no judgments, and expresses no preferences. It merely tries to explain; and the explanations - all of them theories - are in the nature of suggestions and arguments even when they are stated in what seems a categorical tone. I can do no better than quote Montaigne: "All I say is by way of discourse, and nothing by way of advice. I should not speak so boldly if it were my due to be believed."


This book was also one of Allen Scarbrough's The 25 best books for a self education and why.