Value Investing World

Berkshire and Blue Chip are considering merger in 1983. If it takes place, it will involve an exchange of stock based upon an identical valuation method applied to both companies. The one other significant issuance of shares by Berkshire or its affiliated companies that occurred during present management’s tenure was in the 1978 merger of Berkshire with Diversified Retailing Company.

Our share issuances follow a simple basic rule: we will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that.

The first choice of these managers in making acquisitions may be to use cash or debt. But frequently the CEO’s cravings outpace cash and credit resources (certainly mine always have). Frequently, also, these cravings occur when his own stock is selling far below intrinsic business value. This state of affairs produces a moment of truth. At that point, as Yogi Berra has said, “You can observe a lot just by watching.” For shareholders then will find which objective the management truly prefers - expansion of domain or maintenance of owners’ wealth.

The need to choose between these objectives occurs for some simple reasons. Companies often sell in the stock market below their intrinsic business value. But when a company wishes to sell out completely, in a negotiated transaction, it inevitably wants to - and usually can - receive full business value in whatever kind of currency the value is to be delivered. If cash is to be used in payment, the seller’s calculation of value received couldn’t be easier. If stock of the buyer is to be the currency, the seller’s calculation is still relatively easy: just figure the market value in cash of what is to be received in stock.

Meanwhile, the buyer wishing to use his own stock as currency for the purchase has no problems if the stock is selling in the market at full intrinsic value.

But suppose it is selling at only half intrinsic value. In that case, the buyer is faced with the unhappy prospect of using a substantially undervalued currency to make its purchase.

Ironically, were the buyer to instead be a seller of its entire business, it too could negotiate for, and probably get, full intrinsic business value. But when the buyer makes a partial sale of itself - and that is what the issuance of shares to make an acquisition amounts to - it can customarily get no higher value set on its shares than the market chooses to grant it.

The acquirer who nevertheless barges ahead ends up using an undervalued (market value) currency to pay for a fully valued (negotiated value) property. In effect, the acquirer must give up $2 of value to receive $1 of value. Under such circumstances, a marvelous business purchased at a fair sales price becomes a terrible buy. For gold valued as gold cannot be purchased intelligently through the utilization of gold - or even silver - valued as lead.

If, however, the thirst for size and action is strong enough, the acquirer’s manager will find ample rationalizations for such a value-destroying issuance of stock. Friendly investment bankers will reassure him as to the soundness of his actions. (Don’t ask the barber whether you need a haircut.)

A few favorite rationalizations employed by stock-issuing managements follow:

(a) “The company we’re buying is going to be worth a lot more in the future.” (Presumably so is the interest in the old business that is being traded away; future prospects are implicit in the business valuation process. If 2X is issued for X, the imbalance still exists when both parts double in business value.)

(b) “We have to grow.” (Who, it might be asked, is the “we”? For present shareholders, the reality is that all existing businesses shrink when shares are issued. Were Berkshire to issue shares tomorrow for an acquisition, Berkshire would own everything that it now owns plus the new business, but your interest in such hard-to-match businesses as See’s Candy Shops, National Indemnity, etc. would automatically be reduced. If (1) your family owns a 120-acre farm and (2) you invite a neighbor with 60 acres of comparable land to merge his farm into an equal partnership - with you to be managing partner, then (3) your managerial domain will have grown to 180 acres but you will have permanently shrunk by 25% your family’s ownership interest in both acreage and crops. Managers who want to expand their domain at the expense of owners might better consider a career in government.)

(c) “Our stock is undervalued and we’ve minimized its use in this deal - but we need to give the selling shareholders 51% in stock and 49% in cash so that certain of those shareholders can get the tax-free exchange they want.” (This argument acknowledges that it is beneficial to the acquirer to hold down the issuance of shares, and we like that. But if it hurts the old owners to utilize shares on a 100% basis, it very likely hurts on a 51% basis. After all, a man is not charmed if a spaniel defaces his lawn, just because it’s a spaniel and not a St. Bernard. And the wishes of sellers can’t be the determinant of the best interests of the buyer - what would happen if, heaven forbid, the seller insisted that as a condition of merger the CEO of the acquirer be replaced?)

There are three ways to avoid destruction of value for old owners when shares are issued for acquisitions. One is to have a true business-value-for-business-value merger, such as the Berkshire-Blue Chip combination is intended to be. Such a merger attempts to be fair to shareholders of both parties, with each receiving just as much as it gives in terms of intrinsic business value. The Dart Industries-Kraft and Nabisco Standard Brands mergers appeared to be of this type, but they are the exceptions. It’s not that acquirers wish to avoid such deals; it’s just that they are very hard to do.

The second route presents itself when the acquirer’s stock sells at or above its intrinsic business value. In that situation, the use of stock as currency actually may enhance the wealth of the acquiring company’s owners. Many mergers were accomplished on this basis in the 1965-69 period. The results were the converse of most of the activity since 1970: the shareholders of the acquired company received very inflated currency (frequently pumped up by dubious accounting and promotional techniques) and were the losers of wealth through such transactions.

During recent years the second solution has been available to very few large companies. The exceptions have primarily been those companies in glamorous or promotional businesses to which the market temporarily attaches valuations at or above intrinsic business valuation.

The third solution is for the acquirer to go ahead with the acquisition, but then subsequently repurchase a quantity of shares equal to the number issued in the merger. In this manner, what originally was a stock-for-stock merger can be converted, effectively, into a cash-for-stock acquisition. Repurchases of this kind are damage-repair moves. Regular readers will correctly guess that we much prefer repurchases that directly enhance the wealth of owners instead of repurchases that merely repair previous damage. Scoring touchdowns is more exhilarating than recovering one’s fumbles. But, when a fumble has occurred, recovery is important and we heartily recommend damage-repair repurchases that turn a bad stock deal into a fair cash deal.

The language utilized in mergers tends to confuse the issues and encourage irrational actions by managers. For example, “dilution” is usually carefully calculated on a pro forma basis for both book value and current earnings per share. Particular emphasis is given to the latter item. When that calculation is negative (dilutive) from the acquiring company’s standpoint, a justifying explanation will be made (internally, if not elsewhere) that the lines will cross favorably at some point in the future. (While deals often fail in practice, they never fail in projections - if the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price.) Should the calculation produce numbers that are immediately positive - that is, anti-dilutive - for the acquirer, no comment is thought to be necessary.

The attention given this form of dilution is overdone: current earnings per share (or even earnings per share of the next few years) are an important variable in most business valuations, but far from all powerful.

There have been plenty of mergers, non-dilutive in this limited sense, that were instantly value destroying for the acquirer. And some mergers that have diluted current and near-term earnings per share have in fact been value-enhancing. What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value (a judgment involving consideration of many variables). We believe calculation of dilution from this viewpoint to be all-important (and too seldom made).

A second language problem relates to the equation of exchange. If Company A announces that it will issue shares to merge with Company B, the process is customarily described as “Company A to Acquire Company B”, or “B Sells to A”. Clearer thinking about the matter would result if a more awkward but more accurate description were used: “Part of A sold to acquire B”, or “Owners of B to receive part of A in exchange for their properties”. In a trade, what you are giving is just as important as what you are getting. This remains true even when the final tally on what is being given is delayed. Subsequent sales of common stock or convertible issues, either to complete the financing for a deal or to restore balance sheet strength, must be fully counted in evaluating the fundamental mathematics of the original acquisition. (If corporate pregnancy is going to be the consequence of corporate mating, the time to face that fact is before the moment of ecstasy.)

Managers and directors might sharpen their thinking by asking themselves if they would sell 100% of their business on the same basis they are being asked to sell part of it. And if it isn’t smart to sell all on such a basis, they should ask themselves why it is smart to sell a portion. A cumulation of small managerial stupidities will produce a major stupidity - not a major triumph. (Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly-small disadvantageous capital transactions.)

The “giving versus getting” factor can most easily be calculated in the case of registered investment companies. Assume Investment Company X, selling at 50% of asset value, wishes to merge with Investment Company Y. Assume, also, that Company X therefore decides to issue shares equal in market value to 100% of Y’s asset value.

Such a share exchange would leave X trading $2 of its previous intrinsic value for $1 of Y’s intrinsic value. Protests would promptly come forth from both X’s shareholders and the SEC, which rules on the fairness of registered investment company mergers. Such a transaction simply would not be allowed.

In the case of manufacturing, service, financial companies, etc., values are not normally as precisely calculable as in the case of investment companies. But we have seen mergers in these industries that just as dramatically destroyed value for the owners of the acquiring company as was the case in the hypothetical illustration above. This destruction could not happen if management and directors would assess the fairness of any transaction by using the same yardstick in the measurement of both businesses.

Finally, a word should be said about the “double whammy” effect upon owners of the acquiring company when value-diluting stock issuances occur. Under such circumstances, the first blow is the loss of intrinsic business value that occurs through the merger itself. The second is the downward revision in market valuation that, quite rationally, is given to that now-diluted business value. For current and prospective owners understandably will not pay as much for assets lodged in the hands of a management that has a record of wealth-destruction through unintelligent share issuances as they will pay for assets entrusted to a management with precisely equal operating talents, but a known distaste for anti-owner actions. Once management shows itself insensitive to the interests of owners, shareholders will suffer a long time from the price/value ratio afforded their stock (relative to other stocks), no matter what assurances management gives that the value-diluting action taken was a one-of-a-kind event.

Those assurances are treated by the market much as one-bug-in-the-salad explanations are treated at restaurants. Such explanations, even when accompanied by a new waiter, do not eliminate a drop in the demand (and hence market value) for salads, both on the part of the offended customer and his neighbors pondering what to order. Other things being equal, the highest stock market prices relative to intrinsic business value are given to companies whose managers have demonstrated their unwillingness to issue shares at any time on terms unfavorable to the owners of the business.

At Berkshire, or any company whose policies we determine (including Blue Chip and Wesco), we will issue shares only if our owners receive in business value as much as we give. We will not equate activity with progress or corporate size with owner-wealth.

Real Estate in Cape Coral Is Far From a Recovery - By Peter S. Goodman

THE MESS is the product of The Story, the fable that waterfront living beyond winter’s reach exerts such a powerful pull that it justifies almost any price for housing. The Story propelled the orgy of borrowing, investing and flipping that dominated life here and in other places where January doesn’t include a snow blower.

The Story lost its magic amid the realization that speculators had simply been selling to other speculators, making the real estate market look like a Ponzi scheme. The ensuing crash was breathtaking. By the winter of 2007, median housing prices in Cape Coral and the rest of Lee County had fallen to about $215,000, down from a high of $278,000 in 2005. By October 2009, they had fallen to near $92,000.

Somewhere on that long, steep downhill path, what was once portrayed here as a momentary if wrenching setback seeped into the community’s bones, embedding lowered expectations and fear.

The first time I visited in 2007, James W. Browder, the Lee County schools superintendent, had recently scrapped plans to construct seven new schools. When I visited last month, he detailed how one-fourth of his elementary schools were now sending home weekly backpacks of food with students.

“One elementary school principal noticed parents going into schools with kids in the morning and sitting down in the cafeteria with them,” Mr. Browder said. “Then they noticed parents eating breakfast off kids’ plates. And then they noticed parents taking scraps home.”

In Texas, the all-consuming gauge of prosperity is the price of a barrel of oil. Here, it was once the value of a developable parcel of land. Today, it is the volume of foreclosures.

At the end of 2007, the pace was already grim here, with foreclosures running at 1,100 a month, a more than fivefold increase from early that year, according to RealtyTrac, a real estate research firm. By late 2008, the pace had quickened again, to about 2,000 a month.

By the fall of 2009, foreclosures had fallen to about 1,400 a month, prompting hopes that the worst was over. But real estate agents and mortgage brokers wary of optimism are focusing on a new term that has entered the housing lexicon: ghost inventory. Banks appear to be sitting on thousands of homes caught in limbo, neither foreclosing nor receiving any payments.

“We’re not in a recession,” says Bobby Mahan, an amiable broker here, describing conditions in the area. “We’re in a depression.”

…..

The Pellegrinos moved out in July 2008, Charlene explains. A bathroom pipe had burst, and mold had grown on the walls. She and her mother couldn’t afford repairs.

The strangest thing was how the bank implored them to stay, she says. Even after it became clear that they were not going to pay their mortgage, the bank figured that it would be better having them there to deter scavengers who would strip out the cabinets, the wiring, the toilets.

“They wanted us to stay on indefinitely,” Charlene says. “It was weird.”

When the Pellegrinos left, they found an upside to the bust: the seemingly limitless array of affordable rentals.

After walking away from their house and its $1,500 monthly mortgage payments, they rented a nearby four-bedroom home for $950 a month. Now Charlene, earning $2,400 a month as a home health worker, has designs on moving to a better place still, for $700 a month.

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By the end of that year, Mr. Jarrett hadn’t closed a deal in months. He was falling behind on the mortgages for all four of his properties and had dropped his health insurance.

“Here we are, two years later, and there’s no end to this,” he says, leaning into a booth at the University Grill, a steak-and-lobster place he used to enjoy regularly during the boom years. “I make a mean Hamburger Helper now.”

Deals have shrunk to almost nothing. Three of his four homes have been lost to foreclosure. He remains in the place on the water in Cape Coral, though he has not made a payment in roughly two years. “Sometimes I think they just lost my file,” he says.

The house is mostly empty, owing to impromptu yard sales he conducts to keep food on the table. The piano, the sofa, the coffee table, the dining room table and chairs: all gone. His living and dining rooms are devoid, save for one piece of art he cannot bear to surrender: a statuette of Don Quixote.

“You know, dream the impossible dream,” he says. “It’s just one of those little remnants to keep dreaming, because if you don’t dream, you don’t get anything.”

His wife left in July 2008, he says, taking their daughter back to Illinois. (“Not having the finances to sustain the lifestyle you had is very trying on a relationship,” he says.)

Monday, January 4, 2010

Hussman Weekly Market Comment: Timothy Geithner Meets Vladimir Lenin

Last week, while Congress and the nation were preoccupied with the holidays, the Treasury made a Christmas eve announcement that it would be providing Fannie Mae and Freddie Mac unlimited financial support for the next three years. The Treasury's press release notes:

“At the time the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship in September 2008, Treasury established Preferred Stock Purchase Agreements (PSPAs) to ensure that each firm maintained a positive net worth. Treasury is now amending the PSPAs to allow the cap on Treasury's funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years.”

Put simply, in a single, coordinated stroke, the Treasury and the Federal Reserve have encroached on spending powers that are enumerated for the Congress alone. Under the Housing and Economic Recovery Act of 2008 (HERA), the Treasury has no such open-ended authority.

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As I wrote several weeks ago, “The Federal Reserve has expanded the U.S. monetary base by more than 150% since the beginning of the recession. That is not a typo. The monetary base has soared from $800 billion to over $2 trillion. Much of this has been accomplished through outright purchases of mortgage-backed securities (not repurchases) and an equivalent creation of base money. Unless these securities can be sold back out into private hands for the same value that was paid to acquire them, the Fed will have effectively forced the U.S. government to make its implicit guarantee of these agency securities explicit, without the authorization of Congress. To the extent that the underlying mortgages default, the U.S. government will be forced to issue additional Treasuries to retire the mortgage backed securities now held by the Fed. Alternatively, if the U.S. does not explicitly bail out Fannie Mae and Freddie Mac to the full extent, the Fed will have created money, with no recourse, and without the equivalent backing of assets or securities on its books. In short, the Fed is now engaging in unlegislated, back-door fiscal policy.”

The Treasury's action last week completes this circle. It provides a surprise pledge of public resources to make these mortgage loans whole, and an unlegislated commitment to make the “implicit” backing of Fannie Mae and Freddie Mac explicit. All without debate, and without the force of public will. Even as the homeowners underlying these mortgages lose their property to foreclosure.

Or worse, perhaps homeowners who have been diligently making their payments will keep their homes, and homeowners who took out mortgages they couldn't afford will keep their homes as well with no adverse consequence to the lenders – since the underlying loans are now owned largely by the Fed, and the Treasury has pledged its unlimited support. Why pay one's debts if it becomes optional, and the Treasury stands to absorb unlimited losses at public expense?

This policy is likely to lead to far more delinquencies. Whether it will lead to far more foreclosures depends on the nations' capacity and willingness to shoulder multiple insolvencies in order to protect bondholders, mortgage our national wealth to China and other large purchasers of U.S. Treasuries, or alternatively, massively inflate away the dollar value of the underlying loans. The much-vaunted TARP money that has “profitably” come back to the Treasury is a tiny sliver of what has been committed to defend the private bondholders of financial institutions from losses. Either the debt we create to save these bondholders will stand as a claim on our future national production and a diversion of our ability to spend public resources for the benefit of the public, or we must inflate it away. There is no third option. This does not deserve legislative discussion?

What is likely, in my view, is that we will observe far greater issuance of government liabilities, which will predictably create a near doubling of the consumer price index in the coming decade (though probably not for a few years due to credit concerns, which dampen monetary velocity). It is notable that the massive expansion of government liabilities beginning in the late-1960's eventually exploded into uncontrollable inflation by the late 1970's. There are lags between the creation of government liabilities and their inflationary effects. But to expand these liabilities as recklessly as the Fed and Treasury are now doing is to undermine the long-term foundations of the economy.

It is commonly argued that we cannot observe inflation with unemployment so high. In my view, this is a misinterpretation of A.W. Phillips (1958) analysis. While the famed “Phillips Curve” was described as a relationship between (nominal) “money” wages and unemployment, the British data Phillips used was from a period when Britain was on the gold standard, and the general price level was extremely stable. Thus, any wage inflation observed by Phillips was actually real wage inflation. The Phillips Curve is simply a standard economic argument about relative scarcity. It says that when the labor markets are tight, nominal wages rise faster than the rate of general inflation (i.e. real wages rise), and when unemployment is high, nominal wages rise slower than the rate of general inflation (i.e. real wages fall). As we observed in the 1970's, high unemployment can exist in concert with high rates of inflation. All that happens, in that case, is that wages tend to rise slower than prices. Assuming labor productivity is growing as well, real wages don't keep pace with productivity growth. In any event, unemployment emphatically does not prevent the inflationary consequences of reckless creation of government liabilities.

Do Stocks Provide a Sufficient Hedge Against Inflation?

A great article from Ben at The Inoculated Investor blog.

Large Excerpt:

So, with all of the issues with gold, I guess that leaves ownership stakes in businesses as the best inflation hedge, right? Bruce Greenwald thinks so:

“The assets that are most attractive are the franchise businesses that have pricing power, because you can pass along inflationary price increases and you are not subject to competition from excess capacity, the way you are in industries like autos and steel. You have much more control on the downside.”

I never had any reason to doubt that rationale until I picked up the December 2009 edition of Value Investor Insight. In this issue Colin Moran and Geoff Gentile of Abdiel Capital discuss their study of the impact of inflation on stocks:

“The U.S.’s last stretch of high inflation was between 1973 and 1981. In the early 1970s many equity investors, as they do now, imagined generally rising prices would make earnings grow faster, sending stock prices higher and giving investors a good real rate of return.

It didn’t work out that way. Inflation turned out to be a kind of neutron bomb that left revenues and profits standing while decimating the free cash flow available to owners. Even if a company’s GAAP earnings kept pace with the general level of prices, higher working capital needs and increased prices for capital spending meant that free cash flows failed to keep up with the price level.

Overall, inflation and taxes together stripped public-company owners of more than 100% of their reported profits from 1973 to 1981. We measured that by tracking the book value per share of companies in the Fortune 500, which compounded at 10% per year over that period, adjusting for share repurchases and including the after-tax value of dividends paid out. Someone who bought a business in 1973 and sold it in 1981, in both cases for book value, would have actually lost ground. After capital-gains taxes, the investment would have doubled, but over the same period the overall price level more than doubled.

And most owners would probably have done worse. Having for years failed to produce real returns, businesses traded in 1981 for less relative to book value than they did in 1973. As a result, stock prices grew more slowly than book values. The S&P 500 added only 3% annually during this stretch – again including the after-tax value of dividends – but since inflation compounded at 9% per year, stocks’ real value declined 40%.”

Wow. A 40% decline is pretty ugly and seems to fly in the face of the often quoted benefit of stock ownership as espoused by Buffett and Greenwald. If stocks didn’t protect purchasing power, then what about bonds?

“Treasury bills, reinvested every three months from 1973 to 1981, compounded at 8% per year. Long-term government bonds bought in 1973 and held to maturity delivered less. Assuming total state and federal taxes consumed a third of the interest income, Treasury bills ended up delivering a 5% after-tax yield. Cumulatively, these “risk-free” Treasury bills lost 30% of their real value. It's worth emphasizing that tax-paying investors need to compound way above the rate of inflation just to maintain purchasing power. If prices are stable, any positive return gives you a positive real after-tax return. But if inflation is 10%, a investor paying taxes needs 15-20% returns to keep wealth from losing its purchasing power.”

Yikes. A 30% loss in real value is better than the 40% loss that stocks experienced, but neither did the job of protecting purchasing power. Did anything do well over this period?

Gold and oil compounded in the low-20% range in the period. Residential real estate also rose slightly faster than the general price level; and the equity of homeowners with mortgage rates set in the early part of the decade obviously rose faster than the assets themselves. Not all stocks are losers in an inflationary environment. The 25 highest-ROE companies in the Fortune 500 compounded book value at 15% annually from 1973 to 1981. Warren Buffett compounded Berkshire Hathaway's book value at around 20%. In general, businesses that could support a fair amount of leverage, had decent pricing power and had limited capital needs did well. We expect the same to hold true if inflation rekindles in the future.

It comes as no surprise to me that an investment strategy focused on high quality, high return companies served as a reasonable form of protection. It comes as even less of a surprise that value investing as practiced by The Oracle of Omaha was the best of all the strategies.

What should investors conclude from all of this data? Well, at first blush it looks as though gold and oil could potentially be viable inflation hedges, given that the current price does not already reflect future inflation expectations. The problem with both is that there is almost no way to know what is embedded in the current price. Inflation concerns? Supply-demand imbalances? Geo-political fears? Irrational speculation? Accordingly, I think the data corroborates what Buffett and Greenwald have been stressing recently. But that does not mean that blindly owning a stock index is going to be a saving grace. Instead, investors need to focus on buying shares of companies with conservative management teams that are prudent capital allocators and that have sustainable competitive advantages. It is my belief that such stocks purchased below their intrinsic values and with a sufficient margin of safety will always offer investors the best opportunity to compound their wealth irrespective of the inflation rate.

Link to Full Article

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Related previous post: Warren Buffett’s Comments on Inflation

Inflation may be coming. Time to look for a hedge. - By Whitney Tilson and John Heins

Because inflation hasn't afflicted America in some 30 years, it's worth reviewing what rising prices might mean for stock investors. In a 1977 article on the subject in Fortune, Warren Buffett went to great lengths to disabuse shareholders of the notion that they could skate through inflationary times unscathed. He wrote that companies have little ability to improve returns on capital when inflation is high, so investors aren't willing to pay as much for each dollar of corporate earnings. The subpar 5.2 percent annualized return for the Standard & Poor's 500-stock index from 1973 through the end of 1981, a span during which inflation rates often hit double digits, provides ample support for that argument (adjusted for inflation, stock returns were negative).

We'd love for policymakers to successfully reignite the U.S. economy without also rekindling inflation. The more prudent course, however, is to assume that all won't go smoothly.

What do we recommend? We respect many of those who advocate gold, but, like Ackman and Robertson, we believe it's too difficult to assign a value to the metal. Instead, we prefer high-quality companies with significant foreign exposure and the ability to raise prices. Both Microsoft and Pfizer recently reported better-than-expected earnings that signal the resiliency of each company's business. In Microsoft's case, those results don't yet reflect the launch of its Windows 7 operating system, which we think will result in much better profits than analysts expect.

You can also hedge against rising inflation by investing in businesses tied to natural resources, from crude oil to agricultural commodities. One favorite in this category is Contango Oil & Gas, which explores for energy mostly in the Gulf of Mexico.

More adventurous investors who think that higher inflation will lead to higher interest rates can bet against long-term U.S. Treasury securities through options and various exchange-traded funds (bond prices generally fall when rates rise). For example, we've shorted iShares Barclays 20+ Year Treasury Bond ETF, which is designed to gain value when yields fall and Treasury-bond prices rise. If inflation rises rapidly and rates follow suit, Treasury bonds will perform poorly.

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Related previous post: Warren Buffett’s Comments on Inflation

VIW Recurring Donation Link ($7 per month; or $84 per year)

Why We’ll Always Have More Money Than Sense - By Robert Shiller

When it comes to market bubbles and how they are created, very little, if anything, has changed. This is because human psychology has not changed. Massive bubbles are created when large numbers of people buy into "new era" stories that exaggerate how much the world has improved. For example, in the past few years the global equities and housing bubbles were driven by a giddy faith that world markets were on a tear and prices would go up indefinitely. Our animal spirits are sparked by these tales; we find them irresistible. And since as animals we're also given to a herd mentality, in a bubble we tend to invest too much in the most popular stories—and continue to do so even after the bubble bursts.

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Bubbles are also encouraged by the Internet and by high-speed data transmission. People pick up ideas in newspapers, via TV, or online, then spread them via word of mouth. Anyone who's ever played the children's game of telephone knows that, once started, a story or idea takes on a life of its own. It's probably no accident that the tulip mania of the early 1600s occurred around the time the first newspapers and pamphlets began circulating, and that the crash of 1921 coincided with the first mass radio broadcasts. The Internet helped fuel the tech bubble and the financial crisis. I have no doubt that new social media like Twitter or Facebook will contribute to the next craze, or that the Internet will have other, unexpected effects on markets as well.

Martin Capital Management - Fireside Chat No. 7: Among the Last Skeptics Standing

Fireside Chat No. 7 - December 14, 2009 - Length: 28:56

MP3 file - Transcript (PDF)

Excerpts:

Rather, the question that should be on everyone’s mind is whether the reflation in the prices of stocks and lower-quality bonds is a false-positive error, one born of excessive credulity. If the markets in risky assets are correct in forecasting a sustainable economic recovery enabled by a smoothly functioning financial system, that prospect has already been priced into the markets with the Shiller PE pushing a “bubble territory” 20 times earnings.

If, on the other hand, the current financial and economic episode is not a run-of-the-mill, post-World War II business contraction but rather the aftershock of a massive credit bubble that went into overdrive post-2000 , a Shiller PE of 10 is not out of the question. Having read daily summaries for the last seven months of the feature stories in the Wall Street Journal for the corresponding day in 1930, two conclusions jump off the pages: First, for every pound of wheat there were 10 pounds of chaff and, second, the focus was so much on the short term and so deeply influenced by the herd instinct that virtually no one saw (nor did the market discount) the onrushing Depression tsunami until it overwhelmed them. The ongoing exercise is almost surreal—like reading a murder mystery having already seen the end. You turn page after page, incredulous, as the characters miss clue after clue. It reads so much like today.

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The future hinges on forces not easily seen among all the news clutter. Like the 1930s, the “experimenters” in Washington are unquestionably bright but so inexperienced as to often be inept. Their mental models have proved time and again to be too small for the huge task at hand. The factors that make headlines—growth vs. stagnation, inflation vs. deflation, the cost/benefit trade-offs of multiple monetary and fiscal stimulus packages, fiscal budget and trade deficits, dollar devaluation—fall substantially into the realm of the unknowable. Those factors that get little public attention (Will the growing segment of the population that feels disenfranchised be made to once again feel empowered? Will business shake off the burden of leftist government intervention and higher taxes and become spontaneously optimistic?) are the ones that will determine whether employment and the economy generally rise or whether they stagnate. Will the “great moderation” be followed by the “great malaise”? I wish it weren’t so, but I wouldn’t bet against it.

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Related books:

What Americans Really Want...Really: The Truth About Our Hopes, Dreams, and Fears

The Forgotten Man: A New History of the Great Depression

Speculative Contagion: An Antidote for Speculative Epidemics

Why Buffett is Betting on the Railroads

A great find by Shai at the Reflections blog. There are some interesting thoughts in the article on Burlington’s moat and the long-term nature of its cap-ex – which may help to explain Mr. Buffett’s purchase in light of his more recent comments on higher inflation expectations and his past comments about how severe inflation hurts businesses that have to keep reinvesting in cap-ex during inflationary times. Maybe the business categories aren’t just ‘capital intensive businesses’ versus ‘non-capital intensive businesses’ and that during times when there is a significant risk of inflation within a few years, the nature of cap-ex is almost as important as the cap-ex itself. The end of the article discusses some of the cap-ex Burlington has made since 1995.

Link to: Why Buffett is Betting on the Railroads

Tuesday, January 5, 2010

Monday, January 4, 2010

Saturday, January 2, 2010