How About Free? The Price Point That Is Turning Industries on Their Heads

There's an old joke about a businessman who gives away his products. A customer asks: "How do you make money doing that?" He answers: "I make it up on volume."

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It's nonsensical, yes. But a funny thing has happened: Giving away the product has become a legitimate business model on the Internet and even beyond. And it's been getting increased attention. Author Chris Anderson will publish a new book in July titled, Free: The Past and Future of a Radical Price. It's a follow-up to his Wired magazine cover story last year, "Free! Why $0.00 is the Future of Business." Anderson, the editor of Wired and a former Economist reporter, also wrote the 2006 book, The Long Tail, in which he observed how companies such as Amazon.com and Netflix were thriving by offering gigantic catalogs of products that each sell in small quantities. Today, those companies are among the few thriving through a recession.

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Related books:

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Free: The Future of a Radical Price

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The Long Tail

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Related previous post: Free! Why $0.00 Is the Future of Business by Chris Anderson

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Article: "The Long Tail" by Chris Anderson

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Related links:

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Video: Interview With Chris Anderson

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The Grand Unified Theory On The Economics Of Free

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Chris Anderson's blog

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A revizualization of the four kinds of free

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Prem Watsa's 2008 Shareholder Letter - Fairfax Financial

Last year, I quoted Hyman Minsky who said that history shows that “stability causes instability”. He said that prolonged periods of prosperity lead to leveraged financial structures that cause instability – and did we see that in spades in 2008!!With SIVs, CDOs, CDOs squared, among many other structures, leverage on leverage was exposed in 2008. Private equity firms that could do no wrong in 2005/2006 were down 90% from their IPO price in 2007. While Madoff may be the biggest Ponzi scheme yet unearthed, what Mr. Minsky calls Ponzi financial structures, where interest and principal cannot be financed by internal operations, are being unmasked daily in the financial markets. Structured investments based upon consumer debt that we warned you about for some time took a real beating in 2008, as 47% of the original AAA ratings on U.S. residential mortgage-backed and various other asset-backed securities issued between 2005 and 2007 were downgraded. In fact, as of January 9, 2009, over 13% of those securities which had originally been rated as AAA had been downgraded to CCC+ or lower!

Last year, we quoted Ben Graham who said that only 1 in 100 of the investors who were invested in the stock market in 1925 survived the crash of 1929-32. Our experience has been the same. As shown in the table below, we incurred a significant cost annually from 2003 through 2006 because of our equity hedging and CDS exposures. Not shown, of course, is the cost of not reaching for yield in the same time period.
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We think this recession is going to be long and deep and the only comparable data points are the debt deflation that the U.S. experienced in the 1930s and Japan experienced from 1989 to the present time. While the U.S. government has initiated a massive stimulus program and is providing up to $2 trillion for its Financial Stability Program, the effect of these programs will be diminished by the enormous deleveraging going on by businesses and individuals: government in the U.S. only accounts for less than 20% of GNP while the private sector accounts for more than 80%. The situation will have to be monitored carefully over the next few years. Of course, many of these negatives are being discounted in the stock market and credit markets as stock prices are down more than 50% and credit spreads are at record levels. We have not had as many opportunities in both markets in our investing career and we are busy!

Howard Marks Memo: Will It Work?

The other day, my son Andrew – college senior and credit-analyst-to-be – asked whether I think Treasury Secretary Geithner is doing the right things. As has happened before, his question elicited a fatherly response that grew into this memo.

When you want a bridge built, you hire a civil engineer whose “calcs” will determine exactly how much concrete and steel should be used. Then it’ll be sure to hold the weight of the cars you expect to cross it. And if you have to perform a task in carpentry, you can employ specialized tools developed and tested expressly for the job: esoteric things like miter boxes, routers and extractors.

One of the most important things to bear in mind today is that economics isn’t an exact science. It may not even be much of a science at all, in the sense that in science, controlled experiments can be conducted, past results can be replicated with confidence, and cause-and-effect relationships can be depended on to hold. It’s not for nothing that economics is called “the dismal science.”

Solutions in economics aren’t nearly as dependable as engineers’ calculations, and there may not be a tool that’s just right for fixing an economy. Of course, the toolbox offers lots of possibilities, including interest rate reductions; quantitative easing; tax cuts, rebates and credits; stimulus checks; infrastructure spending; capital injections; loans, rescues and takeovers; regulatory forebearances and on and on. But no one should think there’s a “golden tool,” such that solving the problem is just a matter of figuring out which one it is and applying it. Anyone who holds the problem solvers to that standard is being unfair and unrealistic.

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Bubbles, Jobs and Investment Tips: Jeremy Grantham visits Wharton

"Career risk and bubbles breaking, that is all that matters."

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This was how Jeremy Grantham, cofounder, Chairman and active member of the asset allocation division of GMO, began his presentation to Wharton students on February 17, 2009.

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So how does Mr. Grantham feel about how most universities cover market efficiency? He began to address this topic by saying "science advances one funeral at a time," which was a famous statement made by Max Planck, the late German physicist. Mr. Grantham continued by commenting on how a University of Pennsylvania alumnus, Mr. Charles Kindleberger, once claimed that academics too often ignore the facts in defense of a theory. This makes sense given that Mr. Kindleberger was an economic historian. In fact in his book Manias, Panics, and Crashes, he relied on narrative exposition and knowledge of history rather than mathematical models to prove his point.

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Like Mr. Kindleberger, Mr. Grantham also relies on history when trying to make sense of the markets, but he utilizes quantitative and statistical means to support his claims. One such claim, made about ten years ago, was that we were in a massive bubble. This claim was indeed accurate, as the tech boom ultimately came crashing down, but not to where GMO forecasted it would. It was only after the most recent crisis, the one we are all experiencing now, that their forecast came to pass. Mr. Grantham explained that all bubbles follow a similar path: they are all mean reverting. From his calculations, he found twenty seven "bubbles" in history. According to efficient market theory, this is completely valid, as this number coincides with what academics refer to as "random events".

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Where Mr. Grantham and the academics differ, however, is how these bubbles act when they pop. According to the market efficiency theory, all movements in the market are random and thus when a bubble pops, the market should follow a random walk (i.e. sometimes the market will go up, while other times the market will go down). But from Mr. Grantham's calculations, each of the 27 bubbles he studied "nose-dived back to the mean". The one exception, as noted above, was the tech bubble. When this bubble popped it did not revert back to the mean in 2003. Mr. Grantham claimed that this was due to two historic events, 9/11 and Alan Greenspan's decision to lower interest rates to the point where real rates were negative, which ultimately led to increased borrowing (surprise, surprise!). According to Mr. Grantham, these two events helped create "the biggest sucker rally in history".

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Despite the harsh realities of the investment management industry, Mr. Grantham did leave us with some hope. His estimate of fair value for the S&P 500 is 900, so with today's closing value of 752.83 (on 2/26/09), we should all be cautiously returning to the markets. His forecast for real market returns is seven to ten percent. He also thinks that oil is a good investment in the thirty dollar range, and in the very long term, it might be a good idea to look to emerging markets. He did also tell us that the hedge fund industry will implode and the private equity industry is doomed, but for now, let's focus on the positives.

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Related book: Manias, Panics, and Crashes: A History of Financial Crises
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Related previous post: GMO - Jeremy Grantham's 4Q 2008 Letter (Parts 1 & 2)
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Other, bubble-related books:
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A Short History of Financial Euphoria
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Tulipmania
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Panic of 1819
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The Panic of 1907
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The Great Crash of 1929
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The Go-Go Years
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Bull: A History of the Boom and Bust, 1982-2004
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Speculative Contagion
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Mr. Market Miscalculates
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Graham and Doddsville Newsletter - Winter 2009

Columbia Business School's Graham and Doddsville Newsletter

Featuring Bruce Berkowitz, Michael Mauboussin, and Bruce Greenwald

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Excerpt (Thanks Linc!):

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Berkowitz: The amazing thing is that people just don’t seem to learn from history. Difficult times correct problems. Companies are tightening up, losing the fat, becoming more efficient, learning very tough lessons about leverage, and relearning about the sanctity of the balance sheet. They are learning that you should not play Russian roulette even if the gun may have a thousand chambers and only one bullet because if you hit that bullet, you are dead. Much of the probability and statistics work—for instance, Monte Carlo simulations—are based upon thousands and thousands of spins of the wheel. But if you kill yourself that one time, you can’t spin again. I don’t know where that is addressed in the statistical courses. Now we know it. Now we have books about black swans and fat tails, and we understand that a bad thing can happen more often than you think.

In life as in investing, what kills you is what you don’t know about and what you’re not thinking about. Today investors are focused on most of the ways in which you can die, which is a great signal for the future. It is when you’re not thinking about it that you get hurt. It is when you pay that optimistic price. It has always paid to be very greedy when everybody else is quite fearful of the environment, because that fear factor is priced in. You tend to get a relatively decent margin of safety based on the price you are paying for a given level of free cash flow. That is where we are today. What better time is there? If not now, when? Was it a better time to invest three years ago? Six years ago? And the answer is no. What is happening today, as in most bear markets, is that people either don’t have the cash or they don’t have the stomach—hence the low valuations.

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Warren Buffett's 2008 Shareholder Letter

Warren Buffett's 2008 Letter to the Shareholders of Berkshire Hathaway Inc.

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Excerpt:

The table on the preceding page, recording both the 44-year performance of Berkshire’s book value and the S&P 500 index, shows that 2008 was the worst year for each. The period was devastating as well for corporate and municipal bonds, real estate and commodities. By yearend, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.

As the year progressed, a series of life-threatening problems within many of the world’s great financial institutions was unveiled. This led to a dysfunctional credit market that in important respects soon turned non-functional. The watchword throughout the country became the creed I saw on restaurant walls when I was young: “In God we trust; all others pay cash.”

By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.

This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly.

Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.

Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.

Take a look again at the 44-year table on page 2. In 75% of those years, the S&P stocks recorded a gain. I would guess that a roughly similar percentage of years will be positive in the next 44. But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.

In good years and bad, Charlie and I simply focus on four goals:

(1) maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash;

(2) widening the “moats” around our operating businesses that give them durable competitive advantages;

(3) acquiring and developing new and varied streams of earnings;

(4) expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.

Jeff Bezos on Charlie Rose

James Montier’s CIMA Presentation

Yet another link that I discovered on my friend Miguel's blog, Simoleon Sense, which is my favorite blog out there (no offense to all the other excellent blogs).
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James Montier’s CIMA Presentation

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Eddie Lampert's Letter to Sears Shareholders

The Adaptive Organization

The pace of change over the past few years and the volatility of the last twelve months seem to have accelerated to the point where businesses and governments are struggling to keep up. In order to drive a strategy one needs to have a context in which that strategy is executed. When oil goes from $50 to $145 and then back to $35 all within a year, what type of strategy can contemplate and manage that? Those who hedged oil purchases looked very smart when oil went up, but when oil declined, some companies experienced huge losses and had to post collateral to maintain those hedges. Nobody wanted to buy trucks last summer and nobody wanted to buy a Toyota Prius in the fall. By winter, nobody wanted to buy any cars or trucks.

As discussed above, during the past year we underwent a major organizational transformation to help us adapt to the accelerated pace of change across all of our businesses. This change goes far beyond economic conditions. New technology and business models have forced many mature industries and businesses to reassess their ability to compete. We put in place boards and leadership teams and developed internal financial reports for each of the business units. We are working to align incentives to close the gap versus industry productivity metrics, as emphasized in our planning process this year. While several steps remain to finalize the processes and systems supporting this structure, we made rapid strides this year in laying the foundation for a more adaptive organization.

In the past, we have described a portfolio approach to managing the business at Sears Holdings. This includes the way we reorganized our business units as well as the way we have invested our capital and managed risk. This is a complicated and complex transition for any company that is used to thinking in a single scenario. For those who don’t agree with the idea of a portfolio approach as the underpinning of strategy, I respectfully disagree. It is easier in theory to manage to a single scenario and a single plan. It is much easier to communicate based on a single scenario and a single plan. But the world is complex and it doesn’t always cooperate. Whether it is changing events on a battlefield, changing events in a sporting contest, or changing events in an industry, being able to adapt and change faster than the competition is a huge advantage.

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Fairholme Conference Call

Fairholme Capital Management held a conference call on February 11th, moderated by Bruce Berkowitz:
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Audio ---------- Transcript

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