I left one small question for last; I gave a partial answer to this one at the conference.  I think I was the only one that said much on it.  Here it is:

Where does academic theory fail in finance and in economics?

Little questions, big answers.  How do you eat an elephant?  One bite at a time.  Let’s start with math in economics:

1) We have to reduce the complex math in economics — I think we are trying to apply math where it is not valid.  As such, the true strength of ability to explain what is going on decreases, while economic becomes an odd “inside game” for a funny group of mathematicians trying to make sense of an idealized world that bears little resemblance to our own world.

2) The next piece is on maximizing utility or profits.  Maximizing takes work, assuming one can even do it.  Work is a negative, so people conserve on that.  Most of us know this: we look for a solution that is “good enough,” and do it.  That means we don’t maximize utility, and the pretty equations don’t represent reality.

What’s worse is that men care more about relative results than absolute results.  We would rather be kings over an impoverished realm rather than middle class in a wealthy country.  We are worse than greedy; we are envious.

It’s even worse for firms.  There you have agency problems where the management often has its own goals that do not maximize profits, or their net present value, but maximize the benefits they receive.  Boards are frequently a cover for management, rather than advocates for the shareholders.

Regardless, since firms don’t maximize, the elegant math does not work. Putting it simply, if you want to understand economics better, don’t listen to economists — become a businessman.  An ordinary businessman knows more about how the world works than a neoclassical economist.

3) One of the beauties of a capitalist economy is its dynamism.  It adapts to changing needs and desires.  The variation is considerable; as an example, go through your supermarket and try to count the total number of different tomato products.  Or  look at the amazing degree of variety in a major tools catalog.  Or go to Costco, Walmart, Home Depot, Ikea, and look at the incredible variety that exists under one roof.

But that level of variety cannot be mathematically accommodated by economics.  They have to aggregate the complexity into categories, and a lot of the reality is lost in the process.  That is why I distrust  many economic aggregates, such as inflation, GDP, etc.  Politicians find “economists” to suit their political ends, and they come up with complex reasoning for why measured inflation is higher than it should be, inequality is rising, etc.  You can find an economic advocate for almost anything.

Macroeconomics

4) Because of the aggregation problem, the link between microeconomics and macroeconomics is made weak, especially since utility cannot be compared across any two people, and yet the economists mumble, and implicitly do it anyway.

5) At least with microeconomics, we can agree that demand falls as prices rise, and supply rises as prices rise.  But with macroeconomics, there is little agreement as to whether a given policy aids real growth or not.  Modern neoclassical economics is to me a bunch of sorcerer’s apprentices playing around with very large and crude tools that they think can affect the economy, only to find the results are not what they expect.  Somewhere, economists got the naive idea that they could eliminate the boom-bust cycle, only to find that by eliminating minor busts, they set up the conditions for growth in indebtedness, leading to a huge bust.  Far better to be McChesney Martin, or Volcker, who let recessions do their work, than slaves of the government who did not — Burns, Miller, Greenspan or Bernanke.

Take inflation as an example.  Does printing more money, or creating more credit boost asset prices, product & services prices, both, or neither?  The answer to this is not clear.  The Fed has taken many actions over the past 30 years, using a model that assumes tight relationships between short interest rates and inflation/ labor unemployment.  The evidence for these relationships are not evident, except at the extremes.

6) The idea that running deficits to “stimulate” the economy is questionable.  Debts have to be paid back, repudiated or inflated away, any one of which would make business and consumers less confident.  Further, the way the the money is spent makes a great deal of difference.  Much government spending inhibits or does not help economic growth; think of the complexity of the tax code — a recipe for wasted time, and unneeded social enginerring.  Some government spending does aid economic growth, where it lowers the costs of consumption or production — critical infrastructure projects, etc.  But those are rare.  If it were really needed, lower level governments or private industry would do it.

The thing is, most of the deficit spending has not been useful; there’s no economic reason to run such large deficits.  If we were rebuilding all of our aging infrastructure, that would be one thing, but the crazy quilt of tax breaks and subsidies affects behavior, but does not compound and aid growth.

7) We need to admit that culture is not a neutral matter.  Some cultures will have faster economic growth, and others will be slower.  There is no universal culture, no generic economic man.  Some cultures are more enterprising than others.  That has a big impact on growth quite apart from resources, population, education, etc.

8 ) Whether the money is tied to gold or fiat, banking must be tightly regulated.  Solvency of all financial institutions should be tightly regulated.  With financials risks arise when the is too much leverage, and too much leverage that is layered.  Things should be structured such that there is no possibility of dominoes knocking over other dominoes.

• Limit leverage
• Increase liquidity of assets vs liabilities
• Forbid lending to/investing in other financials
• Derivatives should be regulated as insurance, insurable interest must exist, which means that bona fide hedgers must initiate all transactions.

On Finance

9) The first thing to realize is that a mean-variance model for investments is loopy.  First, we can’t estimate the mean or the variance, much less the covariance terms.  There is also good evidence that variances are infinite, or close to it.  Thus the concept of an efficient frontier is bogus.  Far better to try to estimate crudely the likely forward returns on a cash flow basis, the way a businessman would, and weakly factor in the uncertainty of the forecasts.

10) Thus, beta is not risk, and volatility is not risk.  At least at present, until the low volatility funds get too big, there seems to be an anomaly where low volatility equity investing beats high volatility equity investing.  This is consistent with my theory that the relationship of risk and return is non-linear.  Taking no risk brings no return; taking moderate risk brings decent return; taking high risks brings low returns.  There is a sweet spot of prudent risk-taking that brings the best returns on average.

11) Multiple-player game theory indicates that to win, you assemble a coalition with more than 50% of all of the power, and you get disproportionate benefits.  Think about the poor buyer of a home in 2006, going into the closing with the deck staked against him.  Or think about forced arbitration of disputes on Wall Street, where the investors rarely win.

Complexity is not the friend of most ordinary economic actors.  Avoid it where you can.

12) Capital structure does matter; it is not irrelevant like Modigliani and Miller said.  Companies with low leverage tend to return more than companies with high leverage.  There are real costs to being in distress or near distress.

13) Markets can have non-linear feedback loops, like in October 1987, or the “Flash Crash.”  Markets are not inherently stable, and that is a good thing.  Instability shakes out weak players that are relying on a shaky funding base, leaving behind stronger players who understand risk.  It is not wise to try to eliminate the possibility of disasters occurring.  When you do that, pressures build up, and something worse occurs.  Better to let the market be free, and let stupid speculators get burned, so long as they aren’t regulated financial companies.

Ethics matters

14) Economics would be more valuable if it focused what is right, rather than what is “efficient.”  I know there will be differences of opinion here, but a discipline that focused on explicit and implicit fraud could be far more valuable than men who don’t have good models for:

• Inflation
• Asset Allocation
• GDP
• Unemployment
• and more

Imagine applying all of that intelligence to fair dealing in economic relationships, rather than vainly trying to stimulate the economy, and accomplishing nothing good.  It would be like the CFA Institute applied to the economy as a whole.

One thing that came out of our “employee empowerment project” was a need to improve our equity and bond fund offerings.  At the same time, a fund manager manager [FMM] came out of the woodwork and suggested to us that we could do multiple manager funds.  They had analyzed many managers and had found some that they thought were great.

The more we thought about it, the more we thought it would be a great idea. Here’s why:

• Our own abilities to find superior managers were limited.
• A few members  of our team (including me) possessed ability to analyze what FMM would bring us.  We thought we could add value.
• We came up with a clever name, “The All Pro Funds.”
• We also thought we could add value  in changing weightings every now and then, and firing managers that we felt had become uncompetitive because they were now running too much money, had critical staff losses, or were underperforming style-specific indexes by a wide margin.
• We could increase our fee a little to pay FMM and us for the additional work entailed.

And whaddaya know?  It worked.  The portfolios in aggregate  outperformed  their indexes even after fees, and fund flows increased dramatically.  The representatives had a story to tell.  Morale improved everywhere.  We were rolling, until…

A day came where we heard from one of the underlying managers that FMM had recommended their termination because they wouldn’t rebate more of their fees back to FMM.  I would not say that we went ballistic when we heard this — instead, we went cold on FMM.  Act fast?  No, act deliberately.  The senior officers tasked me and the #2 guy in marketing to deal with the problem.

We had a rule in our division — we will pay disclosed compensation, or we will pay undisclosed compensation, but we will never pay disclosed and undisclosed compensation.  Why?  We wanted our clients to know that if compensation was disclosed, that’s all there was.  If there is no “sticker price” but you are happy with the services provided, and don’t need to know what any agent is making that’s fin with us.  But we will not pass more money quietly to those that have said, “This is the sticker price.”

FMM had violated our sense of ethics to the core.  The two of us decided to put out an RFP, asking them to bid to help manage the now $1 Billion of assets. We excluded FMM.  We chose 10 well known manager consultants. Most responded to the RFP and we invited 5 to come present to us on a given day in spring.

-=-==–=-==-=-=-=-

I need to mention one other thing.  When we first started dealing with FMM, we appreciated their qualitative research, which seemed to have some punch.  After a year, they discovered returns-based style analysis.  This allowed them to analyze many more managers just by looking at their returns, and correlating them to a variety of equity and other indexes.  They stopped the qualitative research.

The first time I saw it, I thought it was hooey, even as I think MPT is hooey.  When you have a lot of highly correlated indexes, any attempt to intuit the style of a given manager is problematic; the error bands get too wide.  It is too difficult to determine what the correct answer is.  The optimal answer mostly represents happenstance, and not fact.  Tiny tweaks to the data produce big changes in the answer.  Not a good system.

There was one incident where I met with their new quantitative analyst, a woman 10 years younger than me.  She ask if we understood how the method worked.  I replied with some mathematical jargon regarding the method, leading her to say, “Oh, so you *really* understand this.”

Also, when I analyze a manager, I like looking at what they own.  I like looking at their trades.  I want to see consistency with what they claim is their strategy.  I also like to hear why they do what they do, and what sustainable competitive advantage they think they have.  There is value in that style of analysis.  There is little value in analyzing returns.

=-=-=-===–==-==–

To our surprise, one well-known consultant [call them STAR] that had no for-profit clients was one of the five.  The leader said it was a one-time experiment, so they were evaluating us, as much as we evaluated them.

On the day when they came to present, the presentations were all over the map, from highly professional to “did not prepare.”  Some big names could not answer basic questions about what sustainable competitive advantages they brought to the process, or were fuzzy about how they earned their money.

STAR had the best presentation, services, model, ethics, etc.  It was almost “no competition,” and they liked us as well.  We hired them, much to the chagrin of FMM, who begged us to keep them.  It had the following positive results:

• Management fees down by 60%
• Fund manager fees down by 50%
• Far better marketing cachet
• Better models for investment analysis.

We reduced client fees, but had better margins, and still greater growth.  Our division was transformed thorough the two projects.  Before we started our ROE was around 8%, and we were growing AUM at a 5-10% rate.  By the time all these changes occurred, our ROE was 25%, and our growth rate was not far from that.  We were now the stars of the firm, even though the firm culturally could not acknowledge that, because the life division was so big.

I learned several things from this five-year escapade:

• Creating a desirable investment product takes work.  If you do something different that seems to add value, it will attract clients. (“We manage the managers for you, so you don’t have to”)
• Focus on ethics in those you work with.
• Reduce fees where possible, both your own, and that of suppliers.
• Name recognition helps.
• Be careful what you accept as analysis.  Just because there is clever math does not mean it represents how reality works.
• If you don’t take chances, you won’t achieve anything great.  We didn’t have to burn our old strategy, and move to multiple manager funds, but we did it, and it made clients a lot happier.  The added work was work that that we liked to do.
• Even if you have a supplier that did something good for you, do not tolerate breaches in ethics.  Find someone else to help you even if it costs more.  That it cost us less was merely a plus.

When I worked for Pacific Standard, which had the dubious distinction of being the largest life insurance insolvency of the 1980s, I had few investment-related tasks.  Investments were handled by the overly aggressive parent company Southmark, which gave little attention to risk.

But I knew things weren’t going well, and so I interviewed widely, finally landing two job offers with Midland National and AIG.   I chose the spot with AIG, because they led me to believe I would work on the international side.  When I arrived, lo, I had a job on the domestic side.  As far as the job went, had I known I would be placed on the domestic side, I would have rather gone to Midland National.  They thought I had real leadership potential — whether true or not, that’s what I was told, and I would not have minded living in South Dakota, or nearby.  As it was, there were many good things that happen to me as a result of living in-between Wilmington, Delaware, and Philadelphia, living on the PA side of the line for reasons of adoption and homeschooling.

When I got to AIG, there was one main thing that involved my risk management skills.  AIG parent wanted growth in GAAP earnings.  They wanted to see a 15% ROE, which few in the life industry were attaining.  In order to do that, they entered into reinsurance treaties (before I arrived).  These would lever up the balance sheets of the subsidiary companies, without incurring debt.  Most of them passed risk to the reinsurers, one did not.

So, when I was called into an examination by the Delaware State Insurance Department auditor over the one treaty that did not pass risk, he said to me, “You know this treaty does not pass risk.”  I replied, “Under ordinary circumstances, I would agree, but the reinsurer has taken a significant loss from this treaty.”  He said, “What do you mean?”  I replied that when Congress passed the DAC tax, the reinsurer suffered the loss — they paid up front, and we pay over time, with zero interest.

He looked at me and said that reinsurance treaties did not exist to cover tax policy, and that the treaty was a sham.  I just shrugged.  I was not the creator of the treaty, and would not have done it if I had been at AIG two years earlier.

But the there were the two larger treaties that passed risk with a vengeance to a large reinsurer [LR] who is no longer a reinsurer (if anyone wrote treaties like these, he might not be a reinsurer anymore either).  In one sense, the treaties were structured like the trading requirements in CDOs.  If you must trade:

• Get more income
• Don’t give up rating
• Don’t extend maturity
• And a few more smaller things.

I was not there when the treaties were created.  Had I been there, I would have paid a lot more attention to them, and instructed the investment department to set up segregated portfolios, which was not done.  As it was, bonds that underlay the treaty were casually sold as if free to do so.

Now I arrive on the scene.  After reading the treaties, and looking at the data, I conclude that the treaties have been abused on our side.  I suggested to LR that I go through the history, and reallocate bonds that would have fulfilled the treaties strictures, an re-work the accounting so that the terms of the treaty would be fulfilled.  Initially LR agreed to this.

The treaty passed all investment risk to the reinsurer, so defaults would hit them.  What was worse, the liabilities underlying the treaty were structured settlements.  (Structured settlements result from a court case where someone is injured.  The defendant offers to buy from a reputable life insurer an annuity that will make the requisite payments.  Low bid wins, and if the plaintiff is badly injured, the cost goes down for payments that terminate at death.  That’s where most of the bad estimates com in.)  In those days, structured settlements were a “winner’s curse.”  If you won, it was because you mis-bid.  AIG Domestic Life Companies regularly overbid for their business (as did most of the industry).  LR did not do enough due diligence to see the underwriting errors.

I did a mortality study to estimate how badly we needed to increase reserves, and lo, it was more than $100 million, all of which would flow to LR.  LR decided to sue.  After I had gone on to Provident Mutual, AIG settled with LR.  Our missteps with the assets made the case tough, and the reinsurance treaty was rescinded.  That should have been enough to jolt AIG’s earnings for a quarter, but it did not.  Funny that, and it always left me a little suspicious of AIG.  (And LR.)

Before I left AIG, I had clipped the wings of the underwriters of the structured settlements so that they could not write on cases for the most severely disabled.  I also shut down a tiny line of variable annuities that was losing money left and right to an outsourcer who had a sweet contract from a prior management team, but upon leaving AIG I did not feel that great, because I had not built anything — most of my time had been spent trying to limit losses from prior bad underwriting and planning.  It wasn’t fun, and I loved my next company more because I got to build.

PS – a prior note on AIG.

All hail the CFA Institute.  They are trying to inject more ethics into the market through their “Future of Finance” initiative.  I largely agree, but think they are overly optimistic in some areas.

Here are their basic ideas: http://www.cfainstitute.org/learning/future/about/Pages/statement_of_investor_rights.aspx

Here are their dreams: http://www.cfainstitute.org/about/vision/serve/Documents/integrity_list.pdf

My main problems are with the dreams.  Yes, I eventually want every investor to work with someone who has a fiduciary interest in his well-being.  But many people don’t want to take the time to find the people who have their best interests at heart.  There are many things we can overcome, but we cannot overcome the laziness of investors, both retail and professional.  This laziness is part of the nature of man; a few cure it through consistent effort, but most don’t.

To that end, some blame belongs to the unintelligent investors who barge into a market without sufficient knowledge.  That’s how it should be, because in many areas of business those that try to compete with insufficient knowledge lose vitality because they don’t know the basics of the business.

You can’t protect people from stupidity.   Fraud is another matter.  Deception is different from dumb agreement.

But here is my main challenge to the CFA Institute: where do your ethics come from? Why are they right?  Are they God-given, or merely an agreement among men?

This matters a great deal, because if it is merely an agreement among men, many men will say, “So what! Why should I listen to you?”  If they are God-given, even if men argue with them, the answer comes back from God, “You are a sinner in many ways, including this.  When will you humble yourself to me, and trust in the sacrifice of my Son, which was the largest event in history?”

Ethics aren’t neutral; people disagree about what is right and wrong to a high degree.  Even in finance, there are considerable disagreements in what is the correct behavior:

• Active vs Passive mangement
• Value vs Growth
• Does Technical Analysis work?  (Is there truly a single discipline there?  I don’t think so.)

That’s a considerable reason why it would be difficult to enforce the views of the CFA Institute over the markets.  There is no commonly agreed-upon view of how the markets work.  The views of the academics are ridiculous, and do not reflect market realities. But many asset allocators trust them, even though their results are poor.

Don’t get me wrong, I largely favor what the CFA Institute is proposing.  I just think it will be hard to turn it into public policy because of the large disagreements over how finance actually works.  Also, the degree to which neglectful parties buy into the markets through the persuasion of sellers, because they won’t look out for their own best interests directly.

So, look at what the CFA Institute is up to.  They are part of the “White Hats” in the market, like me, who argue for the good of investors.  My only difference with them is that their model of the market is not fully accurate.  Nor do they understand how men can err, even with detailed ethics codes.

From a reader:

As a reader of yours, I find your views always interesting and well thought-out, even when I disagree. Thank you for sharing your thoughts, wisdom, and experience, as I truly believe you raise up the areas of thought you touch.

I have a question that I hope you will address on your blog, though the urgency is low. As a CFA and CFP working in a small RIA, I have been paying close attention to the debate about imposing a uniform fiduciary standard onto RIAs and brokers. I would loved to hear your thoughts about this topic, maybe addressing the following:

• Should brokers giving advice be held to the high fiduciary standard of advisers?
• Could a two-tier fiduciary standard work (i.e. codification of the Merrill rule)?
• The primary broker argument against the fiduciary standard, as I hear it, is that it would make services to retirement accounts unprofitable. Do you agree?

I hope to hear your thoughts on this published on your blog because I know that quite a few people with second or third degree connections (maybe first, but I don’t know) to the policy makers and lobbyists read your blog.

First, thanks — I know my reader base stretches into some lofty places, not that I deserve it.

There should be informed choice when choosing those that advise investors.  I don’t think that brokers should be held to a fiduciary standard, but I do think they should have to state to clients that they have a potential “conflict of interests.”  Clients don’t make money when trades occur, but brokers do.

The trouble is, retail investors are the dumb money.  There is a tension between allowing freedom and letting people get shorn by those that are more skilled.  Some financial products are sold not bought, and it is largely because people will not plan in advance for themselves.  We see that in life insurance all the time.

Here’s the other side of it: we can’t make retail investors smart.  In most transactions of life, the foolish get hosed.  We can’t protect people from being dumb.  If we did that consistently, our economy would probably fail.

The idea of “just prices” does not work.  It’s not flexible enough.  In the end, things work best when we let let markets work, but require extensive disclosure that most will understand, and some won’t.

Perfection is not possible in law or regulation.  If we get “pretty good” we have hit the top.  Enjoy pretty good where it exists, though I would encourage investors to use those that have to put your interests ahead of all else.

PS — there has to be a way to service retirement accounts — as with insurance contracts, some sort of AUM fee or trailer commission would do it, but not something based off of transactions…

I’ll let Buffett speak, and I will add a few comments.

When the partnership I ran took control of Berkshire in 1965, I could never have dreamed that a year in which we had a gain of $24.1 billion would be subpar, in terms of the comparison we present on the facing page.

But subpar it was. For the ninth time in 48 years, Berkshire’s percentage increase in book value was less than the S&P’s percentage gain (a calculation that includes dividends as well as price appreciation). In eight of those nine years, it should be noted, the S&P had a gain of 15% or more. We do better when the wind is in our face.

To date, we’ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. (The record is on page 103.) But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five year wins will end.

One thing of which you can be certain: Whatever Berkshire’s results, my partner Charlie Munger, the company’s Vice Chairman, and I will not change yardsticks. It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P. If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund.

I appreciate Buffett & Munger not changing their metric.  They could have said that the market return beat the S&P in 2012, but they didn’t.  Buffett is a compounder.  He figures that if he compounds net worth at an above average rate, he will beat the market returns of the S&P 500 over the intermediate term.  I agree; building intrinsic value will almost always lead to outperformance, unless the stock was significantly overvalued at the beginning.

On Searching for Acquisitions

Our luck, however, changed early this year. In February, we agreed to buy 50% of a holding company that will own all of H. J. Heinz. The other half will be owned by a small group of investors led by Jorge Paulo Lemann, a renowned Brazilian businessman and philanthropist.

We couldn’t be in better company. Jorge Paulo is a long-time friend of mine and an extraordinary manager. His group and Berkshire will each contribute about $4 billion for common equity in the holding company. Berkshire will also invest $8 billion in preferred shares that pay a 9% dividend. The preferred has two other features that materially increase its value: at some point it will be redeemed at a significant premium price and the preferred also comes with warrants permitting us to buy 5% of the holding company’s common stock for a nominal sum.

Once again, we don’t know all of the details, but it really looks like Buffett got the better part of the deal, and by a decent margin.  He continues:

Our total investment of about $12 billion soaks up much of what Berkshire earned last year. But we still have plenty of cash and are generating more at a good clip. So it’s back to work; Charlie and I have again donned our safari outfits and resumed our search for elephants.

As many expected, Buffett has more than enough cash to deploy if he sees the right deal.  With valuations being high, I don’t see how they fire the elephant gun, unless a company with protected boundaries wants to sell.

Though I failed to land a major acquisition in 2012, the managers of our subsidiaries did far better. We had a record year for “bolt-on” purchases, spending about $2.3 billion for 26 companies that were melded into our existing businesses. These transactions were completed without Berkshire issuing any shares.

Charlie and I love these acquisitions: Usually they are low-risk, burden headquarters not at all, and expand the scope of our proven managers.

The tuck-in acquisitions of BRK are particularly valuable.  Done out of the spotlight, they get done at reasonable terms, and grow BRK organically.

The new investment managers, Combs and Weschler, did well in 2012, and Buffett is giving them more assets to manage.

As noted in the first section of this report, we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money.

Now interest rates are low, and underwriting standards are far tougher across the industry than if we were in a high interest rate environment.

Let me emphasize once again that cost-free float is not an outcome to be expected for the P/C industry as a whole: There is very little “Berkshire-quality” float existing in the insurance world. In 37 of the 45 years ending in 2011, the industry’s premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue.

What Buffett is saying is that his float is unique because:

• His company underwrites carefully.
• There is a decent amount of long-tailed business.
• The short-tailed business (GEICO) is growing, which makes short-dated float feel long — in essence Buffett can borrow short and invest long, for now.

A further unpleasant reality adds to the industry’s dim prospects: Insurance earnings are now benefitting [sic] from “legacy” bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years – and perhaps for many years beyond that. Today’s bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over.

He is overstating the case here.  Most P&C insurers run short asset portfolios and have already adjusted to the low interest rate environment.

Now regarding the non-insurance operating businesses of BRK, they almost all had good years in 2012.  I’m not going to say more, though I will say that Buffett spent too much ink on newspapers; it is a teensy part of BRK.

Finally. Buffett talks about dividends.  There are two major ideas here:

• Dividends are tax-disadvantaged versus buybacks.
• If you can compound earnings at an above-average rate, there is no reason to ever pay a dividend.

What this might mean is that when a future CEO of BRK concludes that “there are no more worlds left to conquer” a la Alexander the Great, it would be reasonable to pay a dividend.  That said, he could also:

• Centralize HR, legal and other functions.
• Streamline subsidiaries, and make fewer managers manage more of BRK.
• E.g., turn BRK into a real company.

There would be many ways to reshape BRK post-Buffett.  There are benefits and costs to doing that, but I think the benefits would be significant, unless the new CEO could keep the “hands off” way that Buffett does private equity.

Full Disclosure: Long BRK/B

Thanks to all of my readers, whether you read me via RSS, e-mail, twitter, or natively at the website.  But I have a favor to ask… if you read me elsewhere, drop by the site every now and then, because not all of my commentary gets republished by those that reprint my work.  Also, not that we get a ton of comments at Aleph Blog, but I appreciate the quality of almost all of the comments we get here, even if I may disagree with some of them.  If you read me elsewhere and want to comment, come to Aleph Blog and do so, or, just e-mail me.

Now for a few housekeeping items.  1) People sometimes ask me for books to help explain insurance stocks, and in the past I have pointed to my own writings, especially this one.  My flavors of insurance series helps also.  I’ve also pointed to works from the Society of Actuaries, Casualty Actuarial Society, LOMA, CPCU, and others.  But now, I think this piece could be useful to some readers.  It’s relatively comprehensive, and not that long.  It’s not the way I do it, but it is well thought out.  It suffers from the same problem as one using the models of Aswath Damodaran; it’s too detailed.  I can’t think of anyone that uses such a model — it is overkill.  But maybe readers could what I would do with such a model: boil it down into something simpler.

That is what I am trying to do with my current series on analyzing insurance stocks.  There are three or so more parts left to write, and I should get them out in coming months.

2) Some people ask me how they can read the articles in my Major Article List, and I wish I could read them too.  Trouble is, TheStreet.com has lost them.  They are there, maybe, somewhere in their computer systems, but since they changed the way that they named files, the links to most pre-2008 posts has been lost.

Now, if any of you think you have a way to find those posts, let me know.  There are pieces on that list that are gold, silver, and bronze.  I would at least like to get the gold ones back.

3) Sometime soon, I will create a small website for my business.  It will explain what I do for a living for those that might want me to manage money for them.  I will not link to it here; I try to keep a separation between the blog and my business.

4) I write about a lot of topics, and I tend to go in streaks on given topics.  It’s not what I intended when I started this, but I can understand why I have readers follow me and leave me.  My blog is consistent over a long period, but over intermediate periods it concentrates on one area, then another.

5) I’m not out of things to write about.  Here’s what I am planning for the future:

• Completion of my work on a new asset pricing model
• Completion of my “On Insurance Investing” series
• More posts on the idiocy of US & Global macroeconomic policy
• Buffett’s Shareholder Letter and Annual Report.  (Note: the letter gets more press, but the Annual Report has more substance.)
• Commentary on new ideas from the CFA Institute… some good, some bad…
• More commentary on investments that rip people off.
• And more, I have a long list of ideas to write about, and many book reviews to publish

6) I would have never expected  it, but February 2013 was my highest readership level at the blog directly, despite the short month.  Thanks to all who read what I wrote.  I try to write good stuff; I do not aim to be controversial, though I know that some of my views are controversial.

7) When I started this six years ago, I would have never dreamed how much I would end up writing.  I thought I wrote a lot for RealMoney.  If anything, I have written four times as much per unit time, which means that as prolific as I was at RealMoney, I have written 4-10x as much here.  And it all started with an extended conversation with readers on Jim Cramer’s “blog,” which led me to do what I had resisted for two years — start my own blog.

As I have developed this blog, I now earn more than I did writing for RealMoney.  That’s not much, but every little bit helps.

8 ) You can’t believe how many people write me asking to do a guest post at my blog.  It happens about 15 times per month.  Then there are the scummy advertisers, who don’t want their advertisements to be labeled as such.  I have a strict policy that all advertising should be identified as such.  Why?  Because I never want to scam my readers.  When you come here, I want you to be comfortable that I am saying what I say for reasons of truth, not profit.  Profit is incidental here.  Truth is paramount.  I know how I could make this place more profitable, and I reject it because I would compromise my message.

9) I began with thanks to readers; I end there as well.  Truth, I treasure all of the emails giving me praise, but my internal response is “Wow, you’ve all been so great to me over the years.  It really gets to me, you know.  I hope I always make you proud.  That’s all.”  (What the Flash said to the citizens of Center City… yeah I know, a little dumb, but you had to see it.  Start it at 8 minutes.)

My main focus is on ethics in investing, and secondarily explaining how things work.  I hate seeing people ripped off by investment firms, or their dishonest governments.

I have no idea how long I will continue this blog, but I would love to do it as long as I live.

Sincerely your friend,

David

From a reader:

I’ve been following your blog for a little while and appreciate your analysis. I’ve been particularly interested in your coverage on the penny stock phenomenon and started doing some of my own digging. I’ve found a few “companies” that seem to share characteristics with the ones you have highlighted. Digging into the 10-Qs reveals all sorts of red flags around related party transactions, health of balance sheet, past history of management, etc. The question I’ve been trying to answer is how these companies continue to exist? In the cases I list below their sole purpose appears to be to move cash from unwitting investors to the management of the company. 

Would be interested in your perspective.

Wanted to respond to you earlier, but time did not permit.  But thinking about it, I realized that for penny stocks, the most relevant statement to analyze is the Consolidated Statement of Changes in Stockholders’ Equity/Deficit.  You can see what prices they issued stock at.  Proceeds divided by shares gives you the internal valuation of where the company is willing to offer shares.  Few ask, but all should ask, “If the company is willing to issue stock at 30 cents per share for salaries, services, etc., why does the stock trade for $1 per share?”

Sometimes a merger, or a purchase of a business can inject money into a company; sometimes debts are settled for shares. That can temporarily grow the company, and combined with a reverse split, it can give it a share price and a market capitalization that seems respectable.

Number two is the hidden bidding up of the shares through sham transactions where related parties buy & sell at progressively higher prices (netting to no loss, aside from commissions) until some speculators see the microcap stock and start driving it higher, possibly supported by promotional paid research.

But here’s the hard part for me: Sometimes the companies are involved, sometimes not.  Sometimes I can tell how the promoters make money, sometimes I can’t.

This is what I suspect: Promoters have several shell corporations for promotion and trading.  Let’s say one has 4 shells.  When A promotes a stock, B, C, and D trade.  When B promotes a stock, A, C, and D trade.  When C promotes a stock, B, A, and D trade.  When D promotes a stock, B, C, and A trade.   Then each promoter can say they have no economic interest in the stock mentioned that they are “advertising.”

This is an ugly space.  Supposedly you can get a borrow on these bits of financial trash (in order to short them) through Interactive Brokers.

Time for my penny stock scoreboard:

You have to admire the consistency of capital destruction among promoted penny stocks.  Tonight’s loser-in-waiting is Echo Automotive.  Here is the bullet points to illustrate the future carnage:

• Minimal Revenues
• Negative net worth
• Negative earnings and getting worse.
• Management sucking in a lot in salaries.
• The long list of stock promoters engaged by DH Media LLC.  This is only the email effort.  They paid $1.9 million to disseminate the shiny, colorful 10″ x 14″ “newsletter” via snail mail.    They paid $25,000 to the tout that wrote the copy, or maybe, spiffed up DH Media’s bullet points. Add in disclaimers in 5-6 point type.
• Risk factors list longer than you can shake a stick at.
• Predecessor company “Canterbury Resources” was pursuing mining interests in New Zealand.
• Predecessor acquirer company “Controlled Carbon” was working on solutions to reducing carbon emissions.  They now own 70% of the combined company, paying four cents a share for their stake. (So why does it trade at near 80 cents a share now?
• Now the combined company has some solutions that will double fuel mileage on vehicles that use gas.  What a wonder.

If you really had a technology that could double gas mileage, you would set up a joint venture, or a licensing agreement with one of the major automakers, and divide the profits  off of their high vehicle sales.  You would make a bundle doing that.  You would not buy a shell company in a different industry and let costs get out of control.  That looks like management does not have a real technology, but is simply trying to “take something off the top” through salaries and benefits, and perhaps rewarding friends.  After all, in the stub of the third quarter, Echo blew threw virtually all of the new capital that it raised, and for what?

The company might or might not be affiliated with the promoters.  The promoters say the company is not affiliated with the promotion.  In one scam, Luxeyard [LUXR] a different set of promoters did reveal that the company was paying the promotion to facilitate sales of stock.  The proof is in the pudding.  If Echo goes and does a PIPE or a secondary IPO, maybe there was some hidden affiliation.

The promoter also says they won’t trade for 90 days.  Now, the economics of this one is tough, because the parties that owned “Controlled Carbon” own 70% of Echo Automotive.  Dilution at low prices does not favor them, and I don’t see how they could easily monetize a large portion of their stake.

That leaves the remaining 30% of the company to be traded.  The promoter has spent over 2 million to promote the stock.  Unless he owns a big chunk, and sells into this wave, I don’t see how he makes money.  And if he does sell into the wave, and a lawsuit is brought later, that would stand against them in court that they violated their disclosure.  Maybe they take that risk anyway — they are working at the edge of the law anyway.

Except, maybe a lot of scammers work together as in this example from the FBI.  I’ve posited that idea before.  Given all of the non-identifiable shell companies involved, that could be going on here also.  It would be interesting to try to prove the existence of and break a ring like that.

Anyway, steer clear.  The company is horrid, and with promoters around, those that buy and hold for any significant length of time (say 1-3 months) are 99% certain to lose money.  Don’t be one of the pockets that gets picked.

Some of the dumbest things I have seen in my life inside corporations revolve around incompetent managers, who don’t have the foggiest idea how to grow value organically, and use a variety of shortcuts or cheats to give an illusion of creating value by doing nothing.  I have given a few examples in these two articles:

• “Is He Economically Rational?”
• Bottom Left Hand Drawer Issues

Here are some more examples:

Some acquirers tend to despise the employees of firms that they acquire, and assume there is a lot of fat to be cut.  So it was that a client that I managed assets for that was acquired by a British company.  A few months after the acquisition the client firm announced that they were firing half of the accountants, and all of the accountants dealing with investing.  I went to the management of the firm that was a new client of ours and expressed my concerns, saying that they would lose all customization and control of results by outsourcing investment accounting — it could never be as responsive as retaining “in-house” staff.  Also, firing half of the remaining accountants would lose a lot of local knowledge where systems are deficient and need “hand holding’ with regular adjusting entries to make sure the accounting was correct.

In this example, the investment accountants were actually quite good, though their leader did not present well.  I had a good relationship with him and his staff, and helped them find new jobs, much as I hated to see them go.  I did the same for some of the other accountants that were let go, since I interacted with some of them as well.  It almost seemed like the new client wanted to eliminate all of the accountants with special long-term knowledge of the business, and retain the cheaper ones with less institutional knowledge/tenure.

As it was, my dealings with the new heads of financial reporting left me scratching my head, wondering why the new guys were a “trade up.”  They seemed to understand the issues less well than those they replaced, but were advertised to be really bright.  Okay, lost on me.

I relayed my concerns to my bosses, and they said, “Not much we can do.  We have the same ultimate parent company, but they’re not geared toward taking feedback at what would be such a micro level for them.  Let’s just watch and see what happens — if it is as bad as you think, it should materialize in six months or so.”

As it was, my bosses were right, and so was I.  For the first six months after the accounting change, profits were astounding.  The new management team was patting itself on the back, certain that their decisions were leading to greatly improved profitability.  (As an aside, I remember sitting through interminable meetings where new accounting software was being introduced. The old stuff was not good enough.)

Then came the year end audit, and new internal auditor plus new external auditors questioned accruals produced by the new outsourced investment accountants.  I was asked what the right approach was for accruing income on some obscure fixed income security.  Belying their cheap cost, the new investment accountants did not make the correcting entries into the system that the old accountants had, leading to a massive over-reporting of income.  Far from being more profitable than the past, it was far less profitable, despite all of the firings in accounting.

This was the first comeuppance of many for an untalented management team that eventually all got fired, as well as the ultimate CEO of the firm that trusted them, and invested a lot of money into that subsidiary.

Warnings to the wise: always analyze your profit margins in a competitive industry, and if results seem too good to be true, don’t accept them, push back and look at all of the squishier accrual items to see if there is an error.  Bad management teams accept good results without question, and criticize bad results always.  Good management teams criticize unusual results, whether good or bad, but bias income to the low side of fair, allowing small positive surprises to emerge.

Then there was the time where an insurance company that I worked for bought out a smaller company, and the hidden price of the deal was that the new CEO would be the CEO of the acquired company in a year.  Bad move.  The guy was an accountant, and his only means of “adding value” were cutting employees, and skimping on squishy accrual items.  While he was CEO, I kept track of how mach GAAP income outpaced my adjusted Statutory income, which should have been close to GAAP.

The CEO had a fragile personality as he did this, emphasizing that the team he had assembled (loyal, but less competent) was highly ethical.  As it was, the CFO tried to find ways to convert capital gains into regular income for GAAP but not tax purposes, which maximized ROE, which was the largest contributor to management bonuses.  They were even the first ones to try an unusual derivative marketed by Morgan Stanley — bull/bear notes, as they were called. It was a bond that would split in two after a certain trigger, leading to two bonds — one with a premium income that would be held, and one with a discount income that would be sold for a capital loss.

Sadly, the company had a hard time evaluating the offer, until they approached me.  (Here is where ability conflicts with ethics.)  The chief actuary (via the Peter Principle, but true of all of that management team) showed me the derivative, and I said, “Oh, that’s easy.”  I told him I would have results by the next morning, and it was 4PM already.  I took it home, worked on it through the evening, and the next day presented the result.

I told him that the math worked mostly, but that if the US Treasury applied anti-abuse rules, it would be invalidated.  I also told him that I didn’t think the transaction was ethical, because restructuring merely to avoid tax, and change the GAAP statement impact had no economic substance.

He ignored my warnings, and so I found myself a week later presenting before all of the leading managers of the company the details of the transaction to be.  (Before that, I talked to the instigator of the idea at Morgan Stanley, and showed him errors in his spreadsheet.  Do not assume that investment banks are infallible.  Also, don’t assume that actuaries or any quants are infallible.  They are human too, and subject to their own biases.  People often shout the word “science” when they are the most weak.)

I told them that I thought the idea was not ethical, but that it would do what was promised.  They were happy with that.  I was already known to be opinionated, though my results were very good.  That poisoned me with senior management which prized loyalty over truthfulness.

Two months later, I was working with a new firm, and the boss came to me and said, have you ever heard of bull/bear notes?  I roared with laughter, and puzzled, he looked at me and I said, “Heard of them?  I corrected their models!”

It should have been a warning sign because our client (the same as mentioned in the first story prior to the acquisition) was willing to consider such garbage in order to increase operating income.  Good managements don’t go for gimmicks.  Going for gimmicks means you aren’t focused on real organic growth.

So, we started in on a new transaction.  The rep from Morgan Stanley was surprised to talk to me again.  Very easy to do, because I knew the model as well as he did, or maybe better, much as I did not like it.

I went through the same schtick with the new client, but they were determined to do it no matter what.  I still remember being in a dim conference room with my boss, when FASB’s EITF [Emerging Issues Task Force] disallowed the transaction going forward, and required all of those that had done it do disclose the results in a footnote.  (Only one company had done it, my prior employer.)

-==-=–=-=-=-==-=–==-=-

The company that actually executed the bull/bear note eventually sold itself to another firm.  While I was working as a buy-side insurance company investment analyst, I got to meet the CFO of the company that bought them.  I said to him, “Would you like me to tell you the history of how this came to be?”  With a grim face he told me no.  It was a thing of pain, but he did not want to know the truth.  He kinda knew it already, and simply absorbed the loss.

With Epictetus, I can tell you that the truth will set you free.  Lies always constrain.  With Jesus, I can say, “You will know the truth, and the truth will set you free.”  This is far more personal, and useful, because Jesus himself lives to teach and protect his own. He is the Truth.

To all, I say, be wary of management teams that control results overly — this seems to be more common in finance, where results are harder to judge.  Finance is all accruals, which makes results ephemeral.

But good managers of financials are conservative.  That is the thing to look for in financials.  If my two examples above are not enough, it is not wise to buy financials that offer growth, because it often stems from scams, not real growth.

I have seen my share of fakers in this life in financial company management.  Be wary when you invest in financials; there is a reason why they are separate from industrials and utilities.  They are less reliable, particularly in time of stress.

So, to investors that care about what they invest in:

• Analyze acquisitions — most aren’t good
• Scrutinize accounting — most of the devils lie in accrual entries
• Analyze management, if you can — understand their ethics, or lack thereof

I’ve written too long, but consider what I have said for your own good.  It will help you.