March 2011 – Page 3 – The Aleph Blog

Book Review: Eat People

Posted on 4 March 20114 March 2011 by David Merkel

You are either going to love this book or hate it.? Why?? The author’s style is in-your-face, something that I don’t prefer.? I agree with him intellectually, but I develop it differently.? Capitalism is morally good because creates an environment where the one that delivers goods and services that people want get rewarded.

As my son Peter said when he saw the title, “Doesn’t that conflict with Psalm 14, where we are not to take advantage of people, and implicitly “Eat them?”? I said that it had to do with labor productivity, and that the book had a bad title.? There is no way to avoid the troubles from technological change except to become wise about technological change, and benefit from it.? Now, some don’t have good parent(s), but there isn’t much that can be done about that.? There are many coming out of bad situations that have overcome bad beginnings with significant effort.

Th book puts forth the idea that those that deliver the most service get rewarded.? But, there are many ways to do that.? The author focuses on businesses that have been created as a function of low marginal costs via the internet.

Now, am I such an entrepreneur?? My asset management business is only possible because I am reasonably well-known on the internet for honest talk on investing.? I started my business for a small amount of money, and offer asset management services at low cost to upper middle class people.? But I am not going to scale the way that a Google or a Facebook does.? To do that, you have to be doing something entirely new and different, filling needs that people have, but did not know they have.? That is hard to do.

The author has many good points including that vertical integration rarely works, that if you find processes that allow you to do more with fewer people, you will make additional money, and release labor to more productive areas.? He also has some clever ways of categorizing mankind into those that produce and those that don’t, especially affecting politicians who cozy up into crony capitalism, which in the present day is as great of a threat as socialism.

Finally, he focuses on how one locks users into a system that allows the entrepreneur to develop a significant revenue stream, even in the face of torrent sites, etc.

This book is well written for the area it serves.? However, it is not as Rich Karlgaard says on the cover, “Every entrepreneur should read this book.”? No.? Relatively few entrepreneurs will benefit from this book whose businesses are not purely virtual.? That’s where the scaling and low marginal cost come in.? Not every business will be that way.

Quibbles

I found George Gilder’s comments on page 220 to be dumb.? Profits are not a measure of altruism.? Neither the buyer nor the seller is altruistic.? Both are looking for gain.? Profits are a measure of meeting the needs of buyers, relative to the supply of those wishing to meet those needs.

Who would benefit from this book:

Entrepreneurs in the internet space will benefit from this book.? Other who want clever writing about entrepreneurship related to the internet will also benefit.

If you want to, you can buy it here: Eat People: And Other Unapologetic Rules for Game-Changing Entrepreneurs.

Full disclosure: This book was sent to me by the publisher after I asked for it.

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.

csissoko@sissokodesign.c

NO, Buffett is NOT going to buy that firm

Posted on 3 March 2011 by David Merkel

BERKSHIRE HATHAWAY INC.
ACQUISITION CRITERIA

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are ?turnaround? situations),
(3) Businesses earning good returns on equity while employing little or no debt,
(4) Management in place (we can?t supply it),
(5) Simple businesses (if there?s lots of technology, we won?t understand it),
(6) An offering price (we don?t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion range.

We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.

We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer ? customarily within five minutes ? as to whether we?re interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don?t participate in auctions.

Charlie and I frequently get approached about acquisitions that don?t come close to meeting our tests: We?ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: ?When the phone don?t ring, you?ll know it?s me.?

There have been a variety of article recently suggesting what Warren should buy.? Examples:

Well intended as these articles are, Buffett has already said that he needs no advice on public companies.? Buffett is a price-sensitive buyer, and does not pay up for most acquisitions.

Beyond that, until he has bought more industrial companies, and float is scarce, he won’t buy other insurers, cheap as they are.? He has too much cash as it is.

If I were to write an article on this topic, I would look at the largest private businesses in the US, and even some mutual or government owned corporations like the TVA or NRUC, and try to analyze which of them would fit well in Berky.

Berky does best with private companies that want to preserve their culture.? With big private companies, it is less likely to preserve culture, so Buffett acquires a lot of special smaller firms.

But I don’t expect Buffett to buy what pundits are predicting.? It is not his way.

On the Usefulness of Yield Spreads

Posted on 2 March 20112 March 2011 by David Merkel

When I was a risk manager and bond manager for a life insurance company (at the same time, dangerous, but great if done right) I had to have models that drove yields on corporates from Treasury yields.? Initially, I found that I had just eight years of yield data from Bloomberg.? That didn’t seem right, so I went to my boss,? who said, “Call our coverage at Bear and Merrill.? Ask to talk to the “Historian.”? Bear and Merrill are likely to have the longest data series.

So I went and called them and they handed me off to a researcher who had been working with bonds a long time.? The response was, “Computers changed everything.? No one thought in terms of spreads until computing power was cheap enough to calculate spreads.? Assuming that we kept the bond trading data, you probably would have seen prices in dollars as late as the mid-1980s.? No yields.? No spreads.? And the truth is we don’t do a good job of preserving the past.”

This explained why my boss had this antiquated bond calculator at his desk.? Every now and then he would use it.? Me?? I would use Bloomberg, or a model that I built myself.

Ugh.? Okay, so no data.? 96 months will have to do it.? As it was, I noticed that the highest quality bonds had the tightest relationships with Treasury yields, but by the time you got down to single-B bonds, the relationship was tenuous at best.? Betas versus Treasury yields declined with credit quality, as did the goodness-of-fit (R-squared).

Another incident seemed unrelated at the time, but today seems very related — one day I asked the high yield manager what sorts of spreads he looked for in buying bonds.? He told me that he did not trade on the basis of spreads — high yield bonds were quoted in dollar terms.? Spreads were just a fallout, though he added that yield was more important to high yield bonds than spread, particularly in a low interest rate environment — he said that there was a risk to high yield bonds that went beyond the spread.? High yield bonds are risky enough that when nominal yields get low enough, it is probably time to start reducing exposure.

Now, we don’t have any significant data series on high yield bonds.? But we do have one on BBB bonds.? Oh, sorry, we have to speak Moody’s here — Baa bonds.? And, we have the same series on Aaa bonds, available at FRED.

The data series go all the way back to 1919 on a monthly basis, and back to 1986 on a daily basis.? The yields are comprised of noncallable bonds 20-30 years in maturity.? Moody’s did the calculations, and we are all the better off for it.

Now, anyone that does work on the Treasury yield curve knows that the US government made life tough when they withdrew the 30-year back in 2001.? As an aside, when the US government did that, there was a huge grab for yield on the long end.? I sold into it, realizing that the Bush Administration would be offering a lot more debt than the omission of the 30 would eliminate.? I bought much of it back 6 months later for gains.

Both the 20-year and 30-year yield series are incomplete.? That said, Treasury yield curve shapes are pretty limited.? If you have four points on the curve, you can estimate the rest with 99%+ R-squareds.? I created pseudo-data for the gaps in the 20- and 30-year yield series.

I needed both series, because the 30-year series went back to the mid-1970s on a daily basis, and the 20-year series went back to 1953 on a monthly basis.

Anyway here is what I learned when I ran my two regressions:

And then the monthly calculations:

I take some heart that the beta coefficients are very similar, and the residuals are as well.? R-squareds are very high as well.? So what does this tell us?

There is a credit factor that effects yields, and the effect on Baa bonds is roughly 1.5x that of Aaa bonds.
As Treasury yields get lower, Baa bond yields rise at roughly 45% of the rate.? There is the nominal yield need — even Baa bonds tend to need a certain nominal yield, particularly for 20+ year bonds.
Present yield levels are fair for long Baa bonds, to the extent that Moody’s measures them accurately.

Unlike beta calculations, this estimate is consistent across monthly and daily observations.? We can have some confidence here.? Thus I would say be near the benchmark in terms of credit exposure.? And remember, spreads are not the most useful way to think about yields.

Musings on Yield

Posted on 1 March 2011 by David Merkel

When I closed my piece on Warren Buffett’s Annual Letter, I ended with an important statement tat when I read it in the morning, I thought many would find it cryptic.? Here it is:

And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.? Yield is the decision of the company, but what you should? ask is what is the increase in value of the company.? Look for investments that increase your net worth the most.

And I would add “With an eye toward safety.”

When I say there is no such thing as yield, I am overstating a matter to make a point.

Will the debtor make the interest (or principal) payment?
Will the company pay the regular dividend?? Will they increase it?
Will you be able to hold the instrument so that you can realize the yield over the long haul?

During times of stress, yield has a nasty tendency to disappear, often with significant principal losses.? Thus I am skittish whenever I hear someone say that they need to get a certain yield.

Individuals and Institutions, for better, but usually for worse, often rely on getting a certain yield from fixed income investments.

If I don’t get this yield, I won’t be able to meet my monthly expenses.
If I don’t get this yield, my quarterly earnings will miss.
If I don’t get this yield, our ability to support our charitable endeavors will suffer.

Sigh.? Look, this could have been entitled “Education of a Corporate Bond Manager, Part 13,” but I didn’t because this is more broad and important.? It affects everyone.

Once there are no wages/nonfinancial profits, investors usually move into a yield-seeking mode.? I experienced this in spades for the insurance company that I helped to manage money for.

And yet, in the midst of the furor 2001-2003, we often acted against the insurer’s wishes in order to save their hide.? Particularly me; I could not bear doing the wrong thing, thinking that I would have the failure of an insurer on my conscience.

So in the midst of the nuttiness of 2002, I often did up-in-credit trades, reducing complexity trades, etc., when the market favored it.? Lose yield, gain safety, when the market is hot.? (Not when it is cold.)

I preserved the capital of the insurer, and it survived.? I even made extra money for them in the process, which they wasted on writing underpriced annuity business.

There was no level of yield that could have satisfied that client, even assuming that we could get it with safety.

But now as I start my asset management business, I deal with clients that are aiming for a certain yield.? To my surprise, even my Mom, the one who taught me the rudiments of investing is seeking for yield now.

You might or might not recall that the fourth real post at this blog was entitled Yield = Poison.? There are times to look for yield, and times not to.? The times not to are when yields and spreads are low.? At such a time, the best decision is not to reach for yield, but rather to forgo yield and preserve capital.? Buy TIPS, foreign bonds, and move up in quality and down in maturity in dollar terms.

I did this for an internal client 2004-2007, and made money for them, but it was utterly unconventional.? They could afford to deal with my idiosyncracies, because they didn’t need a current yield.

So, as I move to offer a fixed income strategy, I find myself butting heads with those that want a reliable income from bonds, and other fixed income instruments.? I’m sorry, but preserving principal is more important than getting yield.? Far better to eat into principal a little when spreads are tight, than to meet the spread target and get whacked in the bear phase of the credit cycle.

So, do I have a market for such investing in bonds, or is human nature so unchangeably mixed up that there will be few if any takers for my fixed income management?? Sadly, I think the answer is the latter.

Critical Analysis of Buffett?s Annual Report

Posted on 1 March 20111 March 2011 by David Merkel

After reviewing what I wrote Saturday night on Buffett’s Annual Letter to shareholders, I said to myself, “That wasn’t very critical.”? Now perhaps I have less to criticize him over — he isn’t boasting about risk free retroactive profits, or being a significant player in life settlements, two things I find morally dubious at best.

But today I reviewed the Annual Report and the 10-K.? The two are very similar; I will only mention one thing from the 10-K, but that one thing is big.

But let’s start with basic blocking and tackling.? Start with the income statement, balance sheet, and cash flow statements of Berky.? The balance sheet and income statements split out by division, but the cash flow statement does not.? The cash flow statement has the fine distinctions for the company in aggregate, but the income statements and balance sheet do not.

I want the best of both worlds. I want the cash flow statement segmented, and I want enterprise-wide income statements and balance sheets for Berky, with fine levels of detail.? I want those without eliminating what is being done now.? That would not be a lot of extra work, and it would only add a few pages to the 10-K — the work is probably done already; all that needs to be done is the formatting.

Notes

1) Berky trades at 1.9x tangible book.? Not saying that it is fair or unfair.? It is what it is.? (When one of my kids says that, I reply, “Except when it’s not.”)

2) From page 44, Buffett made some tremendous deals during the crisis, but the lesson here is to have dry powder.? Buffett made great decisions with respect to Goldman Sachs, GE, Dow Chemical, Swiss Re, and Wrigley.

3) On page 50 there is positive prior year reserve development for the last three years.? I don’t know how far that goes back; I will have to research that.? But as I reviewed their reserving policies, I thought they were more than reasonable.? They seemed to be a good mix of methods and judgment.

4) I don’t fault Buffett on derivatives.? One can use them wisely while decrying their stupid use.

Where I have more difficulty is trying to justify the amounts on the balance sheet.? My view of level 3 assets is that those holding them should spill the calculations in detail.? We don’t have that here with Berky, though it is better than many companies.

That Berky does not have to post collateral for the most part is significant, and lends to their creditworthiness.

5) Statutory surplus had to increase at the main P&C insurance subsidiaries, because of the acquisition of Burlington Northern.? Why?? I’m not sure.? Ideas?

6) On page 60, the expected return assumption should not have risen 2009 to 2010.? 7.1% is too high as a long-term assumption — something in the 5-6% range is reasonable.

7) Berky is half an insurance company, and half and industrial/utility company.? It is neither fish nor fowl, and that is what helps make analysis difficult.

8 ) If I were made President/COO of Berky, would I centralize hiring and procurement?? No, but I would hesitate before answering.? Berky is so unstructured, that there have to be some gains from centralizing, but that said, you don’t want to negatively affect the culture of Berky, which allows acquisitions to continue as if they had not been acquired.? That might be changed cfter the death of Buffett, but who can tell?? There is a competitive strength in Berky for leaving operations alone — many sellers who love their employees like that.

9) ?We view insurance businesses as possessing two distinct operations ? underwriting and investing.? So it says on page 68.? And how beautiful, underwriting gains every year in every segment.? I have not traced the history here, though I know that Berky has been better than most companies.? I would only note that the value of float depends on how long the float exists.

10) On page 70, Buffett admits that Workers Comp and other casualty have not done well, which is rare among the lines that have done well.

11)? On page 71, he admits that terms are not generally attractive for life business.? Also oddly, there are no life premiums earned in 2008 and 2009, but losses in both years.? I don’t get this.

12) On page 74, the allocations to junk debt seems too high, though I might make that bet as well.? Where else do you go in this environment?? The high allocations to foreign debt I suspect are there to immunize Berky on foreign liabilities it has written.

13) Page 76 contains what I think is the core strategy for Berky — Inflation-protected investments in regulated industries funded by the short-term float generated from writing P&C insurance.

14) Page 78 shows how economically sensitive “other manufacturing” can be for Berky, in that profits doubled over 2009.

15) Page 79 — The change in NetJets was the decisive factor as far as changes in the profitability of Berky’s service businesses.? Score a big one for David Sokol.

16) Page 81 — the discussion on impairment of equity stakes is fascinating, but I think it would all be easier if Buffett just valued everything at market.? Who cares at what level you bought it?? The important question is for what can you sell it?

17) The Contractual Obligations exhibit on page 84 made me edgy, because total obligations are large relative to assets.? Then I took a step back and said, “But that’s the nature of liabilities, and the difference between that and the value of liabilities is not large.”? All that said, review my second risk factor at the end of this article.

18) On page 94, it reveals that Berky is mismatched short, assets versus liabilities.? That is a bet that I would take as well, but it is a bet.?? In a depressionary scenario, it would get pinched.

19) On page 97, he lists his “owner related business principles.”? I am an admirer here — the ethics are excellent, relative to the rest of our financial markets.? If I wee summarizing much of it I would say:

Ignore the accounting if it doesn?t represent the economic reality.
Act like an owner.
Lumpiness is normal for good investments.? Don’t look for smooth results.

20) I appreciate the humility that Buffett displays on point 9 of his principles. He didn’t phrase it right, and now he has corrected it.

But now for what should be at the top of what Warren writes:

The Two Real Risks for Berky

From the 10-K on page 19:

Insurance subsidiaries? investments are unusually concentrated and fair values are subject to loss in value.

Compared to other insurers, our insurance subsidiaries invest an unusually high percentage of their assets in common stocks and diversify their portfolios far less than is conventional. A significant decline in the general stock market or in the price of major investments may produce a large decrease in our consolidated shareholders? equity and under certain circumstances may require the recognition of losses in the statement of earnings. Decreases in values of equity investments can have a material adverse effect on our consolidated book value per share.

If I were Buffett, I would put this on page one of his shareholder letter, because this is the biggest risk.? No other insurance company in the US takes as much equity risk as Berky.? Buffett is a great investor, but in a Great Depression scenario, Berky could be a zonk.

The second risk is more quiet and insidious.? Debt has grown where the Berky parent company is on the hook, whether directly, or by guarantee, as at the finance subsidiary.? This was AIG ten to fifteen years ago.? The initial increase in debt was innocuous, but it led to more increases in debt.? After 20 years, AIG was overindebted both in cash terms and synthetically.

What I am saying is that once the discipline against debt is breached, it becomes easy to justify more debt.? I think we are seeing that now, and Buffett is compromising his principles.

Hey, Greenberg eschewed debt for two decades, and then piled it on for two decades.? Is Buffett doing the same thing?? Personally, I think he is, though I don’t think he has thought it through.? Warren, if you are reading me, pull back on the debt.? It killed Hank.