Saturday, February 28, 2009

Learn From The Best

I've always believed that you should always learn from the best teachers, and that goes from physics to the martial arts. In the investment business Warren Buffett and Charlie Munger have always been in my personal pantheon of great teachers and practitioners. Their 2008 Annual Report was published today, and it is, as usual , full of study material, quotable quotes, refreshing candor and introspection. I'm going to reflect on a particular issue in an upcoming newsletter, but here are some notable points from a first reading.

Buffett, a world-class poker player, acknowledges that in the current credit crisis, the Fed and Treasury are "all in." Our own limited perspective gives us considerable heartburn, although Buffett does talk about having to take an aspirin. However, his overarching conclusion is that "America's best days lie ahead." I retain this point as a take-away. The financial websites seize on the comment that the economy is in a shambles and may stay that way. However, reading the letter closely and thinking about financial theory, Buffett concludes that neither he nor Charlie Munger can forecast the performance of financial markets during the same period. If indeed they lead at economic turning points, they may very well outstrip the shambolic economic performance. Who knows? I take comfort in the comment, because it's based on an economic and financial mindset, and not on wishful thinking. I'm happy for my children.

Buffett talks about the first principles underlying their management of Berkshire Hathaway. This should be obvious from a history of reading the letters, but human short-term memory makes a restatement useful. Whatever the economic backdrop and stage of the cycle, they strive to:
  1. Maintain a "Gibraltar like" financial position, meaning excess liquidity, modest short-term obligations, and lots of sources of earnings and cash;
  2. Widen the economic moats of existing businesses in the portfolio;
  3. Acquire and develop new earnings streams;
  4. Nurture and expand their stable of business managers who have led to the substantial value creation within Berkshire Hathaway.

If you own a position in a public company, take this list and ask yourself, "Is this what my executive leadership team is doing?" Now, there will have to be some adjustments to a literal interpretation, but if there is a wide divergence, you probably don't have a long-term investment on your hands, but a trade at best.

On the last point, this is something that is almost completely missing from the leadership philosophy of most public companies. Despite the windy rhetoric, apart from the CEO, most members of the leadership team at public companies are considered to be interchangeable cogs. The same philosophy holds for the senior staff of the executive leaders. The Berkshire letters are always rife with genuine praise for the integrity, philosophy, and business acumen of the leaders of their portfolio companies from Sees Candies up to the biggest insurance and utilities businesses. This is, in my opinion, a very important factor in decomposing their performance advantage over the S&P 500.

If you're approached by a brilliant financial engineering mind with a model that supports buying a securitized or structured product, think about this quote: "Beware of geeks bearing formulas."

On a set of related points, Buffett opines that improved transparency will not cure the problems that derivatives pose. He is not aware of any reporting mechanism that can effectively describe or measure risk from derivatives. Remember who's saying this. Insurance and re-insurance are their core business. His stable of managers in this business includes Ajit Jain and others whom he sees as among the most brilliant minds. Yet, he makes this comment. Furthermore, he correctly states that, "auditors cannot audit these contracts." So, we can't rely on their puerile efforts.

Then think about the fact that a lot of legislative and regulatory energy will be devoted to enacting measures around the clarion cry of transparency. So, our teacher is telling us that there will be no measurable benefit to the buy side of the market from all this make work.

Although Buffett has too much knowledge to try and forecast the market, he makes this substantive comment, "The investment world has gone from underpricing risk to overpricing it." He opines that looking back on this period, writers will talk of a bubble in Treasury securities, and this certainly seems to be the case.

For portfolio re-allocators, he offers this bromide, "Beware the investment activity that produces applause; the great moves are usually greeted by yawns." "Cash is king" is on the tongues of all the television talking heads, to lots of applause. High quality corporates and municipal bonds have been the yawning-inducing strategies pursued by some institutional investors. Interesting stuff as always.

Finally, we know that on Wall Street no one is responsible for the current, near-death crisis. No one has admitted to any errors of omission or commission. Yet Warren Buffet does so in his 2008 letter. Berkshire invested $7 billion in the common equity of ConocoPhillips a the peak of oil prices; as of the measurement date, the investment is worth $4.3 billion. Buffett laments his timing, although he believes that the fundamentals point to higher oil prices than current levels of $40-50 per barrel. I'm sure that he's right about oil for a variety of reasons. This candor and self-reflection is refreshing. But, using his own philosophy that no one can time a market, this hardly seems like a big deal. For someone who holds himself to a high standard, though, it's irritating.

Lots of good education for a Saturday.

Thursday, February 26, 2009

Microsoft R&D Investment

Microsoft made a splashy public announcement that they are going to up their R&D investments in the face of the overarching financial meltdown and cyclical technology spending slowdown. That's the kind of message that we like to see--the company plans to thrive on the other side of this cycle and is being opportunistic because it has the resources.

What's not clear to me is how to look forward and think about the value creation from these expenditures. Microsoft's history of innovation and market creation, beyond SQL server, has been lackluster. Their desktop monopoly and the ever more expensive, bloated Office suite are still the bedrock of the company's cash creating abilities. If, at one point, they were willing to splash out cash for Yahoo! or for its search business, and now they have gone on to higher R&D spending, is this just a second best alternative?

Google, by contrast, with their 20% time allocation for staff engineers to spend on high concept projects seems to have yielded a panoply of applications, including Google Maps, that really sets the company apart and gives it a wide reach into potential downstream revenue opportunities.

This was a nice communication of commitment and strength from Microsoft, but it could have used more beef to finish the message and to answer the question, "Why am I, as a shareholder, going to better off as a result of this R&D spend?"

Saturday, February 21, 2009

Black Swans and Black Suits

Nouriel Rabini, writing in the Wall Street Journal today, comes out on our side for nationalizing the banks. Here's a short, cogent excerpt from the interview, "Mr. Roubini tells me that bank nationalization "is something the partisans would have regarded as anathema a few weeks ago. But when I and others put it in the context of the Swedish approach [of the 1990s] -- i.e. you take banks over, you clean them up, and you sell them in rapid order to the private sector -- it's clear that it's temporary. No one's in favor of a permanent government takeover of the financial system." (The Wall Street Journal, Online Edition, January 21st, 2009)

He talks about Greenspan's intellectually slavish adoption of Ayn Rand's economic view, and the Bush administration's disastrous idea of turning the Fed into the "lender of only resort." What's needed now is not a discussion about the merits of a free market system--an academic concept--but rather decisive action.

Thursday, February 19, 2009

Take A Pill

My friend, patent attorney Bob Beck mailed me a very interesting essay-like post on the bank lending crisis from John Hempton of Bronte Capital. It comes to much the same conclusion we came to in our recent post, "Fail--Nationalize--Renew," but he comes at it from a completely different discipline and experience, namely that of a former banker himself. It's good reading.

The point that stood out to me was his characterization of the root of the crisis being "a crisis of confidence." The banks are illiquid because of a lack of trust. They can't become liquid by selling assets. However, the reason is not the avowed one, namely that there isn't a market for the assets. The reason, Hempton says, is that the banks don't want to have "price discovery," because they know that their GAAP yield to maturity prices are way above market prices. Marking to market would mean that banks are marginally insolvent as a whole. Anything to deny reality, which is as American as apple pie.

Finally, there is the question of leadership, which is an important element of confidence in any investment, whether in credit markets or equity markets. With the current ad-hoc system of arbitrary and ineffective plans, the boards and managements of these horrifically managed enterprises are virtually unchanged. A nationalization would bring about some wholesale changes, which could be extremely beneficial to the post-crisis renewal period.

The Obama mortgage plan is a leftover Mulligan stew that won't really keep 7-9 million people in their homes as advertised, but perhaps 1 million, as Mark Zandi estimates. More sweeteners will have to be doled out to servicers. It's not clear whether after all is said and done, consumers will owe more than they do now, but they may get some modest reduction in their monthly payments. All this for $275 billion plus additional subsidy amounts. Take a pill and go to bed. This was not worth staying up for.

Friday, February 13, 2009


After waiting with bated breath for the Treasury's latest rescue plan, it's clear that we're out of ideas and have lost clarity and focus about issues and effective solutions. Today, there is much being written about Japan's "Lost Decade," and the need to learn from it.

Heizo Takenaka, who headed up the Japanese financial reform effort is quoted in the New York Times as telling Japanese banks, "Don't cover up. Don't distort principles. Follow the rules." So, let's learn from this.

Whether by enhanced Comptroller of the Currency audits or not, let's acknowledge that banks holding a large percentage of national deposits are insolvent. Wipe out the shareholders, which unfortunately are the rules of the game for owners of the residual interest. Nationalize the banks, and workout the assets. Let new banks emerge and bid for the assets. Let a new banking industry emerge, and incidentally it should be much smaller. If private equity types want to play in this field and operate banks under much tighter oversight and scrutiny, then that's preferable to the alternative.

A really bad idea that won't go away is to have government buy the distressed and toxic assets in partnership with private equity investors. A basic principle: that partnership's benefits will accrue to one and only one side, namely the private equity players. If really smart bond market investors can't value the assets properly, then certainly the government can't. The pressure to build in a rental, or subsidy, element into the prices will be irresistible on the Hill. A truly bad, bad idea.

In a related area, the legislation to require private equity vehicles to register and be subject to SEC oversight and regulation should be passed. Arthur Levitt, former Chairman of the SEC, correctly identified the 'levelling of the information playing field" to be critical for the efficient functioning of the capital markets and so it is. I wonder if we have the gumption for this, but now with the ineffective former leadership of the SEC out, perhaps we can find the fortitude.

If we believe in capitalism, then don't only focus on capital creation, because capital destruction is an integral part of the cleansing and renewal process. Take the medicine now and be done with it.

Friday, February 6, 2009

Haste Makes Waste

As we close out the week and reflect on what has been accomplished so far with the expenditure of TARP funds, we would have to conclude that "Never have so many accomplished so little with so much." (Apologies to Winston Churchill)

The GAO report had a sentence that summed it up best: "...Treasury's strategic vision for TARP remains unclear." We know that the first vision for the program was to buy bad assets from the banks to clean up their balance sheets. This vision was quickly scrapped in favor of direct capital injections into troubled banks, essentially for the nine banks that accounted for about 55% of all deposits.

After the strategic 180, the execution of the direct capital infusion program fell apart completely, as the funds got dispersed to hundreds of banks as opposed to focused on the ones that could cause a systemic failure. Furthermore, the valuation of the government's investment was so incompetently executed that taxpayers gave significant subsidy elements to the banks. Whereas Warren Buffett and others got more security value per $100 of investment, the taxpayers got much less in value for their investments.

There are "ongoing questions about the (Treasury's) communications strategy" for reporting on the success of the TARP program. In the interim, the Obama Administration has gone off tilting at windmills about executive pay. Of course, if an institution didn't take TARP funds, the limits don't apply to them, and that includes some behemoths, like Goldman, Sachs. Use of the TARP funds we find out now has been for executive bonuses and dividends and not for net new lending. What a surprise! However, it gives politicians lots of press release and television sound bite opportunities. "We stuck it to those overpaid CEO's!" Meanwhile, the banking and credit systems are still in intensive care.

Bill Gross and others have emphasized the need to address falling asset prices, and that still has not directly been done, especially for mortgages, where the volcanic pressures really broke. Instead of fixing this problem, we are now talking about direct assistance to homeowners. Which homeowners will get assistance? How much? These are not economic decisions, but redistributive decisions, and we know how these work out, namely arbitrarily and unfairly.

It is amazing how many ill conceived and half-baked ideas continue to be talked about in the press. As we all get "issue fatigue," stimulus bills that represent not output creation but pure transfers get passed because we can't deal with the scale and complexity any more.

Gregory Bateson wrote, "There is an ecology of bad ideas, just as there is an ecology of weeds, and it is characteristic of the system that basic error propagates itself." (Steps To An Ecology of Mind)