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Archive for April, 2011

Regarding David Sokol, Part 4

Saturday, April 30th, 2011

As I did last time, I would like to start this with the public counterarguments from Sokol’s attorney:

“David Sokol is deeply saddened that Mr. Buffett, whom he considered a friend and mentor, would disparage him as he has done today. Neither Mr. Buffett nor the Audit Committee at Berkshire has requested to speak nor has spoken to Mr. Sokol since his resignation was made public by Mr. Buffett on March 30th. Mr. Buffett drafted the March 30th press release announcing Mr. Sokol’s resignation in cooperation with Mr. Charlie Munger and Mr. Ronald Olson both of whom are Berkshire Board Members. They know the law and they know the Berkshire policies. In that context, Mr. Buffett correctly declared Mr. Sokol’s conduct lawful and indeed was effusive of his praise of him. There is no new information or new fact which has become available to them since that press release was issued on March 30th. At no time did Mr. Sokol attempt to withhold information from Mr. Buffett, Berkshire Hathaway or the Audit Committee. Every question asked of Mr. Sokol on or prior to March 30th and any information requested of him has been provided. The Audit Committee report, which was prepared by the law firm of Munger Tolles & Olson contains errors and omissions, both of which could have been avoided if the Audit Committee had inquired of Mr. Sokol.

It is alarming that Mr. Buffett would be advised to so completely flip-flop and resort to transparent scapegoatism. After 11 years of dedicated and hugely successful service to various Berkshire Hathaway subsidiaries, Mr. Sokol would have expected to be treated fairly. That would have been in Berkshire’s interest.

Let me be clear about central facts: At no time did Mr. Sokol violate the law or any Berkshire policy. At no time did Mr. Sokol intend to personally profit at the expense of Berkshire or its shareholders. At no time did Mr. Sokol mislead or deceive. Such a conclusion would be wholly out of character and the Berkshire Board is keenly aware of that. At all times he faithfully discharged his fiduciary duties to Berkshire, a company he heroically served and continues to regard with reverence.”

First, a note to the lawyer: I know this is a press release, but why issue a press release at all?  If you have good evidence that is not known to the public, better you should keep it to yourself, and wait for your day in court, because what you did write today will be unlikely to persuade the directors of Berkshire Hathaway from their current course of action, which may include pursuing claims against your client.  It certainly won’t change any results in the current shareholders lawsuit.

Look, let me tell you the facts of life.  Authority comes in two flavors: formal and informal.  And there is no telling initially which will be more important.  Buffett is the Chairman and CEO of BRK.  And as things commonly works at BRK, ordinarily he acts as a king, with Bonnie Prince Charlie aiding him. ;)  But that is informal, and in our society, the informal must always be approved by the formal.

The Chairman of the Audit Committee, who has formal authority, did not receive the full data he needed.  Neither did Buffett.  Buffett’s failure to request data was one thing, but the formal responsibility was for Sokol to disclose the data in full, which he didn’t do.  Buffett’s transgression is a far lesser matter, which I believe he made up for by admitting his fault, and if BRK pursues a claim against Sokol.

The formal authorities were ignored by Sokol.  That will be the basis of any court case.  He did not follow the explicit rules, of which notifying Buffett is not a part of the deal.

Now, in one sense, the audit committee is rallying behind Buffett to protect him and the company.  All other things equal, I think Buffett wanted to let Sokol go out of gratitude for prior actions.  But the legal world does not trade past goods for present bads.  Instead, we have to justify our lives every day, and any infraction can bring judgment on us, no matter how much good we have done in the past.

I am stisfied by the apologies that Buffett offered today, and would only add that it is in the interests of BRK to pursue a case against Sokol.  As for my own opinions, I am satisfied, and I have no grudge against BRK or Buffett.

As for David Sokol, I would only say this: negotiate the best settlement that you can.  And find better legal counsel, if you insist on contesting this.

The Jeans for the Scene — In, Out, or Ob?

Friday, April 29th, 2011

I was minding my own business, doing research when I saw an ad that showed a back view of a woman in very tight jeans, with the text: “If you think I’m hot you should see this stock! OBJE”

Remember my rule, “Don’t buy what someone wants to sell you.  Buy what you have researched for yourself.”  It is true with physical objects, but even more true where the goods are immaterial, and quality cannot be easily verified, as with stocks.  So when I hear a pitch for a stock through advertising, I am immediately skeptical.

Now, I am not the first to the scene here, partially because I delayed. 24/7 Wall Street noted that OBJE has a going concern problem.  Good job, Doug.

But there is more: where is the company located?  In a residence in Florida.  Not much for a company with a market cap of 30MM+.  But what else is located there?  These businesses:

Quite a lot to be going on in one residence.  But wait, the woman who lives there, who was a crucial part of OBJE’s strategies has been let go by OBJE.  Curious, huh?

Now the current CEO, Robert Federowicz has done many things, but nothing worthy of being a CEO of a small public company.

He previously served as Chief Information Officer of a start-up international power development company and as government affairs liaison for an international power company. From 2005 to 2009, Mr. Federowicz was an Owner and Operator of a fitness gym in Houston, Texas. During 2010, he served as an Account executive for Screentek, Inc., a seller of LCD screen technology for laptop computers.

Of course the company has press releases touting its non-existent products.  And there are penny stock touts that pick up the furor.  Just because a stock has a low price does not make it a buy.

Then there is the investor relations page at their website.  No credible company lays on the “buy us” mantra so thick.

That leaves us with the hard data.  Let me start with the opening lines from the risk disclosures in the 10K:

BECAUSE WE HAVE NOT PRODUCED A SAMPLE OF OUR OBSCENE BRAND JEANS AND COMPLIMENTED PRODUCTS, THESE PRODUCTS, MAY NOT WORK OR FIT PROPERLY AND/OR THE PRODUCTION COST CAN EXCEED EXPECTATIONS

OUR LACK OF AN OPERATING HISTORY GIVES NO ASSURANCE THAT OUR FUTURE OPERATIONS WILL RESULT IN PROFITABLE REVENUES, WHICH COULD RESULT IN THE SUSPENSION OR END OF OUR OPERATIONS

WE ARE A NEW COMPANY WITH NO OPERATING HISTORY AND WE FACE A HIGH RISK OF BUSINESS FAILURE WHICH WOULD RESULT IN THE LOSS OF YOUR INVESTMENT

As of the date of this prospectus, we have earned no revenue. Failure to generate revenue will cause us to go out of business, which could result in the complete loss of your investment.

BECAUSE OUR CURRENT OFFICER AND DIRECTOR DOES NOT HAVE SIGNIFICANT EXPERIENCE IN STARTING A JEANS PRODUCTS COMPANY AND WE LACK CUSTOMERS AND SUPPLIERS, OUR BUSINESS HAS A HIGHER RISK OF FAILURE

BECAUSE WE ARE SMALL AND DO NOT HAVE MUCH CAPITAL, WE MUST LIMIT OUR MARKETING ACTIVITIES. AS A RESULT, OUR SALES MAY NOT BE ENOUGH TO OPERATE PROFITABLY. IF WE DO NOT MAKE A PROFIT, WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS

OUR PRODUCTS MAY NOT FIND ACCEPTANCE FOR OUR PRODUCTS IN HIGH END BOUTIQUES AND DEPARTMENT STORES.

OUR OPERATING RESULTS MAY PROVE UNPREDICTABLE WHICH COULD NEGATIVELY AFFECT OUR PROFIT

OUR SOLE OFFICER AND DIRECTOR MAY NOT BE IN A POSITION TO DEVOTE A MAJORITY OF HER TIME TO OUR OPERATIONS, WHICH MAY RESULT IN PERIODIC INTERRUPTIONS AND EVEN BUSINESS FAILURE

(and she has been let go)

KEY MANAGEMENT PERSONNEL MAY LEAVE THE COMPANY WHICH COULD ADVERSELY AFFECT THE ABILITY OF THE COMPANY TO CONTINUE OPERATIONS

IF OUR COMPANY IS DISSOLVED, IT IS UNLIKELY THAT THERE WILL BE SUFFICIENT ASSETS REMAINING TO DISTRIBUTE TO OUR SHAREHOLDERS

IF WE ARE UNABLE TO GAIN ANY SIGNIFICANT MARKET ACCEPTANCE FOR OUR PRODUCTS OR ESTABLISH A SIGNIFICANT MARKET PRESENCE, WE MAY BE UNABLE TO GENERATE SUFFICIENT REVENUE TO CONTINUE OUR BUSINESS

MANAGEMENT’S ABILITY TO IMPLEMENT THE BUSINESS STRATEGY MAY BE SLOWER THAN EXPECTED AND WE MAY BE UNABLE TO GENERATE A PROFIT

IF WE ARE UNABLE TO MANAGE OUR FUTURE GROWTH OUR BUSINESS COULD BE HARMED

OUR PRODUCT MAY NOT BE ABLE TO DISTINGUISH ITSELF IN THE MARKET AND WE MAY BE UNABLE TO ATTRACT ENOUGH CUSTOMERS TO OPERATE PROFITABLY, WITHOUT A PROFIT WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS

WE MAY BE UNABLE TO MAKE NECESSARY ARRANGEMENTS AT ACCEPTABLE COST, WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS ENTIRELY WHICH COULD RESULT IN A TOTAL LOSS OF YOUR INVESTMENT.

COMPETITORS MAY ENTER THIS SECTOR WITH SUPERIOR PRODUCTS, INFRINGING OUR CUSTOMER BASE, AND AFFECTING OUR BUSINESS ADVERSELY.

SINCE OUR SOLE OFFICER AND DIRECTOR CURRENTLY OWNS 100% OF THE OUTSTANDING COMMON STOCK, INVESTORS MAY FIND THAT HER DECISIONS ARE CONTRARY TO THEIR INTERESTS YOU SHOULD NOT PURCHASE SHARES UNLESS YOU ARE WILLING TO ENTRUST ALL ASPECTS OF MANAGEMENT TO OUR SOLE OFFICER AND DIRECTOR, OR HER SUCCESSORS

Notable, because she was let go with little fanfare, aside from an 8K.

THERE IS SUBSTANTIAL UNCERTAINTY ABOUT OUR ABILITY TO CONTINUE OUR OPERATIONS AS A GOING CONCERN

THE ENACTMENT OF THE SARBANES-OXLEY ACT MAY MAKE IT MORE DIFFICULT FOR US TO RETAIN OR ATTRACT OFFICERS AND DIRECTORS, WHICH COULD INCREASE OUR OPERATING COSTS OR PREVENT US FROM BECOMING PROFITABLE.

SINCE WE ANTICIPATES OPERATING EXPENSES WILL INCREASE PRIOR TO EARNING REVENUE, WE MAY NEVER ACHIEVE PROFITABILITY

IF WE CANNOT SECURE ADDITIONAL CAPITAL, OR IF AVAILABLE CAPITAL IS TOO EXPENSIVE, OUR BUSINESS WILL FAIL.

WE DO NOT HAVE SUFFICIENT CAPITAL TO CONTINUE MAINTAINING OUR REPORTING STATUS.

What do you see when you review the most recent 10K and 10Q?  They are starving for liquidity, and have negative earnings and a negative net worth.  This is not a recipe for success.

This would have been obvious from the share offering as well, which was done at far lower prices.

If I worked for the SEC, I would ask this question — who was willing to buy the shares after the offering, creating prices that would deceive others?  Answering that question could reveal networks that cheat.

 

Regarding David Sokol, Part 3

Thursday, April 28th, 2011

I would like to start this with the public counterarguments from Sokol’s attorney:

I am profoundly disappointed that the Audit Committee of Berkshire Hathaway would authorize the issuance of its report to the public without the care and decency to ask even a single question of Mr. Sokol. Mr. Sokol had been associated with the Berkshire Hathaway companies for 11 years. During this time, his indefatigable efforts helped create enormous value for the Berkshire shareholders. He deserved better. While I take issue with much of the Committee’s report, I briefly make the following points. If the Audit Committee had asked, it would have learned that:

  • Mr. Sokol had been studying Lubrizol for personal investment since the summer of 2010; such investments are specifically allowed by his employment agreement.
  • Mr. Buffett was told twice, not once, about Mr. Sokol’s ownership of Lubrizol stock before Mr. Buffett engaged in any discussions with Lubrizol.
  • Contrary to the Audit Committee’s statement, Mr. Sokol’s Lubrizol shares were not acquired pursuant to a “100,000 limit order.” Rather, they were purchased as a result of several limit orders, over a period of days, at specified prices, for the day only, in order to acquire the stock at low prices. At that time, Mr. Sokol had no reason to anticipate that Mr. Buffett would have any interest whatsoever in Lubrizol.

I have known Mr. Sokol and have represented his companies in business litigation since the mid 1980s. I know him to be a man of uncommon rectitude and probity. He would not, and did not, trade improperly, nor did he violate any fair reading of the Berkshire Hathaway policies.

Okay, let’s take the three points in order:

1) Yes, Sokol may have looked at Lubrizol prior to December 2010, but he only chose to invest in Lubrizol in December 2010.  Personal investments might be allowed by his employment agreement, but not those where BRK might have an economic interest, at least not without full disclosure to the relevant powers inside BRK.  Remember, though Buffett acts as a sort of King inside BRK, even he is subject to the corporation and the committees set up by the board.

2) And that is relevant to Sokol telling Buffett twice, something that was already known.  Buffett is not the head of compliance.  Sokol needed to give full disclosure to the CFO and the Audit Committee

As the audit committee wrote:

  • “All actual and anticipated securities transactions of Berkshire and its subsidiaries that have not been publicly disclosed should be considered material.”
  • “Other public companies to which this prohibition is applicable include those that may be involved in a significant transaction with Berkshire. . . .”
  • “If a . . . Covered Employee is aware that Berkshire has taken or altered a position in a public company’s securities or that Berkshire is actively considering such action, trading in any securities of such public company ... [trading in the securities] is expressly prohibited prior to the public disclosure by Berkshire of its actions . . . (or until the [employee] becomes aware that Berkshire did not take and is no longer actively considering such action).”

and wrote again:

  • “Covered Parties who have access to confidential information are not permitted to use or share that information for stock trading purposes or for any other purpose except the conduct of the Company’s business.”
  • “Covered Parties are prohibited from taking for themselves opportunities that are discovered through the use of corporate property, information or position without the consent of the Board of Directors of the Company.”

And further wrote:

All of these internal policies are underscored by the law of Delaware, where Berkshire Hathaway is incorporated. Under Delaware law, corporate representatives owe their company a duty of loyalty. The duty of loyalty includes  a duty of candor, which requires them to disclose to the corporation all material facts concerning corporate decisions, especially decisions from which they might derive a personal benefit. Mr. Sokol’s actions did not satisfy the duty of full disclosure inherent in the Berkshire Hathaway policies and mandated by state law. His remark to Mr. Buffett in January, revealing only that he owned some Lubrizol stock, did not tell Mr. Buffett what he needed to know. In the context of Mr. Buffett’s question how Mr. Sokol came to know Lubrizol, its effect was to mislead: it implied that Mr. Sokol owned the stock before he began considering Lubrizol as an acquisition candidate, when the truth was the reverse. A candid disclosure would have revealed the timing and size of the purchases, and the communications with Citi concerning obtaining a meeting to mutually explore interest in a potential acquisition that had preceded them. Knowledge of those facts would likely have prompted further questions by Mr. Buffett and could have allowed Berkshire Hathaway to evaluate measures that could have been taken to alleviate the problem before negotiations proceeded with Lubrizol.

Mr. Sokol’s answer to Berkshire Hathaway’s CFO, Mr. Hamburg, concerning the investment bankers similarly fell short of the degree of candor required of a corporate fiduciary, and suggests his answer to Mr. Buffett’s earlier inquiry noted above was intended to deceive.

The main idea here, as I have written about before, is that Sokol owed a duty to BRK as an employee.  Could he buy stocks of companies, as specified by his employment agreement?  Sure, but within limits which he violated.  BRK deserved the initial benefits of his work, when the data was intended for BRK and not for Sokol.

3) That the orders were not 100,000 share limit orders is not relevant to the case at hand.  Mr. Sokol, if your attorney is making such bogus arguments, either you have a really bad case, and should compromise, or you need a better attorney.

As I commented to the excellent Colin Barr, in his early piece on the topic:

I don’t think we need a new law here. If Buffett wants, he has grounds for a tort against Sokol on his misappropriation of data that rightfully belonged to BRK. I suspect Warren will just let it slip — Sokol did a lot of good for BRK, and Buffett has loyalty to managers generally. At least, that’s how it seems today. His ruthlessness for the reputation of BRK is subordinate it seems to his loyalty.

Which leaves any complaints that shareholders might have against BRK. Now, those complaints are not against Sokol, but against Buffett and his management team’s oversight of Sokol and his activities.

So, let’s be careful here. BRK is a conglomerate that owns insurers, and not an asset manager per se. The SEC and other regulators probably do not have something actionable here. But the two actions that I mentioned above could be taken in the civil courts, should Buffett or a group of shareholders decide to pursue those remedies.

Well, now we have a court case against BRK and the possibility of BRK proceeding against Sokol.  Both of my tort remedies might happen.

But What About Buffett?

I think Warren Buffett can defuse most of his troubles through a heartfelt apology at his annual meeting.  Something like, “Yes, I blundered.  I should have asked Sokol for details, but I was rushed that day.  I still firmly believe in the ethics that I have promulgated for BRK, but I slipped in not enforcing them as best I could.  I gave him the benefit of the doubt, because he was so valuable to us, and I should not have done that.”  And before that, go to those suing BRK and seek a resolution.  Your reputation would prevail, Warren.

Look, I try to be an ethical guy, but I make mistakes also.  The greater error as to deny guilt/fault when it is obvious to many.  I have confessed fault freely during the times I have blown it, and have ended up stronger for it.  Warren, the same would be true for you.  People will forgive you if you accept your responsibility in the matter.

Remedies

This is not the end of the Audit Committee’s work. Still under way are:

  • Work with Company management and legal counsel to identify and implement lessons learned from these events, including possible enhancements to its procedures.
  • Cooperation with any government investigations relating to this matter, and monitoring any developments that may emerge from them.
  • Consideration by the Board, or the Audit Committee, or such other committee as the Board may think appropriate, of possible legal action against Mr. Sokol to recover any damage the Company has sustained, or his trading profits, or both, and of whether the Company is obligated to advance Mr. Sokol’s legal fees associated with proceedings in which he is named.

They may go after Sokol.  The damages are far greater than the gain of $3 million on the takeover.  As Buffett said he cannot afford to lose any of his firm’s reputation.  Now may Buffett heed his own advice.

Redacted Version of the April 2011 FOMC Statement

Wednesday, April 27th, 2011
March 2011April 2011Comments
Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually.Information received since the Federal Open Market Committee met in March indicates that the economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually.Shades up their view of GDP and employment.
Household spending and business investment in equipment and software continue to expand.Household spending and business investment in equipment and software continue to expand.No change.
However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.No change.
Commodity prices have risen significantly since the summer, and concerns about global supplies of crude oil have contributed to a sharp run-up in oil prices in recent weeks. Nonetheless, longer-term inflation expectations have remained stable, and measures of underlying inflation have been subdued.Commodity prices have risen significantly since last summer, and concerns about global supplies of crude oil have contributed to a further increase in oil prices since the Committee met in March. Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued.They say, “…measures of underlying inflation are still subdued.” which conflicts with their other statement below, “Increases in the prices of energy and other commodities have pushed up inflation in recent months. “

Which is it?

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.  The unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.No change.
The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations.Increases in the prices of energy and other commodities have pushed up inflation in recent months. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations.Perhaps it should read, “Yes, we see inflation in the recent past, but we don’t think that there is any trend to higher inflation.”
The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.No change.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November.To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November.No change.
In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and will complete purchases of $600 billion of longer-term Treasury securities by the end of the current quarter.No real change.

They will stealth-fund the US Government to the tune of $600 Billion.

The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.The Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings as needed to best foster maximum employment and price stability.They see the end of QE2 coming, and will manage their bloated balance sheet as best they can.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.No change.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.No change to this meaningless sentence.

Would you do otherwise?  If we know that the opposite is impossible, why have the sentence at all?

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.No dissent.  Where are the so-called hawks?

Comments

  • The FOMC is a lot more bullish on the strength of the economy than the general public.
  • They say, “…measures of underlying inflation are still subdued.” which conflicts with their other statement below, “Increases in the prices of energy and other commodities have pushed up inflation in recent months.”  Which is it?  Perhaps it should read, “Yes, we see inflation in the recent past, but we don’t think that there is any trend to higher inflation.”
  • To me, without much evidence, the Fed is hoping that the economy is strong, and that inflation moves back down.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
  • Where are the hawks?  This report does not give a fair rendering of the rising risks of inflation, driven by commodity, agriculture, and energy costs.
  • The next real set of events is how the Fed shrinks its balance sheet, and how they preview it to the market.

It Would Have Happened Already, Redux

Tuesday, April 26th, 2011

I went to a set of presentations at Towson University this evening and heard two panels on the investment outlook — one domestic, one international.  What fascinated me was the relative unanimity of opinion.  All or almost all agreed that:

  • Bonds are overvalued.
  • Stocks are slightly undervalued.  Large Cap Value is attractive.
  • Commodities, especially gold, are a bubble.  ETFs are driving that bubble.
  • Interest rates will rise soon.
  • Avoid emerging markets.
  • Inflation is coming.

As I listened to the relative unanimity of opinion, I began to think, “Okay, what can go wrong with this?  If they are all invested to reflect these outcomes, maybe we will see things run more against them before an eventual correction takes place.

I think that some of what I heard at Towson University this evening does express the consensus for a number of markets.  Now the consensus is not always wrong — in the middle of a move the consensus is usually right.  But these calls, aside from equities, call for a change in direction.

Beyond that, a rise in bond yields would increase competition for stock valuations.

Also, some agreed that the Dollar was the best of a bunch of bad currencies, and would remain as the global reserve currency.  But then they said that commodities were a bubble.  Okay, stop.  If you say that all major currencies in the world are bad, what will you do to maintain purchasing power?  Buying commodities no longer looks so bad.  Commodities become what most currencies aren’t — a store of value.

I did not hear one argument for deflation this evening, nor did I hear anyone discuss the overindebted nature  of the American public.  There were many, many comments about the overindebted US government, but few comments on how it would affect other US investments.

Look, I am not saying that those in the panels are wrong — some of those biases are mine.  But when you hear little difference in the spread of opinions, it should make you re-examine your theses, because it is possible that all money has been committed to an idea, and even if the idea is right, we should see a counter-rally the other way before the smart money is proven right.

In closing, remember, if it were certain, prices would have adjusted already.  What this says is that we are not certain.

Book Review: The Financial Numbers Game

Monday, April 25th, 2011

I think that accounting quality is the single most neglected area of investing.  There are few that spend time trying to analyze whether the financial statements are fairly presented.  For value investors like me, that can be the difference between a value investment and a value trap.

Accrual entries on the balance sheet can be true or false, but cash rarely lies.

  • Are the accounts truly receivable?
  • Will the inventories sell?
  • What is the property, plant and equipment truly worth?
  • Do the goodwill and intangibles have any value?
  • What are the revenue recognition policies?
  • Some expenses can be capitalized as assets because of cash flows that are expected in the future.  How reasonable is that expectation?

And with financial companies, the questions are different — what are the nature of the cash flows promised and purchased?  Tough questions for anyone to answer, but at least the questions point us in the correct direction.

There are also the gambits to distract us from whether value is being created or not.  Operating earnings are not wrong, but many companies abuse the concept.  The idea should be to estimate what earnings are repeatable in future quarters/years.

There is a lot to chew on in this book, but it all boils down to:

1) What do we allow to be accrued for cash flows in the future?

2) How do we adjust those accruals as events change?

This is a great book — worthy of being in every person’s library.

Quibbles

None.

Who would benefit from this book:

All individual and institutional investors would benefit from this book, bar none.

If you want to, you can buy it here: The Financial Numbers Game: Detecting Creative Accounting Practices.

Full disclosure: I bought this book with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

It Would Have Happened Already

Saturday, April 23rd, 2011

After we went and got the pizzas for the birthday celebration of my youngest son, my second-youngest daughter (younger still) said, “Elizabeth [oldest daughter] says that gas prices will reach $6/gallon this summer.”  I said, “If it were that certain, it would have happened already.”  I added that there is a tendency for gas prices to rise a little in the summer, but that it wasn’t always so, and that refiners are not running at capacity, as it was the last time gas prices spiked.

This piece is a warning against listening to those that say something is certain to happen when the present price is far from what is predicted.  If it really were that certain, it would have happened already.

I have my guesses, but I am not certain how the global economy or the markets will change from here.  Beware certainty in matters economic.  It blinds us to alternative ideas that might be less risky or more profitable.

Thus when you run across rhetoric like:

  • Interest rates must rise.
  • The US Dollar must fall.
  • The US Government will go broke.
  • Inflation must rise from here.
  • The stock market is too high and will soon fall from here.

Be skeptical.  There may be some wisdom there, but the result is not certain, or it would have happened already.

When Everything is Strong, Redux

Saturday, April 23rd, 2011

It has been a long day, but I want to add one note to Thursday night’s piece: I would not sell the market immediately.  The summary of my recent research is that market moves from undervalued to overvalued, to more overvalued.  At more overvalued, momentum of the market slows down.  This is the time to exit before the correction occurs.  Momentum is still strong enough, but when momentum gets average when valuations are high like today, it would be a time to exit.  We are not there yet.

As for what is weak, there is housing.  Dark supply.  Many investments in housing are pre-planned losses.  Probably better to be in money market funds.

Gains and losses are not purely random, they tend to streak.  Here’s my stylized view of how an equity/credit cycle works:

  1. After a washout, valuations are low and momentum is lousy.  People/Institutions are scared to death of equities and any instruments with credit exposure.  Only rebalancers and and deep value players are buying here.  There might even be some sales from leveraged players forced by regulators, margin desks, or “Risk control” desks.  Liquidity is at a premium.
  2. But eventually momentum flattens, and yield spreads for the survivors begin to tighten.  Equities may have rallied some, but the move is widely disbelieved.  This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn’t far below you.
  3. Slowly, but persistently the equity market rallies.  Momentum is strong.  The credit markets are quicker, with spreads tightening to normal-ish levels.  Bit-by-bit valuations rise until the markets are fairly valued.
  4. Momentum remains strong.  Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures.  Liquidity is cheap, and only rebalancers are selling.  (This is where we are now.)
  5. The market continues to rise, but before the peak, momentum flattens, and the market meanders.  Credit spreads remain tight, but are edgy, and maybe a little volatile.  This is usually a good time to sell.  Remember, tops are often a process.
  6. Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue.  Some think that the problem is an isolated one, but search begins for where there is additional weakness.  Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.
  7. The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high.  A few institutions and investors fail who you wouldn’t have expected.  Momentum is lousy.  We are back to part 1 of the cycle.  Remember, bottoms are often an event.

You could call part 4 of my stylized cycle “borrowed time.” But it is borrowed time that can last a long time.  At the end of the bull cycle, the equity market catches up to the credit market, creating a situation where the valuation of the equity can no longer be sustained by further increases in leverage (part 5 leading to part 6).

Note to readers

I will be sending part 1 of my Impossible Dream research to clients this coming week.  In the next week, those that have asked for the research will get part 1, and clients will get part 2.  The week after that, those that have asked for the research will get part 2, and I will publish part 1.  The week after that, I will publish part 2.

When I was a corporate bond manager, I was relatively open about my ideas, because I knew that imitation was a lot more difficult than it seemed.  That is still true now.  But out of honor to my clients, they get the first look, and requesters get second look, and casual readers get third look.

When Everything is Strong

Friday, April 22nd, 2011

For every buyer, there is a seller.

For every debit, there is a credit.

Net exports globally equal zero.

Identities.  They help bring rationality when some people think that the economy only goes one way, as if China could sell off its US Dollar holdings without harming itself.  No one in the global economy has unbridled power.

Thus, I would like to bring to your attention this post from The Capital Speculator.  Everything is strong except high quality bonds.  Hmm… when was the last time I saw this?  Oh yeah, a piece by Richard Bernstein back in 2006, when everything was running hot.

This is not zen, but when everything is strong, something is weak.  Well, okay, high quality bonds are weak… that is normally true when liquidity is rampant.  Money markets are weak too… worse than 2006. Urk.

Think of it this way… long term fixed income claims are not prospering, and savers are getting peanuts, and very, very few peanuts.

Can this continue?  Yes, for two years at most in my opinion.  When the asset markets bifurcate into risky and non-risky, we are close to a top or bottom in the risky assets.  This is not a bottom.

Look, I have made calls at awkward times… equities in 2004, residential housing in 2005, subprime mortgages in 2006, and high yield 2008-2009.  I am not a permabull or permabear.  I aim for what will make money over the intermediate-term.

When everything is strong, be careful.  Trees don’t grow to the sky.  This is the time to pull in the horns.  Counting in the Fed’s future retreat from excess liquidity, it is all the more the time to be careful.

Sixteen Questions for Dr. Bernanke’s Press Conference

Wednesday, April 20th, 2011

Mmmm… I live near DC, but what does it take to get an invite to the Fed’s press conference?  One e-mail, four phone calls, four messages… and not even the courtesy of a reply?  What, does the Fed think they run this place?!  (Uh, maybe.)

I mean, it would be reasonable to receive a response that says, “Sorry, bloggers are NOT a part of the press, no matter how much reach you have.  We only deal with REP-utable media.  You are not an impartial reporter of information.”  But being ignored is just tacky.

I’m assuming that I will have no access to the press conference.  So, I’m writing out a list of questions that those in the press can use if they like.  Some questions are normal ones, some less so.  To those that follow me that may have contact with those who are invited to the press briefing, I ask that you pass the questions along to them.  Thanks.

1) Why has the NY Fed’s open market’s desk been buying predominantly intermediate nominal Treasuries, but with TIPS, predominantly the long end?  Is the Fed trying to purchase a long-dated inflation hedge?

2) Growth in developing world means more competition for food and energy supplies, and other commodities, which are forcing prices up in those areas.  Why does the Fed focus on so-called “core” measures of inflation, when food and energy prices (though volatile), always seem to go up more than the “core?”

3) If you are trying to smooth out fluctuations in inflation, wouldn’t it be better to use the median or a trimmed mean, rather than ignore data, particularly data that minimizes the effect of inflation for households for which food and energy are a large portion of their budgets?

4) In 1992-1993, the Fed held the Fed Funds rate down at levels that produced a very steep Treasury yield curve.  When the Fed began tightening policy, in 1994 the bond market had annus horribilis, with a self-reinforcing sell-off in the Residential Mortgage-Backed Securities market.  As you begin removing policy accommodation, what assurances can you give that we won’t have a similar selloff?

5) How are you regulating banks differently now than you were in 2005?

6) Why did the Fed resist legitimate FOIA requests so vehemently?  In the insurance industry, every asset is public.  Why did the Fed and the banks resist disclosure of items that should have been regarded as trivial?

7) Why did state-regulated insurers come through the crisis better than federally-regulated depositary institutions?

8) Why does the Fed employ so many Ph.D. Economists when the economics profession proved incapable of forecasting the recent crisis, when all anyone had to do was look at overall debt levels relative to GDP to see that we had surpassed the levels of the Great Depression?  Why employ so many from a failed area, when it would be better to hire History Ph. Ds. who might note the problem?

9) Why is the Fed so big in terms of employment, when all you do is set monetary policy, and pretend to regulate financials?  Why can’t the Fed  be slimmed down to provide a greater payback to the US Treasury?

10) Are you concerned that the Fed’s balance sheet is a record 16-17% of US GDP?  If you begin to shrink your balance sheet, what will the effect be on the banks, lending and the general economy?

11) Some suggest that the removal of liquidity will prove difficult.  So far the Fed has minimized price inflation, but how will you manage the removal of accomodation from QE2, particularly if inflation begins to accelerate?

12) If you find the US in stagflation one year from now, how will your policy be different from that of the Fed in the late ’70s?

13) What evidence is there that quantitative easing works?  Japan is still a basket case, and they have done it the most.  Ignore theory, and give concrete examples.

14) Quantitative easing has forced investors to take more risk, particularly retirees who need income.  Is it fair to engage in an economic policy that is unfair to investors and seniors?  Why harm savers who deserve a good return on their savings?

15) Don’t you think that holding interest rates so low just builds another bubble?  Low interest rates relative to growth in GDP often fosters speculation that blows up once the economy overheats and the Fed adjusts policy.  Why engage in such policy?  Why not aim for something more sustainable, a la Knut Wicksell?

16) Why is the Fed sucking down 50% of the US Government’s issuance of debt?

-=-=–=-=-==–=-==-=–==-=–==-=-=-=-=-=-=-

Okay, so I am biased and not politically realistic.  Yet I am trying to be real with the economy as it is, and the distortions that the Fed has created through their horrendously loose monetary policy.  I firmly believe that the history books will condemn Greenspan, and to a slightly lesser extent Bernanke, for their mishandling of monetary policy and supervision of financial companies.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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