Leucadia 2007 Letter to Shareholders

In 2007, Leucadia reported $484.3 million in after tax income ($2.10 per share, fully diluted). We lost $88.3 million from continuing operations pre-tax and had non-cash income of $542.7 million by bringing into income part of our deferred tax asset. In the confusing world of GAAP, in a year where we lost money, did not harvest any major gains and all of our reported income came from tax savings on income we have yet to earn, net worth went up 43%, principally from marking to market our investment in one security.

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To sum up as we see it: 2007 was a mediocre year in which (a) the combination of operating company earnings, corporate overhead and security gains were negative and (b) interest on our cash hoard was less than the interest due on our corporate debt. We also had mark to market losses in several limited partnership investments. Time will tell whether they recover. Fortunately our investments in our two mining ventures described below are progressing very well and we have potential profits in both, only some of which has already been recognized in shareholders’ equity.

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Run Spot Run
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What follows is our oversimplified version of what has happened to the world over the last 30 years.
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In 1988, one of us, with children, took a trip up the Amazon River on a flat bottom boat. After a week of travel, as the river grew shallower and narrower, we rounded a bend. There ahead, someone had cleared an open space where a small village resided. We disembarked to investigate.

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Off in the distance a familiar sound could be heard. With the village children in tow we followed a path into the jungle. There was a small Sony generator, a TV and a moveable satellite dish that a scientific team left behind years before. Using this equipment, the inhabitants of the village were watching CNN.

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Even people living in the jungle eking out a subsistence living were watching television and vicariously experiencing the abundance of the Northern Hemisphere. Governments in every part of the world have responded to the rising expectations of their populations. China, despite being a dictatorship, has devised ways for its population to raise its standard of living by becoming the low cost manufacturing center of the world. India has followed a slightly different path, but there too living standards are rising at a dramatic rate. These two countries alone account for one-third of the earth’s population and adding in the rest of Asia over half. The demand generated by the growth of Asia accounts for the dramatic increase in commodity prices that we are all experiencing and reading about in the newspapers.

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This prologue explains why we have ended up doing well with our investments in two mining companies. A great deal of steel and copper is required to supply and build the infrastructure for 3.7 billion people. The growth story in Asia is continuing and in the future we may be looking for more opportunities to participate, whether inside or outside the U.S.

Whitney Tilson: Let the herd stampede first before making your move

Without doubt, timely and democratic access to financial and market information contributes to smoothly functioning financial markets. But it’s worth asking whether the ubiquity of such information today is a friend or foe of sound investment decision-making. For all but the most active professional traders, the answer is often “no”.

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The biggest problem, as studies have shown, is that investors tend to over-react to news, so its 24/7 availability harms their long-term success.

Take financial talking-heads with a grain of salt - By Mark Sellers

Everyone acts in his or her self-interest. This is a key facet of humanity, and keeps our society moving forward.

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Think about that the next time you make an investment decision. As an investor, it is in your interest for your portfolio to do as well as possible with the least risk possible. Unfortunately, this is not the goal of most of the people you may rely on for news and advice. There are conflicting incentives everywhere in the world of finance.

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This is something to keep in mind when you read the newspaper, watch CNBC, or manage your personal finances. Various stock market players have different incentives, none of which is necessarily in your best interest:

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And a note to Mark Sellers, since the above links to the last article he'll be writing for the Financial Times, thank you for your rational thoughts and all the best!

What Warren thinks...

In early April the megabillionaire hosted 150 students from the University of Pennsylvania's Wharton School (which Buffett attended) and offered Fortune the rare opportunity to sit in as he expounded on everything from the Bear Stearns bailout to the prognosis for the economy to whether he'd rather be CEO of GE - or a paperboy. What follows are edited excerpts from his question-and-answer session with the students, his lunchtime chat with the Whartonites over chicken parmigiana at Piccolo Pete's, and an interview with Fortune in his office.

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I know you had a paper route. Was that your first job?

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Well, I worked for my grandfather, which was really tough, in the [family] grocery store. But if you gave me the choice of being CEO of General Electric or IBM or General Motors, you name it, or delivering papers, I would deliver papers. I would. I enjoyed doing that. I can think about what I want to think. I don't have to do anything I don't want to do. It might be wonderful to be head of GE, and Jeff Immelt is a friend of mine. And he's a great guy. But think of all the things he has to do whether he wants to do them or not.

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How do you get your ideas?

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I just read. I read all day. I mean, we put $500 million in PetroChina. All I did was read the annual report. [Editor's note: Berkshire purchased the shares five years ago and sold them in 2007 for $4 billion.]

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What advice would you give to someone who is not a professional investor? Where should they put their money?

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Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time

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How does the current turmoil stack up against past crises?

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Well, that's hard to say. Every one has so many variables in it. But there's no question that this time there's extreme leveraging and in some cases the extreme prices of residential housing or buyouts. You've got $20 trillion of residential real estate and you've got $11 trillion of mortgages, and a lot of that does not have a problem, but a lot of it does. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. That's a hell of a lot - I mean, we talk about having $150 billion of stimulus now, but that was $330 billion of stimulus. And that's just from prime mortgages. That's not from subprime mortgages. So leveraging up was one hell of a stimulus for the economy.

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If that was one hell of a stimulus, do you think the $150 billion government stimulus plan will make an impact?

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Well, it's $150 billion more than we'd have otherwise. But it's not like we haven't had stimulus. And then the simultaneous, more or less, LBO boom, which was called private equity this time. The abuses keep coming back - and the terms got terrible and all that. You've got a banking system that's hung up with lots of that. You've got a mortgage industry that's deleveraging, and it's going to be painful.

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The scenario you're describing suggests we're a long way from turning a corner.

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I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.

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Your OFHEO example implies you're not too optimistic about regulation.

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Finance has gotten so complex, with so much interdependency. I argued with Alan Greenspan some about this at [Washington Post chairman] Don Graham's dinner. He would say that you've spread risk throughout the world by all these instruments, and now you didn't have it all concentrated in your banks. But what you've done is you've interconnected the solvency of institutions to a degree that probably nobody anticipated. And it's very hard to evaluate. If Bear Stearns had not had a derivatives book, my guess is the Fed wouldn't have had to do what it did.

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In the above article, it mentions that Mr. Buffett told students, in response to the question on how he gets his ideas, "I just read. I read all day." Along similar lines, take note of the quote from Charlie Munger:

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"In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time -- none, zero... You'd be amazed at how much Warren reads -- at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out."

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And the Mark Twain quote:

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“The man who doesn’t read good books has no advantage over the man who can’t read them.”

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So, if you're looking for something good to read, START HERE.

CEO Interview: Costco's James Sinegal

IN HIS WARMLY lit open-air office, James Sinegal pulls up the back of his shirt collar to reveal Costco's in-house brand. The shirt is a noticeably fine, tightly woven sky-blue cotton, and the obvious point from the chief executive wearing it is that it's a bargain, at $14.99. "This would sell for $50 to $70 in a department store," he says.

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One of the best bargains Costco offers is the CEO himself. Though the stock is up 15% in the past year, his salary has remained at $350,000 with a maximum $200,000 bonus, putting him near the bottom of most corporate-salary surveys. At a time when investment-bank CEOs are resigning with huge payouts, this sort of frugality is refreshing. But instead of finding the charm in a thrifty CEO who's content to shove six Formica tables together in the conference room, many analysts have pleaded with him to cut costs elsewhere. Take salaries: Costco's average hourly pay, $18.15, is 68% more than the average pay at Wal-Mart. What's more, "he could raise prices a negligible amount and the stock would go through the roof," says Deutsche Bank analyst William Dreher. That advice falls on deaf ears. "That's where it starts, and before you know it, you've got Sears," whose decades-long decline is an American tragedy, in Sinegal's view.

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These days Sinegal is gearing up for another potential tragedy: the American consumer. With unemployment up and home prices down, consumers are getting squeezed. The store that Sinegal cofounded in 1983 caters to the cost-conscious, whose ranks will certainly be growing in the coming year. Costco's goods are priced no more than 15% above cost, which explains why store sales amount to less than 1% of profits.

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Costco's 2.7% profit margins don't indicate much progress toward your 2003-stated goal of 4%. Apparently, this is a thorn in your side. Want to take it back?

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I will not take it back. Shareholders have a right to earn more. But when there is difficult competition, we have to respond.

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You could raise the price of, say, a bottle of ketchup to $1.03 instead of $1, and no one would know. Raising prices just 3% per product would add 50% to your pretax income. Why not do it?

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It's like heroin: You do a little and you want a little bit more. Raising prices is the easy way.
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So how will you improve margins?

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We will sell more of our private label — up to 25% of sales, instead of the 15% we sell now. But I don't want to confuse people. We realize people come for our Sony TV sets and Michelin tires, and we won't disappoint them. We are opening 35 new stores a year — any more would be tough on our management team. We'll buy smarter.
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You're Costco — how much smarter can you possibly buy?

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That's why it's called work. There are ways to cut expenses.

Basic Structure of Investment Process and Valuation by Bruce Greenwald

Prof. Bruce Greenwald's presentation in India, courtesy of Prof. Sanjay Bakshi:

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Basic Structure of Investment Process and Valuation

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Books:

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Value Investing: From Graham to Buffett and Beyond

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Competition Demystified : A Radically Simplified Approach to Business Strategy (In my opinion, it is hard to find a better value than this for $5.49)

Buffett tips off MU crowd

During a videoconference yesterday, University of Missouri business students had the chance to pick the brain of the billionaire investor and CEO of Berkshire Hathaway Inc. as a part of a daylong educational forum hosted by MU’s Trulaske College of Business.

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"Develop your own talents," Buffett said via satellite from a television station in his hometown of Omaha, Neb. He added that oral and written communication skills are the most important tools a person can have coming out of college.
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"If you have those abilities when you’re young, you jump out," the 77-year-old business giant said.

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Related previous posts on the importance of writing well:

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Greg Mankiw - How to Write Well

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So You Want To Be The Next Warren Buffett? How's Your Writing?

Crossing the Rubicon - Bob Rodriguez, FPA

These past two weeks have been extraordinary in that the Federal Reserve has had to take actions that have not been used since the Great Depression and a few that heretofore have never been used. There have been several crises in the capital markets that lead us to comment on what they appear to mean. During the last year, we have conveyed a growing concern, through several prior commentaries, as to the dangers and implications of an absence of fear toward various types of increasing risks in our financial system. We believe the culmination of these risks forced the Federal Reserve to take the recent extraordinary actions of creating two new lending facilities for primary dealers and facilitating a merger of Bear Stearns with JPMorganChase to prevent a liquidity and solvency crisis from potentially toppling the U.S. capital markets. The partners of First Pacific Advisors, LLC (FPA) discussed these events on March 21 and came to several conclusions about what the long-term implications of these actions might be and we will share them with you in this commentary. Fortunately, over the last two years, our preparations for potential financial market disruptions have meant that FPA and most of our product areas have essentially avoided the calamitous effects of this credit crisis.

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The Federal Reserve did not regulate broker/dealers since this was the responsibility of the SEC. Now it appears the Fed has become the lender of last resort to a borrower that had not been regulated or subject to review by the Fed. In essence, the balance sheet of the Fed, and potentially U.S. taxpayers, is being placed at risk for institutions that increased their balance sheet leverage and risk, during good times, so as to enhance their firm’s profitability but now, during a time of difficulty, they are looking to the Fed to be the savior, despite their previous business mismanagement practices. In our opinion, this is a strategy of heads they win, tails the U.S. taxpayer loses.

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In an earlier era, Bear Stearns would have been left to fail. This is not the case today since there was apparently a deep fear on the part of the Fed that a failure of Bear Stearns could create a domino-like crisis infecting a wide array of financial institutions, thereby accelerating and deepening the current credit contagion. As Steven Romick said in our FPA partner meeting on March 21, “I’m more concerned about what I don’t see. Why is it that we are not being told about or seeing another bidder for Bear Stearns other than JPMorganChase? Might JPMorganChase be playing defense so as to protect its $91.7 trillion dollar derivative exposure (according to September 2007 Office of the Comptroller of the Currency data) that is supported by just $123 billion of equity? How much counter party exposure did JPMorganChase have to Bear Stearns?” In our opinion, the Bear Stearns transaction looks very suspicious. If the situation were so precarious, why shouldn’t shareholder ownership have been entirely wiped out because of the excesses and mismanagement by their firm? Why should the Fed’s balance sheet be placed at risk while shareholders are receiving some type of compensation? A week later, the bid was raised from $2 to $10 per share, increasing the value conveyed by approximately $1 billion. Again, why should there be any compensation to shareholders? This compensation is being conveyed to owners of a firm that had derivative positions, with notional amounts as of November 30, 2007, totaling $13.4 trillion. Warren Buffett has, on several occasions, described derivatives as potential “weapons of mass destruction.” Apparently, the collapse of Bear Stearns might have triggered a financial market nuclear meltdown and this potential outcome forced the Fed to intervene.

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Apparently, the risk of a CDS contagion helped to force the Fed’s hand to create a bailout of Bear Stearns. The lack of supervision and control by the SEC that allowed this expansion in risk to develop, and the Fed’s bailout of Bear Stearns, are highly disturbing to all of the partners at FPA.

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In light of the above comments, the partners of FPA came to a unanimous conclusion that the recent Federal Reserve actions and the potential new Congressional policies under consideration are likely to lead to a significantly higher level of long-term inflation in the U.S. We are more than disappointed in the substandard decision making that has taken place within the Federal Reserve and other governmental entities these last several years. The misguided monetary policies of the former Chairman of the Federal Reserve, Alan Greenspan, created an era of “too big to fail” that has led to two major asset bubbles. With each successive bubble, the policy actions available to the Federal Reserve to reduce financial system risk have been systematically reduced. The extraordinary actions taken by the Bernanke Federal Reserve reflect acts of desperation rather than long-term policy solutions. The rapidly changing events within the capital markets are forcing the Fed to adopt policies that have the potential of long-term negative consequences. These recent events, and their fundamental changes to the U.S. financial system, are forcing the leaders of FPA’s product areas to reassess their present portfolio allocations. In essence, we believe we have “Crossed the Rubicon” into a new financial era.

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Related Article: How Fund Manager Didn't Lose a Bundle

Amazon Launches Text-Message Shopping

Amazon.com Inc.'s brick-and-mortar competitors have yet another reason to fear the Web: a new service that lets shoppers compare prices and buy things with a few quick taps on their cell phones.

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Amazon TextBuyIt, which launched late Tuesday, lets people text the name of a product, its description or its UPC or ISBN to 262966 (that's "Amazon" on the keypad) from anywhere their cell phones work - including from inside physical stores.

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If Amazon stocks matching items, the service returns two results at a time. Shoppers can immediately buy one of the first two the selections by texting back the number "1" or "2," or they can ask for more by texting the letter "M."

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New TextBuyIt customers will be prompted to enter the e-mail address associated with their existing Amazon account plus a shipping zip code. The service then calls them and walks through the checkout process using an automated voice system. Shoppers get confirmation by text message and e-mail.

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From there, the customers can check on order status on Amazon's Web site.

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Related previous posts: Put Buyers First? What a Concept, Newsweek: The Future of Reading

Fooled by a Percentage Into Catching Falling Knife! - by Sanjay Bakshi

One of my favorite experiments in class involves asking my students the following question:

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“Suppose that you visit a furniture store in a mall to buy a lamp for your bedroom. You find a lamp you like and it has a list price of Rs. 5,000. Happy with this deal, when you approach the sales representative ready to buy the lamp you picked, she informs you that one of their stores which is just a ten-minute walk from there is closing down and you can buy the same lamp over there for Rs 1,000 less. Please raise your hand if the 20% discount is sufficient incentive for you to walk ten minutes to the other store to buy your lamp.”

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About 70% of the students raise their hands.

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My next question is then addressed to only those who raised their hands. I ask them:

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“Suppose that you visit a car showroom to buy a car and after checking out many models, you find one you like. It costs Rs. 500,000, you are told by the sales representative. However, she also informs you that one of their showrooms which was just a ten-minute walk from there is closing down and you can buy the same car over there for Rs. 499,000 or Rs. 1,000 less. How many of you would like to walk ten minutes to go over to the other showroom to save Rs. 1,000?”

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I hardly see a hand raised.

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Somehow, students who were happy to walk ten minutes to save Rs 1,000 on a lamp are reluctant to walk ten minutes to save Rs. 1,000 on a car!

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What is going on here?

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Indeed, when I reframe both questions again, in a different form, students appeared puzzled:

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“Would you walk ten minutes to increase your net worth by Rs. 1,000?”

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In the lamp vs. car experiment, students who chose to walk ten minutes to save Rs 1,000 while buying a lamp but who refused to walk ten minutes to save the same amount of money while buying a car, were suffering from “anchoring bias”. Their minds were latching on to the wrong anchor of a large percentage savings on a list price, instead of latching on to the right anchor of their personal net worth.

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Related link: Presentation by Whitney Tilson - How to Avoid - and Profit From - Manias, Bubbles and Investor Irrationality

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Books:

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Poor Charlie's Almanack

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Seeking Wisdom

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Influence: The Psychology of Persuasion

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Why Smart People Make Big Money Mistakes

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The Winner's Curse

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Nudge

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Irrational Exuberance

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Against the Gods: The Remarkable Story of Risk

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Behavioural Investing

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How We Know What Isn't So

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Filters against Folly

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Everyday Irrationality