Links

Jeremy Grantham Divines Oil Industry's Future (LINK) [Excerpt from his letter.]

The simplest argument for the oil price decline is for once correct. A wave of new U.S. fracking oil could be seen to be overtaking the modestly growing global oil demand. It became clear that OPEC, mainly Saudi Arabia, must cut back production if the price were to stay around $100 a barrel, which many, including me, believe is necessary to justify continued heavy spending to find traditional oil. The Saudis declined to pull back their production and the oil market entered into glut mode, in which storage is full and production continues above demand. Under glut conditions, oil (and natural gas) is uniquely sensitive to declines toward marginal cost (ignoring sunk costs), which can approach a few dollars a barrel — the cost of just pumping the oil.

Oil demand is notoriously insensitive to price in the short term but cumulatively and substantially sensitive as a few years pass. The Saudis are obviously expecting that these low prices will turn off U.S. fracking, and I’m sure they are right. Almost no new drilling programs will be initiated at current prices except by the financially desperate and the irrationally impatient, and in three years over 80% of all production from current wells will be gone! Thus, in a few months (six to nine?) I believe oil supply is likely to drop to a new equilibrium, probably in the $30 to $50 per barrel range. For the following few years, U.S. fracking costs will determine the global oil balance. At each level, as prices rise more, fracking production will gear up. U.S. fracking is unique in oil industry history in the speed with which it can turn on and off. In five to eight years, depending on global GDP growth and how quickly prices recover, U.S. fracking production will start to peak out and the full cost of an incremental barrel of traditional oil will become, once again, the main input into price. This is believed to be about $80 today and rising. In five to eight years it is likely to be $100 to $150 in my opinion. U.S. fracking reserves that are available up to $120 a barrel are probably only equal to about one year of current global demand. This is absolutely not another Saudi Arabia.

Daniel Yergin: Who Will Rule the Oil Market? (LINK) [This article was mentioned by Grantham.]

Related books: The Prize: The Epic Quest for Oil, Money & Power, The Quest: Energy, Security, and the Remaking of the Modern World

Related DVD: The Prize - An Epic Quest for Oil; Money & Power

Nestlé is getting paid to borrow money (LINK)

Once upon a time, you actually had to pay lenders to borrow money. It was an archaic ritual called "interest"—here's the Wikipedia page if you don't believe me—but it's over now. 

In fact, it's the opposite of how things work today, at least in Europe's brave, new, deflationary world. France, Finland, Belgium, Denmark, the Netherlands, and Germany are all getting paid by investors—that is, bond yields are negative—to borrow for up to four, and sometimes six, years. Switzerland is even getting paid to borrow for ten years. That's never happened anywhere before. But it's not just governments that people are paying for the privilege of lending to. It's companies, too. Or at least one of them: Nestlé. Its €500 million debt that comes due in October 2016 became the first corporate bond of a year or longer to have a negative yield, after it got as low as -0.0081 percent on Tuesday. (Its borrowing costs later rose to a, relatively-speaking, punitive -0.002 percent).

Five Good Questions for Jeroen Bos about his book Deep Value Investing (LINK) [Bos also recommended the book The Predators' Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders.]

Broyhill Annual Letter (LINK)

RV Capital's Annual Letter [H/T value and opportunity] (LINK)

Some great David Iben links (LINK)

The Future of New Business is Disrupting Old Business (LINK)

Jean-Marie Eveillard on WealthTrack (LINK)

Michael Covel speaks with Michael Mauboussin (LINK)

Steve Keen: My Friend Yanis, The Greek Minister Of Finance (LINK)

Tim Harford: How to See into the Future (LINK)

The Near Death, and Revival, of Monticello (LINK)

Nassim Taleb recently mentioned this bit of history, which I had never heard of before: The KGB's 1985 Counter-Terrorism Operation in Lebanon (LINK)

Hussman Weekly Market Comment: Expect a Decade of 1.7% Portfolio Returns from a Conventional Asset Mix (LINK)

Friday’s employment report showed a 257,000 increase in January non-farm payrolls. This news was followed by a spike in Treasury yields up to 1.96%, a 4% plunge in utility stocks, a 5% plunge in precious metals shares, and took the S&P 500 within a fraction of a percent of December’s record high, before a late-day retreat. These frantic market movements smack of an investment climate dominated by one-dimensional “theme” based behavior - where asset prices have been amped up on yield-seeking speculation, but where the most marginal change in the outlook can trigger a race for the hills or a pile-on, depending on whether the asset has features that are consistent with that theme. On Friday, the knee-jerk reaction was that stronger employment will prompt the Federal Reserve to raise interest rates sooner, creating a scramble to get out of yield-sensitive Treasury bonds and utilities, to buy dollars, and to sell foreign currencies and gold. Of course, in equilibrium, there must be someone on the other side of those trades, so prices moved to the extent needed to find that match.

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By our estimates, never in history, prior to the past 5 weeks, have the prospective 10-year nominal annual total returns of both stocks and Treasury bonds been below 2% at the same time. We currently project a 10-year nominal annual portfolio total return averaging only about 1.7% annually for anything close to a standard portfolio mix of equities, bonds and cash – regardless of how much diversification one has within each of those asset classes.

Comments from Felix Zulauf, James Montier and David Iben

Link to: We will continue to swim in a sea of liquidity

James, we have slow growth, no inflation, low interest rates and easy monetary policy as far as the eye can see. Are we living in the best of all worlds for investors? 

James Montier: How I wish that that were true. The problem with the policy of raising asset prices is that you borrow returns from the future. You can think of it as the front loading of return. So what you’re really doing is pushing down future returns. So it doesn’t really help anybody a great deal in the longer term. Of course, in the short term the effect is positive as you get some sort of balance sheet repair through rising asset prices. At least that’s what central banks hope. But when you look at today’s opportunity set, you’re left with a set of assets where nothing looks attractive from a valuation point of view. 

Even if interest rates stay low for a long time? 

Montier: Even if we factor in low interest rates for the next twenty years, we’re still not seeing great opportunities. We can find stuff that may be fair value in that scenario, but it’s far from obvious. This is a very difficult time – in contrast to 2007, when risk assets were expensive but cash and bonds were priced to deliver reasonable returns, which is not the case today. It’s much harder to find anywhere to hide. So far from being the best of all possible worlds, this is almost the worst of all possible worlds. 

Do your clients still believe in the much-cited low return environment? The further markets move up, the more you might have a credibility issue. 

Montier: No doubt. We haven’t yet reached the kind of loathing that was displayed towards us in 1999 where we were just told we were complete idiots and several clients banned us from their buildings. I think there is a broader acceptance of the power of valuation, but the longer the rally goes on, the shorter people’s memory gets. Galbraith used to talk about the extreme brevity of financial memory and I fear that’s kind of what we’re experiencing now. People are looking at last year and say look, it can go up 30%, why on earth are you saying future returns are going to be dismal. 

But markets have been expensive for quite some time. How opportunistic should a value investor be? 

Montier: There are two possible states of the world: either they keep rates low for a very long period of time or they don’t. Anyone who says they know which one is going to happen is either a liar or a fool or possibly a linear combination with unknown weights. The reality is, nobody knows the future, particularly when it comes to policy rates. By second guessing we’re playing some sort of ridiculous beauty contest. Therefore we should try to build portfolios which are robust and can survive different outcomes. 

How do these portfolios look like?

Montier: That’s a challenge because the portfolios you want to hold in those two different worlds are almost diametrically opposed. If financial repression continues, you want to own the least bad thing out there, which is equities. In the other world, the only asset which does not hurt you when rates move to normal, is cash. So you end up with this bizarre portfolio where you own some equities where they are cheap. And you want to own some dry powder assets which protect you against inflation, provide liquidity and real return. 

Does cash do the job? 

Montier: Cash historically has done all three of those things very well, but in a world where rates are kept very low, cash does not do at least two of those things very well. So in addition to cash, you have to include some long-short strategies, TIPS and bonds which offer at least some yield. The really unsatisfying thing is that no matter what is going to happen in the future, you won’t hold the best portfolio. But at least, this portfolio allows you to survive.

[H/T Zero Hedge]

Hedge Funds Cut Back on Fees

Pressure from disappointed investors is forcing hedge funds to roll back their fees, putting the standard charge of 2% of assets under management and 20% of investment profits on the endangered list.

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"Most hedge funds aren't worth 2/20, and the smart money has made inroads toward better terms," said Michael Smith, managing director at Global Endowment Management LP, which invests for clients.

When Merchants' Gate Capital LP started in 2007, the stock-focused firm charged management fees of 1.5% or 2%, depending on how long investors locked up their money. In July, it trimmed that to 1.25% and 1.75%. The firm, which manages $2 billion, sought to compete with firms lowering their fees, said a person close to the matter.

Others go further. David Iben, an investment veteran who this year started Kopernik Global Investors LLC in Tampa, Fla., is charging fees of just 0.25% plus 20% of profits for a new "long-short" hedge fund, or one that will both buy stocks and bet against them.

Tradewinds - David Iben’s January 2012 Commentary: Devo

Link to: Devo - by David Iben

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Excerpts:

It has been a strange evolutionary course from the early 1970’s Whip Inflation Now (WIN) campaign of President Ford and then Chairman or the Council of Economic Advisors, Alan Greenspan, to the current era where the very same Greenspan (who now claims to have always viewed the program as “unbelievably stupid”) and Ben Bernanke are well underway with what amounts to the “PIN" program: Print Inflation Now. While some may argue that recent Commentaries have over-emphasized this topic, I will suggest the opposite: it is impossible to over-emphasize the topic of money, especially in this age of Bernanke. So here we go again…..

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But maybe it’s different this time and governments can be trusted (couldn’t even type that with a straight face). Let’s start our investigation of this thesis with a look back at the evolution of the attitude toward debt over time.

“I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared.”

“We must not let our rulers load us with perpetual debt.”

-Thomas Jefferson

“The consequences arising from the continual accumulation of public debts in other countries ought to admonish us to be careful to prevent their growth in our own.”

“There are two ways to conquer and enslave a country. One is by the sword. The other is by debt.”

-John Adams

“There is not a menace in the world today like that of growing public indebtedness and mounting public expenditures”

-Warren G. Harding

“It is critically important that Congress act as soon as possible to raise the debt limit so that the full faith and credit of the United States is not called into question.”

-Timothy Geithner

So our government has gone from one instilled with a deep fear of debt to one that actually believes that the way to maintain credit worthiness is to take on more debt! Unbelievable!

Or maybe we can grow our way out of the mess? That would be nice, but consider QB Partner’s argument that the principal due on bonds outstanding is more than 25 times the cash available to pay them, and it is clear that a default of some type must happen. It is likely to take place in the form of eventual payment being made, but with currency of greatly diminished value. This repayment will not be of much consolation to the recipients.

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Warren Buffett wrote an interesting article back in the late '70s suggesting that stocks are really quite bond-like, since over time the ROE (return-on-equity) gravitates to 12%, effectively making for a fixed return. This is an interesting concept worth paying attention to. Stocks could disappoint badly, especially given current lofty expectations. Equity-holders, of course, have the same problem of getting paid in a devalued currency. This is in addition to the age-old problem of uncertainty regarding any future receipts. On the surface, bonds are preferable, just as we’ve always been taught. Yet, it is also important to be cognizant of the differences between stocks and bonds that tip the scales in favor of stocks.

Stocks offer more than just the right to collect a payment of currency in the future. They offer ownership: ownership of land, buildings, trademarks, patents, goodwill, know-how, and future value creation. While the ROE may not rise with inflation, the E (shareholders’ equity) upon which the returns are generated should, in nominal terms, increase with inflation. The assets of the business can increase in nominal value and/or the nominal value of the services that a business provides can also increase. Therefore, investors are well-advised to forget about CAPM (Capital Asset Pricing Model) and momentum and risk-free rates and quarterly earnings estimates and relative performance and all the other ways in which they can “major in the minors,” and focus instead on owning businesses that can sustainably create value over the long term. We believe this should be done in a diversified portfolio of companies, across borders, in different currencies, and in many industries.

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Related link: JANUARY 2012 CONFERENCE CALL SUMMARY

Tradewinds - David Iben’s July 2011 Commentary: Hard Times and Nursery Rhymes

Link to: Hard Times and Nursery Rhymes - by David Iben

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Excerpt:

Returning to Fortune’s Formula, many pages were devoted to the pros and cons of geometric averaging (vs. arithmetic) and to the Kelly Criterion. While we all understand the power of compounding, a geometric refresher course never hurts. A fifty percent drop in wealth requires a one hundred percent rebound just to break even. A hundred percent decline is a complete wipeout from which there is no return. The Fed, over the past several years, has taken the nominal return on cash to zero and the real (inflation-adjusted) return to minus two percent or perhaps as bad as negative ten percent, depending upon whom you believe regarding the true rate of currency debasement. It has succeeded in pushing up the price of stocks, bonds, commodities and other assets. As a result, these assets are much more risky than they were several years ago. Certainly stocks aren’t intrinsically worth twice what they were two years ago (pre-doubling). Two years ago investors had to ponder the merit of holding cash, and thus losing two to ten percent of their purchasing power versus the prospect of making in the range of negative 25 to positive 250 percent in the stock market. The choice was easy. Now the prospects appear more daunting; a reasonable expectation may be in the ball park of minus 50% to plus 50% in stocks versus the same 0% expectation for cash (negative two to ten percent after inflation). The choice is less clear.

Cash is risky because the Fed is playing a dangerous game.

Hard Assets are increasingly risky because the Fed’s zero rate policy has “succeeded” in running the prices to higher levels than they would otherwise be.

Equities are risky for the same reasons that hard assets are, compounded by the fact that investors are inputting aggressive assumptions into their pricing models.

At the same time, cash offers short-term stability should downside volatility return to assets (real or financial) while hard assets offer scarcity value and equities offer growth and/or ownership of wealth-holding franchises. More than ever, diversification is in order.

While we, at Tradewinds, are still no fan of cash, as just discussed, it may deserve a place in investors’ portfolios. (Investors’ decisions must be made in accordance with their own needs and tolerance for risk.) Some allocation to cash, in addition to meaningful positions in global stocks and hard assets (real estate and metals), seems reasonable. Should inflation soar, as can reasonably be expected given the current gross mismanagement of fiscal and monetary policy worldwide, much of the portfolio is protected. However, if there is a long-overdue correction or bear market, the cash will provide some downside protection and purchasing power as bargains appear. Following two great years, in a geometric world, the third year still matters immensely.

Tradewinds - David Iben’s May 2011 Commentary: Weird Science

Link to: Weird Science - by David Iben

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Excerpt:

Just as the boys were inspired by the movie Frankenstein, one cannot help but imagine a younger Bernanke, back in 1985, watching Weird Science and hatching a plan to use a few computer models, some creative nomenclature, some green pieces of paper and maybe a little lightening, to create beauty and wealth. Maybe using “molecular manipulation” he could turn paper into gold!

Creatively, he decided that calling this experiment “Quantitative Easing (QE)” made it somehow more palatable than using a more forthright—“Dollar Debasement.” There is even a stated goal for debasement—2% every year. They call this “Inflation Targeting.” Keynes, the author of many theories that have been embraced by inflation apologists to defend spurious government policy, had a more honest appraisal of inflationary policy. Quoting Vladimir Lenin of all people, Keynes stated, “Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency.” He added, “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they cannot only confiscate but they confiscate arbitrarily.” Even the father of the communist Soviet Union understood some economic principles that Bernanke does not seem to. The following quotes suggest that he isn’t especially prescient.

“At this juncture… the impact on the broader economy and financial markets of the problems in the sub-prime markets seems likely to be contained,”

- Ben Bernanke, March 2008

“Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”

- Ben Bernanke, February 2006

“The Federal Reserve is not currently forecasting a recession.”

- Ben Bernanke, January 2008

“The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.”

- Ben Bernanke, June 2008

“I expect there will be some failures [referring to smaller regional banks]. Among the largest banks, the capital ratios remain good and I don’t anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.”

- Ben Bernanke, February 2008

(As to how and why inflation results in a highly regressive “tax” on the poorer segments of society, it is too lengthy a discussion to include here, but is explained well in the readings highlighted earlier.)

Uttering perhaps the most scary quote ever made by a Fed Chairman, in a December interview on 60 Minutes, Mr. Bernanke claimed that he was “100% certain” that he could contain inflation.

David Iben's Thoughts on Japan

I think this is from shortly after the events in Japan.

Link to: David Iben's Thoughts on Japan

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Related link: Tradewinds Japan Market Commentary (March 14th)

Tradewinds - David Iben’s September 2010 Commentary: Slumdog Millionaire

We follow our last Commentary, which centered on the runner-up in this year’s Academy Awards, with one inspired by the film that took home the Oscar for Best Picture last year. As usual, I’ve found an investment message in a film. This film is filled with imagery.

I’m usually not much of an Academy Awards fan. Although I love the movies, I usually don’t care for events involving people from any industry spending hours publically congratulating each other. 2009, however, was an interesting year, perhaps reflective of the depressed mood surrounding the financial meltdown. I actually saw all five movies (yes—it was the last year before the Academy took a page from the NBA playbook and allowed almost everyone (save the Clippers and WALL·E) to make the playoffs). Am I the only one who finds 10 candidates excessive?

Hollywood put out four movies ending with dour outcomes, mostly death. The fifth contender was an outsider, a British film, shot in India. It, too, is filled with depression and death. Yet unlike the others, it is also about hope, perseverance, and the triumph of the human spirit. I like upbeat endings and was definitely rooting for Slumdog to take down the award. Yet, the award, like the movie, stirred mixed emotions. For example, what does this mean for America? I was born in a year of American pre-eminence in many things. There was auto manufacturing for example (’57 Chevy, T-bird, etc), but I was still a teen when the Japanese companies began to steam-roll us. We’ve since witnessed America’s loss of businesses such as consumer goods, TV and electronics, resource industries and, more recently, even some service businesses. Unpredictably (I suppose), I’m not going to lament the continuing loss of our hegemony in the film business. No, the question preoccupying my mind is, “when did we outsource the American Dream?”

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[An additional excerpt that I think is brilliant and perfectly states and simplifies what I’ve come to believe is the ideal approach to investment: bottom-up analysis, but that paying attention to the macro and big picture things is a must from a risk management standpoint. The key, in my opinion, is to be a risk-identifier - not a forecaster - when it comes to those big picture things that aren’t directly related to an individual business. But it is also important to keep in mind that the market can stay irrational and that risks can take a long time before they are realized in the market, so it is also important to be careful about betting on the timing of those macro risks playing out (i.e. it is probably better to hold cash and/or try and find cheap insurance instead of making an investment that depends on the timing for mean reversion).]

Additional excerpt:

Before we continue, let’s veer off on a tangential discussion about why a disciplined bottom-up, value-oriented shop like Tradewinds spends time on these broader issues or sends out these topical missives.

I must confess to being a big fan of Charlie Munger, whom I’ve never met. He writes often about the importance of psychology, behavior and incentivization. He talks about a thorough understanding of accounting, mathematics and finance, not as an advantage but, as a necessity. Tradewinds agrees. We don’t believe that anyone ought to hire a money manager because they understand accounting and finance, but they surely shouldn’t hire them if they don’t. An appropriate analogy is a sports team. A team won’t win a game solely because they are in shape and have a decent playbook, but they likely don’t have a chance if they aren’t fit and don’t have plays. To excel, it is important to have a good coaching staff that has studied the other team and has developed a strategy to exploit its weaknesses. It is important to practice, to execute, to have the right attitude and desire. It is important to have talented players. Likewise, in the investment business, so many of us like to classify ourselves as ‘value’ investors or as ‘bottom-up’ investors. Tradewinds does not consider these approaches to be advantages; we view them as prerequisite! Overpaying for investments and/or buying franchises without thoroughly vetting the fundamentals is a tough way to make money. It is certainly no way to steward other people’s money. In addition to these fundamentally obvious disciplines, we believe that it is important to understand economics, psychology, behavioral finance, history and logic. A global, independent thought process is increasingly important. Conviction is necessary and integrity is an absolute prerequisite! Putting clients’ interests ahead of one’s own business interests is an unfortunately rare characteristic, and yet is so fundamentally important.

This was a necessarily long intro into the concept of bubbles. While bottom-up analysis and valuation remain absolutely prerequisite to sound investing, doing so while remaining oblivious to bubbles and other major dislocations in the economy equates to the proverbial ‘rearranging of the deck chairs on the Titanic.’ In 1929, it really didn’t matter what stocks you picked, what mattered was that you shouldn’t own stocks. During the ‘guns and butter’ days of LBJ, not owning bonds for the next fifteen years was much more important than picking the ‘right’ bonds to own. In 1980, with Paul Volcker reining in the money supply, getting out of gold, oil and other commodities should have been at the forefront of everyone’s mind. In the late 1980s, asking if there was any conceivable way that things could work out well for the Japanese market was all that mattered, rather than analyzing which Japanese stocks or buildings to own. In 1999, recognizing that there was no growth rate high enough to make the math work for investors in tech stocks was all that needed to be done. Analyzing tech stocks was generally a waste of time until 2002 (except for short-sellers). During the 2005 through 2008 period, asking the question - will mortgages on overpriced houses, extended to unqualified, over-extended borrowers likely be repaid? - was all that analysts needed to do when assessing financial stocks.

Which brings us to 2010! We believe that the most important analysis that a prospective investor can perform is to ask the question: will governments that have obligations that far exceed their wherewithal to honor, eventually make good on them? If you were considering making a loan to your neighbor for 10 years, you would want some data. High on the list might be: other obligations, integrity, employability, assets/collateral, and income. Low on the list (if there at all) might be: what do the government bureaucrats claim was the CPI or unemployment rate last quarter, what was the ‘output gap,’ whether Bernanke is speaking this week, or what economists are suggesting next quarter’s growth rate will be. Why should loans to governments be treated differently? That Japan, the U.S., and the U.K. won’t honor their commitments is a given in our opinion. When and how they renege is a more legitimate topic. We do not know the answer, but not knowing the answer, we do believe that loaning money to them for 10 years at a sub-3% yield is madness! While it may or may not ultimately work out for buyers, the risk is far greater than the prospective return.

Tradewinds - David Iben’s March 2010 Commentary: Avatar

Thanks to Mike G. for passing this along.

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

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