August 2011 – Page 2 – The Aleph Blog

That’s Mister Buffett to You, Lady!

Posted on 20 August 201121 August 2011 by David Merkel

In my e-mail, I received this tawdry message:

Hi David,

Why is every so in love with Warren Buffett and his financial advice? He used to be a great investor. Not anymore.

Here’s a good article I saw on it from a newspaper in Oregon while I was on vacation there.

http://www.salem-news.com/articles/may182011/warren-buffett-bg.php

That’s Mister Buffett to you, lady.? The garbage article you cited doesn’t have the faintest idea of what Warren Buffett does.? Warren Buffett is not a mutual fund manager, he runs a conglomerate with a real balance sheet and real profitability.? With his friend Charlie Munger, they are wiser than 99% of all the investment advisers out there.? I have my criticisms of Mr. Buffett, but they regard ethics, rather than talent.? Warren needs to repent, he doesn’t need more talent.? There is a difference.

But as for the lousy article, what has the S&P 500 earned over the last ten years — around 1%.? Guess what, of all the big stocks that BRK owns, they have done better than that.? It is irrelevant to cite companies so small that it would not make a difference to BRK if they took a position at favorable prices.

The greater problem is that the article does not understand what Berkshire Hathaway is.? It is an insurance company that owns a lot of businesses.? Whole businesses, not parts of them.? That is 80% of what he does, the rest is like managing a huge mutual fund.

Think of Buffett as a private equity manager with a reputation for not intruding on acquired company cultures.? He is the best place to sell a profitable business to where you want to leave the people you employed intact.

That is a clever niche strategy for private equity.? Give the Buffster some props!

Warren Buffett is deservedly one of the greatest investors of all time.? He made the transition from hedge fund manager, to CEO, but really an investment manager, to CEO of a conglomerate.

Those are three different skills, and Buffett has proved adequate to meet all of the challenges, even after reaching “retirement age.”

I tell you, avoid the envy of articles that want to downplay the results that Buffett has achieved.? He is a master, together with his team, and more than able to manage his company well.? Ignore the naysayers who don’t get it.? Listen to value investors.

The Folly of Large Acquisitions

Posted on 20 August 201121 August 2011 by David Merkel

One of my portfolio management rules deals with use of free cash flow.? I have a hierarchy of how I would like managements to use cash and free cash flow:

Pay down debt; eliminate preferred stock.
Grow existing business organically.
Do small acquisitions adjacent to what the firm is doing, that improve marketing efforts, technology, lower costs, add new geographic markets, add complementary products and services, etc., and then grow those organically.
Buy back stock when it is under the conservative estimate of what the company is worth.
Pay dividends at a level where you can grow them in the future at a reasonable growth rate.
Do a large acquisition that does not materially change the business model, at a fair price.
Do a large acquisition that does not materially change the business model, at a sugar daddy price.
Buy back stock at the current market price regardless of valuation.
Do a large acquisition that materially changes the business model, at a fair price.
Do a large acquisition that materially changes the business model, at a sugar daddy price.

In one sense, aside from step one, this list goes from hardest to easiest.? There are many who think they can add value easily through financial engineering.? Financial engineering means more debt, and that is what led us into this crisis.? I like the companies I own to run with a reasonable margin of safety, but not a huge margin of safety.? Financial engineering is the easiest strategy around, and the rewards of using it are limited.

It’s hard to grow a business organically, particularly in an environment like this where demand is not growing.? The best managers still find ways to grow, without resorting to huge mergers.

Small acquisitions can be very wise for large companies, if they can use the new resources to improve their overall organic growth.

But that’s not the way that lazy, self-aggrandizing CEOs think.? “We need more scale.”? So overpay for a competitor.? For similar companies, there are always cost savings, perhaps some market power, but rarely any other advantages.? Realize the government will be watching more closely, and that there will be some intra-firm rivalry for a few years.? I’ve been there, and I know.

What’s worse is when the CEO decides for a large change in strategy in order to grow faster, and pays a sugar daddy price for a rapidly growing company in a very different business, where the synergies with the existing business are questionable.

I avoid companies that do big acquisitions, unless it is like Buffett, where he does not overpay, or like Exxon/Mobil, where the companies are so similar the it does not matter.

Thus the foolishness of Hewlett Packard.? They had a great culture, and lost confidence in their ability to innovate.? They brought in a series of poor managers — Fiorina, Hurd, Apotheker… it would have been better for the company to sell their PC division to Compaq, rather than buying Compaq.? Hurd manipulated the accounting results.? Apotheker has scores to settle, and wants to beat Oracle, though beating Oracle might have been core for SAP, it should not be for HPQ.

Avoid buying companies that are acquisitive; it is a road to losing money.

Full Disclosure: long ORCL

The Predictions of Michael Pettis

Posted on 20 August 2011 by David Merkel

I learned a lot when I read the book, “The Volatility Machine.”? You will too.? You can buy the book here.? Sorry, it is expensive, because there are few copies relative to demand.

In his weekly e-mail, he decided to highlight twelve questions where he would offer predictions.? Here they are:

BRICS and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis.

Over the next two years Chinese household consumption will continue declining as a share of GDP.

Chinese debt levels will continue to rise quickly over the rest of this year and next.

Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.

Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.

If the PBoC resists interest rate cuts as inflation declines, China may even begin slowing in 2012.

Much slower growth in China will not lead to social unrest if China meaningfully rebalances.

Within three years Beijing will be seriously examining large-scale privatization as part of its adjustment policy.

European politics will continue to deteriorate rapidly and the major political parties will either become increasingly radicalized or marginalized.

Spain and several countries, perhaps even Italy (but probably not France) will be forced to leave the euro and restructure their debt with significant debt forgiveness.

Germany will stubbornly (and foolishly) refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.

Trade protection sentiment in the US will rise inexorably and unemployment stays high for a few more years.

I agree with these, and then some.? I do not fear the actions of China.? In debt crises, the debtor is usually favored.

Book Review: The Era of Uncertainty

Posted on 19 August 2011 by David Merkel

Many fundamental investors have been shaped by Peter Lynch.? Invest from the bottom up.? Analyze companies, not the economy. Time spent on analyzing the economy is wasted time.

This book takes the opposite approach.? If you understand the economy, and think you know how GDP growth and inflation will go, you have a better chance of choosing the right industries and outperforming.

Like my methods of investing, he looks to understand where we are in the business cycle.? After that, look for good companies that exploit the tailwind.

I became familiar with the main author in the mid-2000s, when he worked for ISI Group.? I appreciated his approach to the markets, which was similar to mine, as the bubble grew, and he and I warned about it.

Think of it this way.? If you had been reading the main author in mid-2006, and had listened to him, how much better off would you be now?? Considerably better off and I offer many warnings over at RealMoney.com before the crisis emerged.

The book will help you understand the sectors and factors in the market that affect returns, and what elements lead those returns.

Beyond that the book expresses skepticism over many of the current economic policies of the US and other governments amid the overindebtedness of much of the world.

At the end, rather than saying, “This is what you should do,” the book asks what your views are, and says if you believe in “such and so” as an economic future, this is what you ought to do.

I liked the book a lot.? I think it is of value to most fundamental investors.

Quibbles

None

Who would benefit from this book: Most fundamental investors could benefit from this book.? If you want to, you can buy it here:?The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground.

Full disclosure: The publisher sent me a copy of the book for free.

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.

Leverage Isn’t Free

Posted on 18 August 2011 by David Merkel

I’ve been running across an idea that outperformance is possible with safe assets, so why not take those assets and lever them up until their volatility is equal to common equities, and earn more at the same level of volatility?? That was my only significant disagreement with the book Expected Returns.

I think this is a stupid idea.? (I don’t favor the CAPM either.)? When you borrow money to buy some asset, the distribution of possible returns changes.

Let me give you some analogies.?? First, securitization.? Those that invest in non-senior loan tranches get an enhanced yield, but they face a different risk profile than most corporate bond investors.? Corporate bond investors have a high expectation of full payment, but when default occurs, they lose 60-80%.? Investors in securitized bonds rarely get recoveries.? They usually get paid in full or lose it all.

Second, think of banks or REITs.? They lever up safe assets, and they blow up with a higher frequency than do industrial corporate bonds.

Leverage changes the nature of the distribution of possible returns in three ways:

The cost of borrowing decreases the return.
The returns are levered by the amount of borrowing.
To the degree that others do the same thing, the strategy is no longer undiscovered, and superior returns should not be expected.? In a crisis, the borrowed money leads to overshoots as panicked investors bail out en masse.

Personally. I wish we could get rid of the writings of academic economists and finance writers that don’t actively invest.? They don’t get the dynamics of investing, and assume a simple world that does not resemble our world.

My main point is that trying to buy the asset class with the highest return after equalizing volatilities is a fool’s bargain.? Adding leverage changes the nature of decisionmaking, and what tests in the lab will not likely work in real life.? Paper trading does not always translate to real world profits.

Hypocritical Buffett

Posted on 16 August 2011 by David Merkel

Computer-wise, things haven’t been going my way lately.? My laptop seemingly died this evening, and my Gmail account has hacked by Chinese hackers last week.? Apologies to those who got spammed by my Gmail account as a result.

But that doesn’t mean I can’t keep going.? I backed up all of my files on Saturday, and I have my most commonly used files backed up in real time by Microsoft Live Mesh.? It’s inconvenient, but the data is safe, and I can keep working and serving clients.

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Almost everyone argues their interests on tax reform, excluding me, but including Buffett.? Buffett is in favor of increasing taxes that he doesn’t pay.? Estate tax?? Buffett isn’t paying it, he’s giving his fortune away to the Gates foundation, largely.? Income tax?? Relative to the increase in his net worth, Buffett pays almost nothing in taxes because we don’t tax stocks until a dividend is paid, or until some stock is sold.? What’s more, BRK has a $38 billion deferred tax liability, which measures taxes that would have been paid on GAAP income, but weren’t paid because taxable income was lower for reasons that may revert, someday.

Thus, I say Buffett is a hypocrite on taxes.? Let him argue for the following:

Unrealized gains on assets should be taxed each year, for corporations, partnerships, and individuals.? Losses should receive deductions.
Eliminate deductions/credits from the personal and corporate tax codes.? We could eliminate the deficit instantly with that one simple change.? Don’t use the tax code for social engineering.? Much as I favor a Balanced Budget Amendment, perhaps a “No Social Engineering” Amendment would be better.? Or an amendment that incorporates my anti-gerrymandering idea.
Tax corporations on their GAAP income, or better, whatever they represent to investors as the true increase in period-to-period net worth.
Add in an EBITDA tax on private equity, and everything like it, such that we assume a 15% ROE for tax purposes that trues up when the partnership closes.? Everywhere, make the tax basis equal to GAAP, or modifed GAAP, where it exists.? Where it doesn’t exist, make the taxes punitive enough that adopting GAAP is preferable.

With the present tax rates, implementing all of these would put the budget in a decided surplus, WITHOUT RAISING RATES.? You would even eliminate the estate tax, because estates would finally be taxed year-by-year.? The tax code would then be close to fair, like it was with TRA ’86.

But there is one place where I agree with Buffett entirely:

People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what?s happened since then: lower tax rates and far lower job creation.

Taxes affect business decisions when the definition of taxable income gets changed or credits get offered.? I’ve seen it working on section 42 housing credits, and in insurance company accounting.? I’ve seen it with private equity; I’ve seen with clever investors that max out debt while growing net worth.

In that sense, the definition of income, and the offering of credits make a huge difference in the behavior of those taxed.? But within reason, tax rates don’t make that much difference.? Yes, up 10%, there will be some effect on economic activity.? The bigger changes come from deductions and credits.

You want a pro-growth tax code?? Eliminate the deductions, credits, and deferrals.? Tax us year-by year on an estimate of our increase in income including unrealized capital gains and losses.

Yes, there will be unemployed accountants, actuaries, attorneys and administrators.? But the system as a whole will be better off, and for once, who will argue in favor of preserving the nation, and ignoring special interests?

What Buffett suggests will get little in the way of results.? A focus on defining income properly will bring in more than sufficient taxes, and especially from Mr. Buffett, one of the least taxed relative to the increase in his net worth.

The Rules, Part XXIV

Posted on 13 August 201114 August 2011 by David Merkel

Every excess eventually unwinds.? When an excess unwinds, the fall gets exacerbated by trend-followers blowing out of mutual and other pooled funds with lousy relative performance.

If you had a list of who owned a given publicly-traded asset, and when they bought it, you would know a lot about how patient, intelligent, indebted, etc., the holders of the assets are.? That would give some insight into how they might behave if the asset’s price began to fall.? Would they buy more as it went down, or would they sell in a panic?

Now no one has this data, but some approximate the data by a variety of measures.? Dollar volume traded as a fraction of market capitalization is a measure of speculative activity, though truly, I suspect that the holders of most stocks fall into two camps — long-term (years), and short-term (days to months).? Short-term has gotten shorter as computer power has democratized trading.

We can also read the lists of holders from 13F data.? Managers are pretty consistent.? If they are low turnover, they tend to stay that way.? The same for high turnover.

The holders of mutual funds tend to be late to the news.? There are two reasons for this:

They aren’t paying close attention because the results of mutual funds give slow and unclear signals, which only become clear when the quarterly statement arrives.
Because of loads, and brokers who sold the investors on the funds, regret causes reactions to be slow.

But these holders are late liquidators, and cause funds with bad investment strategies to sell some of their favorite wrong investments, which drives the prices of the investments down further.? This can cause assets to overshoot below their fair value, which value investors quietly accumulate.

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Long horizon investors tend to resist momentum.? Short horizon investors tend to follow momentum.? Long horizon investors tend to have little short-term need for results.? Short-horizon investors want/need results soon.? At bottoms, long-term investors dominate.? At tops, short-term investors dominate.

Mutual funds are in general short term investors, but the few that try to educate their investors that they are long term value investors do get more patient holders, which gets reinforced if the returns are good over a long period.

Book Review: Expected Returns

Posted on 12 August 2011 by David Merkel

How do we estimate what returns are reasonable to expect?? Most investment counselors fall back on easy rules of thumb, but is there a way of doing better?

In this book, the author takes academic research on investment returns, and tries to make it practical.? What are the main findings of the book?

Momentum works.
Value works.
Illiquid assets can work very well if you have a balance sheet that can hold them.
Carry strategies work most of the time, but when they fail, they fail big.? Same for strategies that sell volatility.

The book does a very good job in establishing that the excess returns of stocks over bonds are a lot lower than most believe.? It also supports the idea that moderate risk taking is the superior strategy.? Those that take high risks lose too often.? Those who take no risk don’t make anything significant.? Moderate risk-taking is the sweet spot.

One of the strengths of the book is that it considers almost all assets, and analyzes how many factors affect those asset classes.? The book is comprehensive; it covers everything, even if it is only an inch deep in spots.

I liked this book a lot, but it’s not for everyone.? You won’t find a lot of difficult math here, but you will find a lot of numbers.

Quibbles

I don’t agree with the idea of levering up low risk assets.? Yes, if you are? the only one doing it, fine, be a non-regulated pseudo-bank.? The trouble comes when many do it.? Eventually a liquidity crisis hits, and those levering up low risk assets get hosed.

The same is true of university endowments.? Too many thought it was easy money to invest in illiquid assets, and when the liquidity panic came in 2008-2009, they were forced to borrow, and/or sell illiquid assets at an inopportune time.

The book does cover everything, but it doesn’t cover everything deeply.? I think it is a valuable book to most who do asset allocation, but the author knows his limits, and does not claim to be expert in a number of areas.

Who would benefit from this book: Fundamental investors who want to understand the factors behind return generation can benefit from this book.? If you want to, you can buy it here: Expected Returns: An Investor’s Guide to Harvesting Market Rewards (The Wiley Finance Series).

Full disclosure: The publisher sent me a copy of the book for free.

High Volatility, but not Peak Volatility

Posted on 12 August 2011 by David Merkel

The graph above is the S&P 500 on the right axis with a logarithmic scale, and 4-, 6- and 20-day average absolute percentage price change on the the left axis, linear scale.? As you can see, high price volatility is associated with bear market bottoms.

In terms of 4- and 6-day volatility, this market ranks third in the last 61 years, behind 1987 and 2008.? Wait another three weeks for the 20-day volatility, it could be competitive with 2008 and 1987.? 1987 was sharper and shorter than 2008 because there weren’t any systemic risk issues involved, as there are in 2008 and 2011.

Isn’t it fascinating that the volatility level is so high now — what makes this period of time so special compared to the overvaluations of 1987 or the overleverage of 2008?? I think it is overleverage again, though valuations are somewhat high.

Stagflation-Plus

Posted on 11 August 2011 by David Merkel

I do not agree at all with modern Keynesians who lacked the restraint of Keynes.? Deficits are supposed to be temporary not structural.? Loose monetary policy is supposed to be temporary, not lingering.

Many policies can “work” when governments have the capacity to take on more debt without harm.? We are past that point now.? Additional debt builds up a larger problem, that will result in a greater crisis later.

There is no escape.? There will be a crisis.? Do you want a smaller crisis sooner, or a bigger crisis later?? The actions of our government say, “A bigger crisis later, much bigger and later if possible.”

Much of the inflationary pressure we face today is from two sources:

Loose monetary policy globally
Increased demand for food and energy globally.

We’re a one-world economy, sort of, so demand from growing middle classes in developing countries affects our prices.? But they also deflate our wages as they compete with us for transferable work.

Thus stagflation.? Our economy does not grow because we have taken on too much debt.? Consult Reinhart and Rogoff, but beyond that, know that overindebted consumers and small businesses are anemic in economic terms.

Now toss into the mix the idea that the Fed won’t raise rates for two years.? Inflation has risen over the last several years, what will they do if it rises further?? I see inflation rising from here, but not real growth.

This is one reason why I think Ben Bernanke is an intelligent idiot.? Intelligent?? Of course, he can speak about many things in economics and it satisfies many.? Idiot?? Well, he is not a critic of his discipline.? I would be far more gentle if he were not granted so much power.? After all, I don’t care much about what sideline loonies like Paul Krugman think.? What, do people read the New York Times?? How obscurantist.? Newspapers are the past.

If you are not a critic of neoclassical economics, particularly after the 2008 crash, you aren’t thinking.? The models did not consider the the effects of a big buildup in debt across the economy. They were debt-neutral, which was a big mistake.

Debt affects the incentives of people and makes them more timid.? They don’t want to go broke, and that is far more likely in an indebted economy, where the debts are layered, and the government does not want to take on more costs because they are too indebted already.

Those following simple Keynesian models get things wrong when borrowing parties are overindebted, because every debt involves a promise to pay that other parties rely on.? Overindebted entities do not buy or borrow freely, because they would endanger their rickety solvency.

Let me boil it down to simple ideas:

The world is growing, perhaps more slowly but more rapidly than the US.? That forces inflation up.
There are many people in the world competing against US laborers, forcing wages down.
Developed markets like the US have borrowed too much, and have punk demand as a result.? They can’t borrow as much to buy more.

That’s our economy now.? We face rising prices for consumption, turgid asset prices at best, and the debt burden holds us back.