Mr. Kneale

My investment post will have to wait. The reason, I’m afraid, is Mr. Dennis Kneale.

A few days go, this CNBC news anchor – who, incidentally, does not have a business, finance, or economics degree – made a statement to the effect that the recession was over, and that the worst was far behind us: better times are here, and people should embrace “the hope”. Although this blog rarely criticises individuals outright, I felt strongly about writing a piece proposing a response to Kneale’s statement. I’m not predicting a continuation – or end – of the recession, I’m simply pointing out that investors should be cautious, especially since the markets have rallied over 40% in only 3 months.

In his segment from the 25th of June entitled: “The Recession is Over”, Kneale examins recent data, and points out the bullish implications for both the economy and the stock market. However, for someone who often criticises his opposition for lacking hard evidence to backup their claims, Kneale has very few tangible  facts – and uses the ones  he has in an extremely biased and misleading way (imho). His “pile of data” includes only 4 indicators, many of which are lagging. Oddly enough, he doesn’t mention a single indicator that the NBER (National Bureau of Economic Research) uses when examining recessions; he goes on to talk about Durable Goods, Capital Goods, Stocks and Consumer Sentiment.

Firstly, increases in Durable and Capital Goods orders are perfectly normal in this type of situation, and do not signal the comming “party” Kneale describes. It is a matter of inventories: businesses decided they had too much “stuff” in warehouses, so they slashed production well below final sales. Correspondingly, what we’re seeing is likely the result of the end of this de-stocking process, and start of a “re-stocking” one. Interestingly, both of these indicators describe business spending metrics, and not consumer spending metrics. Given that US GDP, in terms of aggregate demand, is approximately 70% consumption based, it would have been more appropriate to discuss consumer spending, or retail sales.

What about consumer sentiment? Often, in the past, in has been made clear that consumer sentiment is not a consistent and valid measure of future economic and business activity. Further more, it is extremely fickle; for instance, in late 2007, consumer sentiment was almost at an all time high, right before the economy began its largest recession in 70 years. Also, given the massive amount of consumer debt, decline in real wages, unemployment etc., even if consumers do feel better about the economy, can they actually afford to spend meaningfully? (where are they going to get the money to spend?)

Then there is the question of the stock market, which has rallied 40% from the lows. We must remember that the stock market is a discounting mechanism, and “prices future events in”. At this point, the market is clearly pricing in a sustainable V shaped recovery. If this does not come to be, we can expect this “indicator” to decline heavily.

In my opinion, Mr. Kneale has succumbed to some of the investment field’s most common biases: confirmation bias (the tendency to search for or interpret information in a way that confirms one’s preconceptions) and expectations bias (the tendency for experimenters to believe, certify, and publish data that agrees with their expectations for the outcome of an experiment). Also, he conveniantly shows data month to month, and only for the past few months, thus neglecting to show that the recent increases are very small relative to previous levels – and the large declines throughout 2008-2009. As an example, if a company’s earnings decline from $1 billion per year to $100 million, and then rise to $140 million, I would call that improvement. If I showed an investor the past few months of data, showing a 40% increase in earnings, he would probably be excited; that is, as long as I didn’t show him the prior year’s levels and decline. This, in effect, is what Kneale has done with his data, limiting it to the past few months. It is  essential that an investor examine data on longer timeframes, to get a more accurate picture. Mr. Kneale has, in fact, manipulated his audience via this extremely short term picture.

Investors should try to be as unbiased as possible when examining data, by using the most commonly accepted indicators for particular circumstances. As Mr. Kneale focused only on recent data, most of which is less relevant than those I am about to discuss, I will also use a shorter term timeframe (the longer term would require much more time, and would only serve to paint an even more dire picture. Let’s try to stay somewhat “positive”).

So, what data is mostly commonly used for measuring recessions?  The NBER uses 5 metrics:

• GDP
• Industrial Production and Capacity Utilization
• Retail/Wholesale Sales
• Real Earnings
• Employment Situation
  

Let me start by briefly describing each of these, and why they are extremely relevant in determining the future state of the economy.

• GDP: This is one of the most important indicators of all, and is released quarterly. The gross domestic product (GDP) is a basic measure of an economy’s economic performance, it is the market value of all final goods and services made within the borders of a nation in a year. The source is the BEA and the report is released at the end of the quarter (3 month period). Link

• Industrial Production and Capacity Utilization: A very important indicator which often has an effect on the market. It is a measure of the change in production of the nation’s factories, mines and utilities. It also includes a measure of their industrial capacity and how much of it is being used (commonly known as capacity utilization). The level of industrial production divided by the level of industrial capacity equals the capacity utilization rate. The headline numbers are the percent change in production from the prior moth and the capacity utilization rate. The source is the Federal Reserve and the resport is released in the middle of the following month, around the 15th. Link

• Wholesale Survey: The first report of the month on consumer spending; capable of big surprises. Consumer spending makes up 70% of all economic activity in the US, and retail sales account for around 1/3rd of that. If consumers can keep cash registers ringing, it is a sign of overall economic growth and prosperity. Retails sales has some shortcoming though; it represents only spending on goods, such as those found at department stores, gas stations, and food service providers such as restaurants. The report tells us nothing about what’s being spent on services such as air travel, dental care, insurance etc. Also, retail sales is measured only in nominal dollars, which means that no adjustment is made for inflation. It is computed using surveys sent out randomly to 5000 large and small retailers around the country. The government receives a certain percentage back and releases an advanced report. Another 8000 retailers are surveyed a few days later, and a revised report is released, usually four weeks later. Wholesale numbers are, for the reasons described above, a better metric, and are used by the NBER. The source is the Bureau of the Census, Department of Commerce. The report is released about two weeks after the month ends. Link

• Real Earnings: This indicator represents real income. Data on average weekly earnings are collected from the payroll reports of private nonfar establishments. Earnings of both full-time and part-time workers holding production or nonsupervisory jobs are included. Real average weekly earnings are calculated by adjusting earnings in current dollars for changes in the CPI-W. The source is the Bureau of Labor Statistics. It is released mid-month. Link

• Employment Situation Report: The most eagerly awaited news on the economy, which measures if jobs are being created and the situation of American workers. It has great economic and political significance for various reasons: the more workers there are and the more they earn, the more they can buy and propel the economy forward. The report is rich in detail about the job market and household earnings, both of which are drivers of economic growth. It is computed using the Household Survey and the Establishment Survey. The source is the Bureau of Labor Statistics, Department of Labour. The report is usually released the first Friday of every month. Link

Now that we know what each of these is, let’s examine the most recent data in each category (the June reports have not all been released as of right now. I will update the post when them become available):

• GDP: decrease at an annual rate of 5.5% in Q1
• Industrial Production: decrease of 1.1% in May (capacity utilization dwn. to 68%)
• Wholesale Sales: decrease of 0.4% in May
• Real Earnings: decrease of 0.3% in May
• Employment: Unemployment increased to 9.5% in June (with non-farm payroll cuts at 475k, compared to the 350k estimate)

Simply put, none of the 5 indicators used by the NBER point towards an imminent recovery, or the “end of the recession”; not one. Now, it must be said that some are declining at a lower pace, however, they are still declning; until they begin to rise, we must be very cautious about the so-called recovery. Above all, we must avoid making brash statements with carefully selected and less than relevant data (Mr. Kneale).

I’d like to talk, briefly, about recessions, as there are in fact different types. As described recently by Karl Denninger, the types of recessions are inventory driven recessions, the most common, and credit driven recessions.

“Inventory-driven recessions are primarily about excessive industrial capacity for demand.  That is, manufacturers and suppliers of services get too bullish about prospects, build too much capacity and inventory, and wind up engaging in a destructive price war in an attempt to “win”.  This drives down profits and ultimately forces the weaker firms out of business, ergo, recession – GDP and employment decline.  Having cleansed itself of the excess, the economy recovers.   The trigger for these recessions is often (but not always) an external shock such as the oil embargo in the 1970s or the collapse of the Internet fraud-and-circuses games in 2000.

The second sort of recession is a credit-driven recession.  Excessive credit creation – that is, loans going too far toward “fog a mirror” qualifications (and in some cases, such as the most recent event, actually reaching “fog a mirror”) drives one or more asset bubbles.  These pop when effective interest rates in the economy reach an effective level of zero, usually because the amount of leverage available becomes for all intents and purposes infinite (Bear and Lehman at 30:1, Fannie/Freddie at 80:1, AIG at god-knows-what, and duped “home buyers” buying with zero down for a true infinite leverage ratio.)  This excessive credit creation drives a speculative asset bidding war which in turn causes prices to go sky-high for one or more types of asset.

The latter sort of recession is triggered because the cost of borrowing money is never actually zero, even if people pretend that it might be.  As a consequence the lenders begin to earn a negative spread and lose actual purchasing power.  This is an unsustainable situation because cash flow cannot be fudged nor can anyone sustain a negative cash flow for very long; no matter how much you start with if you spend more than you make eventually you go broke.

Recessions cannot end until the conditions that caused the recession are removed from the economy.  This is elementary logic and obvious to anyone with an IQ larger than their shoe size.

For an inventory recession growth returns when enough capacity is destroyed through layoffs and inventory selloffs to bring capacity and demand back into balance.  Employers then hire new workers and the economy recovers.

For a credit recession, however, there is a much larger problem: The reason real interest rates went negative is that debt has a carrying cost and consumes free cash flow; so long as the debt taken on in the credit binge remains the cash flow impact also remains.

Default and bankruptcy clears excessive credit (debt) from the system – if it is allowed to occur.  But if it is not, then the bad debt remains on the balance sheets somewhere and the cash flow impact remains in the economy.  Employment remains weak, capital spending restart attempts falter as demand fails to return and credit quality continues to remain insufficient to support new credit demand.

The consumer is 70% of our economy, give or take a few points.  The consumer’s “savings rate” (which government blithely declares as income minus spending), which was in fact negative (that is, consumers were spending more than they made through taking on more and more debt), but is now solidly positive at 6.9%.

The impact of this (6.9% X 70%) is an immediate 4.83 decrease in real GDP. This is the math, and the math is never, ever wrong.

The truly bad news however is that most of the time saving in fact turns into capital formation – that is, it becomes investment.  But government doesn’t differentiate between actual savings and debt repayment – their formula is simply “income less spending = savings rate.”

Consumers are not saving, they are paying down debt in a furious attempt to avoid defaulting on nearly $1 trillion in outstanding credit card balances that have gone from 11% interest to 29.6% along with OptionARMs that are experiencing a tripling of payments while the home’s value is underwater and precludes refinance, all while consumers are being laid off by the hundreds of thousands monthly.”

I hope this makes the current situation clear (er). I remain very cautious in the current environment, and whilst I think that a slight recovery is possible by the end of this year, it is likely to be short lived, as the infamous “double dip” recession could take hold (that or an L shaped recovery, which could last for years). A great investor once told me: “Let the price come to you, don’t rush it”. I think the same thing can be said for economic indicators, and the market. We should always wait for the data to clearly tell us what is happening, instead of anticipating something thay may or may not materialize.

I will end this with my usual quotation, this one from Ludwig Von Mises on Credit based recessions:

‘The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression (recession), is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.’ -Ludwig von Mises

P.S: The “Golden Cross” that Kneale mentioned is likely to be invalid, as the 200 Day Moving Average is declining. Merryl Lynch has posted research on this, and doesn’t seem to find upside in the market anywhere near 20% following a cross (link). I’m surprised that a journalist for CNBC is not aware of these implications. I question where he gets the “20% increase” number, as other studies I’ve read haven’t found this to be true. In fact, in his research regarding the Golden Cross with a decling 200 day MA, Goepfert concludes:

“…the returns going forward, up to six months later, were little bettern than random and not statistically significant. In fact, in the shorter-term they were a little worse than random. Only when we look out a year do we see some out-performance.”

I would also suggest reading research by Robin Griffiths (well respected technical analyst, and former senior technical analyst at HSBC) and Deborah Owen (Fellow of the Society of Technical Analysts) concerning the cross, as he clearly states that both averages should be rising:

“A cross of the shorter moving average over the longer one can be used to generate buy and sell signals. If both averages are rising when the shorter term average breaks above the longer one, it is known as a “golden cross” and suggests that bullish sentiment is growing stronger.”

Soon

Hello All,

I apologize for the lack of posts over the past month; work has been extremely busy. That being said, I’ve spent a lot of time preparing my  next post, which I hope everyone will enjoy. More to come, soon.

Obama and the Swedish Solution

I don’t often discuss politics or political figures, and the reason is simple: when people discuss politics, emotion overtakes stoicism, often leading to anger and conflict. Very rarely do people discuss politics in a calm and rational manner; it is an area in which biases are all too prevalent, and opinions are very seldom changed. That being said, I wanted to post a very brief piece commenting on an Obama interview I saw recently. Please note that I am as close to a political polygamist as they come, I therefore hope to be as unbiased as possible. Also note that this will not be a recurring type of post…

TERRY MORAN: There are a lot of economists who look at these banks and they say all that garbage that’s in them renders them essentially insolvent. Why not just nationalize the banks?

PRESIDENT OBAMA: Well, you know, it’s interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what’s called “The Lost Decade.” They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn’t see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you’d think looking at it, Sweden looks like a good model. Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would — our assessment was that it wouldn’t make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core — core investment needs of this country.

And so, what we’ve tried to do is to apply some of the tough love that’s going to be necessary, but do it in a way that’s also recognizing we’ve got big private capital markets and ultimately that’s going to be the key to getting credit flowing again.

President Obama’s response shows a reasonable amout of consideration. That being said, it seems as though he may be misinformed here.

First, the 6 largest Swedish banks in 1991 (SE-banken, Handelsbanken, Nordbanken, Gota, Sparbanken Sverige and Foreningsbanken) and the 6 largest American banks today (BAC, C, MS, GS, JPM and WFC) have (or had) similar economics relative to GDP. Although there are indeed thousands of banks in the US today, the majority of toxic assets can be found on the balance sheets of the banks mentioned.  Examining the Swedish solution is therefore appropriate.

So how did Sweden solve its financial crisis in the early 1990s? The first noteworthy step was that government auditors were required to immediately write down bad assets in order to make clear, from the get go, the extent to which banks were solvent. The current crisis has been ongoing for over one year in America, and the public (and government) still has no idea of the extent to which these major banks are solvent.

Once the Swedish government had figured out which banks were zombies (Nordbanken and Gota), and which assets were toxic, they embarked on a 3 step plan which included additional recapitalization – for banks that were not insolvent, nationalization – for insolvent ones, and an aggregator bank to buy up bad assets. Note that the key here was the immediate write down of bad assets. This way, regulators were fully aware of what needed to be done, and balance sheets were thoroughly cleaned out as assets were taken over (or bought) at realistic prices.

What about the cost of the Swedish plan? Yes, the plan was expensive (amounting to approximately 6% of GDP). A similar plan in the US would likely cost more, but even if it were to amount to 10% of GDP – say $1.5 trillion – it seems as though it would be much more effective than throwing money every which way, hoping that it solves the problem. If this were a problem of illiquidity, the “plan to have a plan” outlined by Geithner could possibly work. Unfortunately, the plan as described will not respond effectively to the insolvency issue, which is at the heart of the problem. As stated by James Kwak, “Even if an insolvent bank has access to credit, it is still an insolvent bank, hoping somehow to become solvent, so it’s unlikely to lend or, even worse, it may be tempted to make extremely risky loans as the only possible path to solvency.”

Of course, there are differences between Sweden in 1991 and the US today. For one, the organisation of the US banking system is far more complex. Also, today’s international economy is heavily globalised and flows of capital between nations have lead to an intricate cross-national web. Sweden’s minute economy did not have to deal with such complications. I’m not sure how this would play into the solution; it could possibly call for much more unilateral cooperation between governments.

Still, in my humble opinion, the ”nationalization solution” or “receivership solution” should at least be examined in detail. Today, leading economists are not claiming that every bank should be nationalized permanently (this is where the negative stigma comes from): they are simply pointing out that forthrightness and transparency should be prioritized, insolvent banks should be identified and, with the help of the government, should quickly be resolved through the necessary processes. I’m hoping that the “stress test” Geithner spoke of will identify such banks and act accordingly, but there is no assurance, based on his statement, that this will be the case.

Martin Wolf has pointed out that, in the 1990s, the US gave very specific advice to Japan: “admit reality, restructure banks, and above all, slay zombie institutions”. Perhaps we should take our own advice, lest the US enter its own lost decade. The FDIC has taken a large number of mid/small sized banks into receivership and has been doing so for quite a long time; why not do the same with larger ones? Obama mentions that this will not work culturally, however, bailouts and “give-aways” are also quite un-American, yet we’ve been employing them as of late because they are necessary.

In 1999, Greenspan stated that the key to Swedish recovery was a quick and adequate response. They planned for the worst, instead of hoping for the best. Right now, as the plan stands, we are clearly hoping for the best in America. Our goal should be to clean up bank balance sheets so that, even if the worst case scenario does occur, we don’t have to worry about bank insolvency. Cutting corners will do nothing but exacerbate the severity of the situation.

So, what type of solutions (plan) would work for America? Recently, the president of the Kansas City Fed posted this piece: Too Big Has Failed. I would highly recommend reading it, he makes some excellent points and provides an outline for what seems like an appropriate plan.

Note:

Austrian Economists describe economics as follows: “The art of economics consists in looking not merely at the immediate but at the longer effects of any action or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

There is a specific type of leader which, in my opinion, is most capable of delivering the kind of actions that fit best with the aformentioned description: level 5 leaders. These leaders, as described by Collins (2001), are known as “Executive Leaders”. They build enduring greatness through a paradoxical blend of personal humility and professional will (Collins). In essence, they put the “organisation” before themselves, and focus on the long term effects of their decisions. As of right now, I would describe Obama as a Level 4 leader (which is good, but not great – or sufficient.)

Level 4 leaders are known as “Effective Leaders”. They catalyze commitment to and vigorous pursuit of a clear and compelling vision, stimulating higher performance standards (Collins). These types of leaders can be very effective, and have very good results; however, in the face of serious problems, level 5 leaders simply stand apart, and manage to turn around struggling organisations remarkably.

Although I fully realise that it is difficult, especially within politics, to make decisions that are beneficial for the nation in the long-run – as they are sometimes unpopular in the short run, it is essential. As an example, I would say that President Lincoln was clearly a Level 5 leader. Many of his actions were unpopular at the time, but few question the positive effect they had on the long term development of our nation (it is also noteworthy that Warren Buffet has often been described as a Level 5 leader/thinker).

Many people believe that the long-run is nothing more than a succession of short runs. In truth, however, the things that maximize positive outcomes in the short run often serve to decrease positive outcomes and increase risk in the long run (Howard Marks). It seems as though, for positive long-term outcomes to materialize, one must have a long-term strategy from the get-go. It is apparent that immediate action is needed to help resolve the current crisis, but let us not confuse immediate with short-term; we can act swiftly and with long-term oriented policies at the same time. I realise that Obama has only been in office for 50 days or so, and it may be too early to pass judgement, but I hope that he can evolve into a Level 5 leader, and if (where) possible, adopt this kind of thinking.

Related Links:

• Paul Kedrosky
• Martin Wolf
• Naked Capitalism
• USA Today

Links 10/03/2009

• Why stocks still aren’t cheap
• In Pain and Joy of Envy
• Performance
• 10 Mistakes Investors Make
• Buffet’s Metric Does Not Say Buy
• So this is meant to reassure?
• Stress Tes Results Preditermined
• Possible Approaches to Nationalization
• Cancel the Card
• Citigroup Begs to be 40% Nationalized
• Where we are, where we’re heading
• Dshort Bear Market Udpate
• The Road to Ruin
• Privatize the Banks Already
• Bank Nationalization: A Viewer’s Guide
• The “Bezzle” Defined

Boundedly Rational Investing

I often get asked about the meaning of “bounded rationality”, and how it relates to investing. This post will examine both the definition and relevance of this concept.

Bounded rationality is based on the premise that an individual’s rationality is limited by both his cognitive ability and environment: the purely rational economic man does not exist. Herbert Simon coined the term in 1955, and used the metaphor of a pair of scissors, where one blade is the “cognitive limitations” of actual humans, and the other the “structure of the environment”.  According to Simon, studying one blade is not enough; it takes both for the scissors to cut. Minds with limited time, knowledge, and other resources can be successful by exploiting structures in their environments (Selten).

“Boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information. A great deal can be learned about rational decision making, by taking account of the fact that the environments to which it must adapt possess properties that permit further simplification of its choice mechanisms.”

So, in complex environments (such as the stock market), we can say that humans are not “unboundedly rational” but “boundedly rational”; they must “satisfice” to the best of their ability. In truth, this lies somewhere between cognitive and ecological rationality, governed by simple and straightforward heuristics, which are often context dependent. There needs to be a balance, because using too few heuristics often leads to biases and sub-optimal decisions (Kahneman and Tversky), whilst the use of too many can often lead to confusion (Gilovich).

An illustrative example could be of some help here. Imagine we wanted to predict how an expert billiards player would hit a certain shot. We would measure the angles and distances, get the coefficients of elasticity of the balls and the bumpers, and we would solve a set of differential equations. But is that how the billiards player figures out what to do? I’m not so sure. We don’t know exactly what he would do, but surely optimization theory is not the most efficient way of figuring this out; the “fast and frugal heuristic” actually used by the billiards player would be much more useful.

Simon recommended that individuals think this way in order to make the most effective decisions in a given situation (that is, those with the highest expected value). He also recommended rethinking the norms as well as studying the actual behavior of minds and institutions. It is a multi-disciplinary concept, not unlike Charlie Munger’s idea of “multiple mental models”. Gigerenzer points out three distinct processes that these models specify:

• Simple Search Rules
• Simple Stopping Rules
• Simple Decision Rules

Using these rules as a foundation, individuals must develop an “adaptive toolbox” to deal with different problems in different circumstances – this is where the idea becomes relevant to investors. There are so many companies, with so many variables, that considering them all would be impossible. For this reason, investors must try to act as rationally as is necessary, but no more. “It is the mark of an educated mind to rest satisfied with the degree of precision which the nature of the subject admits and not to seek exactness where only an approximation is possible.” ~ Aristotle.

Boundedly Rational Investing involves beginning with a simple and straightforward screening process, made up of 10 to 15 points. It then involves shifting through masses of information and focusing on the few key elements which make a difference for the company in question (keep in mind, for instance, that all financial ratios are not relevant for all companies – adaptability is key). When analyzing a company, we are often dealing with the future, and therefore, with numerous assumptions. Starting with some checklist style tools – à la Charlie Munger – can help achieve a certain amount of clarity, which I  believe is necessary.

To help you get started, I have pointed out heuristics used by some great investors; think of them as tools for the adaptive tool box. By checking them repeatedly, investors should be able to act in a sufficiently rational way when making their investments, which should greatly improve their chances of success. Although the purely rational man does not exist in complex environments, the sufficiently rational man does.

When considering this “simplistic” approach, be aware that it is mainly a learning framework to help build an appropriate process. It should be combined with significant personal study and analysis to become most affective: investing can be simple, but not easy.

Warren Buffet:

“We selected investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business:

• Favorable long-term economic characteristics
• Competent management
• Purchase price attractive when measured against the yardstick of value to a private owner
• An industry with which we are familiar and whose long-term business characteristics we feel competent to judge”

Seth Klarman:

“We look for good businesses with:

• strong barriers to entry
• limited capital requirements
• reliable customers
• low risk of technological obsolescence
• abundant growth possibilities
• and thus significant and growing free cash flow”

Francis Chou:

“The investments that have proven most successful for us include:

• Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.
• Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.
• Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.
• A stock price which is far lower than what a knowledgeable and rational buyer would pay.”

William Ackman:

“We seek simple, predictable, free-cash-flow-generative businesses that trade at a large discount to intrinsic value:

• Mid and large-cap companies
• Typically not controlled
• Minimal capital markets dependency
• Typically low financial leverage and most economic sensitivity
• Often hidden value asset base
• Catalyst for value creation which we can often effectuate

At the right price, we may waive one or more of the above criteria. Our selection process is designed to help avoid permanent loss of capital while generating attractive long-term returns.

Our concentrated portfolio has many advantages:

• Best idea fund (we invest in our 8 to 12 best ideas; we are always willing to replace an existing holding for a better opportunity)
• Provides transparency to our investors (few investments + detailed disclosure)
• Simplicity (we need only a handful of new ideas per year)

David Einhorn:

“Our portfolio discipline is to construct our portfolio from the bottom up.  As value investors, we take long positions in good companies that we believe have clean and unlevered, or minimally levered, balance sheets and have misunderstood prospects.  Of course, should the economy weaken they may earn less than they would in a strong or normal economy, but we believe that a lot of bad news is baked into their valuations and that these companies will survive the cycle.  On the other hand, we are short companies that have significant problems of various sorts:  some have bad business practices or have played accounting tricks; others trade at very high multiples of earnings expectations that are unlikely to be achieved; while others have flawed business models and are unlikely to be long-term survivors.  We believe that over time, this is a sensible way to invest and will prove to be a lucrative portfolio construction methodology.  Our investment strategy has always reflected time arbitrage in that we position ourselves to benefit from having a significantly longer-term horizon than other market participants.”

“There seems to be some perverse human characteristic that likes to make easy things difficult.” Warren Buffet

The Self-Awareness Paradigm

“We know well that mistakes are more easily detected in the works of others than in one’s own. When you are painting you should take a flat mirror and often look at your work within it, and it will then be seen in reserve, and will appear to be by the hand of some other master, you will be better able to judge of its faults than in any other way” – Leonardo Da Vinci

It is important, in both investing and in life, to try to stand apart from yourself. Some call it “meta-cognition”, but most simply refer to it as “self-awareness”. It is the ability to think about your very thought process, and examine it as if from a third party’s perspective – unbiased. Stephen Covey points out that this ability explains why man has dominion over all things in the world, and why he can make significant advances from generation to generation: “This is why we can evaluate and learn from others’ experiences as well as our own. This is also why we can make and break our habits”. Making good habits, and breaking bad ones, is essential to long term success; in my view, the process starts with the awareness of common biases. The ability to act without bias is one of the hardest parts of investing – as they often lead to misjudgments and errors, of which we only become aware in hindsight (if at all).

For this reason, it is best to be pro-active and not reactive. This is to say that people often view evidence as supporting their beliefs, instead of examining all of the facts objectively, and actively. I would recommend approaching every idea tentatively, and always looking for disconfirming evidence. When examining a company for investment purposes, Warren Buffet recommends avoiding the market price, initially. Instead, one should examine the facts without any preconceptions, and come to a rational conclusion about the value of the business. Once you’ve put a price on the whole business, using the annual report, then compare it to the market price. By using this method, you will not begin your research with any pre-conceived notions, and you will certainly not be subconsciously “confirming” a thesis. Remember that human beings are best at interpreting all new information so that their prior conclusions remain intact.

“If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainties.” ~ Francis Bacon

Note: How am I to find an interesting company without screening for low prices? You can start by using screens such as Joel Greenblatt’s, or simply examining 13-Fs. Just make sure to begin with doubts.

Links 18/02/09

• Stimulus Package Explained
• S&P 500 Q4 Earnings Collapse
• Hussman Weekly Commentary
• Global Eco Analysis on Euro Banks
• Every Consensus Must End
• Tracking the Household Balance Sheet
• Europe is in Bigger Trouble than the US
• Geithner and Summers Consolidating
• Will Europe Trigger the Financial Meltdown?
• Obama to Neuter Bank Pay Restrictions
• US Going Down Japan Path
• There are no Real Stress Tests going on
• Another case of Fraud
• Accounting according to Barclays
• Failure to Save Eastern Europe

Change

“Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.” ~ John Kenneth Galbraith

The ability to change or adapt one’s strategy is extremely important in investing. Warren Buffet started out as a “Cigar Butt” investor, à la Benjamin Graham. Although it took over a decade, he gradually changed his strategy, and began focusing on the qualitative aspects of businesses such as management, competitive advantage etc. This is not to say that he pays no attention to intrinsic value anymore; he simply tries to buy great companies at very attractive prices.

I’ve noticed recently that various famed value investors have evolved in their investments. In a recent article, Whitney Tilson stated:

“I’ve come to a somewhat similar conclusion with respect to paying more attention to macro considerations in individual stock selection and overall portfolio positioning. Like many dyed-in-the-wool value investors, I have traditionally left macroeconomic or political forecasting to the pundits and focused almost exclusively on individual, bottom-up stock selection.”

Mohnish Pabrai, another famed value investor, has also evolved and rethought his strategy:

“There is a lot to be said for running a concentrated portfolio. Good investing ideas are scarce. It is very hard to find dozens of them. Also, as Buffett says, why would you invest money in your 30th best idea versus investing more in your very best idea? And Charlie Munger is on record stating that a well diversified portfolio can be constructed with just four positions.” Before continuing “One needs to be a learning machine and be willing to give up some of our best loved ideas when the evidence suggests they are flawed. Going forward, to temper volatility, Pabrai Funds will endeavor to size positions at 2%, 5% or 10% of assets. For new positions the norm will be a 5% investment. Stocks that strongly correlate (that is move in lock-step with one another) will be sized at 2% and once every few years positions will be up to 10% of holdings.”

Evidently, Tilson has changed his analytic strategy and Pabrai has changed his allocation policy. There is much to be said about investors who manage to overcome biases such as “rationalization”, “overconfidence”, “anchoring” and “confirmation”, and change their investment strategies to improve their results. These investors, like Buffet, are the most likely to find continued success. “When the facts change, I change my mind. What do you do sir?” JM Keynes

Note: The idea for this post is from Noise Free Investing,  an excellent blog, which I would recommend reading (link).

Links 17/02/09

• Charlie Munger Editorial
• Charlie Munger Book Recommendations
• David Einhorn Speech 2008
• David Einhorn Speech 2006
• David Einhorn on Microsoft 2006
• Yves Smith on the Bailout
• Martin Wolf on Bank Bailouts
• Ray Dalio on the Economic Crisis

Excellent Simon Johnson Interview

Here, as usual, are my favorite passages:

“BILL MOYERS: Oligarchy is an un-American term, as you know. It means a government by a small number of people. We don’t like to think of ourselves that way.

SIMON JOHNSON: It’s a way of governing. As you said. It comes from, you know, a system they tried out in Greece and Athens from time to time. And it was actually an antithesis to democracy in that context.

But, exactly what you said, it’s a small group with a lot of power. A lot of wealth. They don’t necessarily – they’re not necessarily always the names, the household names that spring to mind, in this kind of context. But they are the people who could pull the strings. Who have the influence. Who call the shots.

BILL MOYERS: Are you saying that the banking industry trumps the president, the Congress and the American government when it comes to this issue so crucial to the survival of American democracy?

SIMON JOHNSON: I don’t know. I hope they don’t trump it. But the signs that I see this week, the body language, the words, the op-eds, the testimony, the way they’re treated by certain Congressional committees, it makes me feel very worried.

BILL MOYERS: Both the “Wall Street Journal” and “The New York Times” reported this week that Obama’s top two political aides, Rahm Emanuel and David Axelrod, have pushed for tougher action against the banks. But they didn’t prevail. Obama apparently sided with Geithner and the Treasury Department in using a velvet glove.

SIMON JOHNSON: What I read from that is that there is an unnecessary and excessive deference to the experts, or the supposed experts.

And I think the view that a lot of people have in Washington – I live in Washington, I follow this very closely – the view is that you need to rely on the technocrats. And the technocrats are saying, “This is the way to go, and you mustn’t be too tough on because banks, because that will have adverse consequences for credits, and for the economy, and for unemployment,” and so on and so forth. Those technocrats, if that’s what they’re saying, are wrong. That is not the right way to deal with this crisis.

There are many fine professionals at Treasury with great experience, who have spent their lives working on important issues related to the United States. What we face right now is not a typical U.S. issue. We face a crisis, and the president said this on Monday night, the president said, President Obama said, “We’ve never seen anything like this since the Great Depression.”

Therefore, nobody working now, you know, has any firsthand experience. And he also said, “We may face what we call a lost decade.” We’ve never seen that anywhere other than Japan in the 1990s, right?

And something for Treasury officials to really understand, and to really understand the alternatives – they’re not, I mean, with all due respect to them, they’re not the ultimate authority. I don’t think they’re the right people.

The correct people you should be asking this question to are people at the IMF. And I can tell you what they’re saying is the policy that we seem to be perusing, of being nice to the banks, is a mistake.

BILL MOYERS: Why wouldn’t they believe that? I mean, when I watched the eight CEOs testify before Congress at the House Financial Services Committee earlier this week, I had just finished reading a report that almost every member of that Committee had received contributions from those banks last year. I mean in a way that’s like paying the cop on the beat not to arrest you, right?

SIMON JOHNSON: I called up one of my friends on Capitol Hill after that testimony, and that session. I said, “What happened? This was your moment. Why did they pull their punches like that?” And my friend said, “They, the Committee members, know the bankers too well.”

BILL MOYERS: Last year, the securities and investment industry made $146 million in campaign contributions. Commercial banks, another $34 million. I mean, American taxpayers don’t have a flea’s chance on a dog like that, do they?

SIMON JOHNSON: It a massive problem, obviously. And I do think, though, the good news there are people in the White House – I think the president himself, is aware of this broader issue. And, obviously, the campaign, the Obama campaign was very good at getting small contributions, and trying to minimize the impact of major donors like that.

BILL MOYERS: When Tim Geithner said, earlier in the week, that the American people have lost faith in some financial institutions and the government, did it occur to you that this was the same man who was president of the New York Fed through much of this debacle?

SIMON JOHNSON: I have no problem with poachers turning gamekeeper, right? So if you know where the bodies are buried maybe you can help us sort out the problem. And I did think the first three or four minutes of what Mr. Geithner said were very good.

As a definition of a problem, and pointing the finger clearly at the bankers, and saying that the government had been slow to react, and, of course, that included himself. I liked that. And then he started to talk about the specifics. And he said, “The compensation caps we’ve put in place, for the executives of these banks, are strong.” And at that point I just fell out of my chair. That is not true. That is factually inaccurate, in my opinion.

BILL MOYERS: That?

SIMON JOHNSON: That this $500,000 limit, and deferred stock, is some kind of restriction on what they do? It’s deferred stock, Bill. It’s not restricted. You can get as much stock as you want, as soon as you pay back the government, you can cash out of that. That’s one.

Second, you can, sorry to get technical, but reset the strike price. This is something you and your and your viewers, you need to hear this one out. Just look for these words, okay, follow them through the press. When you get into trouble, when your company goes down, and you have massive amounts of stock options that aren’t worth much anymore, because the stock price has gone down, you say, “Oh, well, we’re going to reset our option prices.”

And, basically, it means that, at the end of the day, these people are going to walk away with tens if not hundreds of millions of dollars paid for by basically, insurance policy that you and I are providing.

Think of it like this, our taxpayer money is ensuring their bonuses. We’re making sure that companies, that banks survive. And eventually, of course, the economy will turn around. Things will get better. The banks will be worth a lot of money. And they will cash out. And we will be paying higher taxes, we and our children, will be paying higher taxes so those people could have those bonuses. That’s not fair. It’s not acceptable. It’s not even good economics.

BILL MOYERS: Are we chumps?

SIMON JOHNSON: We’ll find out. Yes, we may be. Okay. It depends on how we play this politically. It depends on what our political system does. It depends, I think, on the level of reaction. The financial system is playing us for chumps, okay? The bankers think we’re chumps. We’ll find out. We have leadership that can handle this. We’ll find out what they do. 

BILL MOYERS: Geithner says that’s something “his” board of directors, the board of Goldman Sachs, will have to decide. But aren’t we all ipso facto stock holders now?

SIMON JOHNSON: We should certainly have a big say over critical matters like this. Like the CEO. Because, two things. First of all, it’s our money that kept these banks in business. Not just the treasury recapitalization money, that’s relatively small.

It’s the financial support provided by the Federal Reserve. Make no mistake about it, if the Federal Reserve hadn’t stepped in late September, in dramatic fashion, to prop up organizations like Goldman Sachs, they would be out of business, okay?

It was our money that did that. The Federal Reserve acting on behalf of the American taxpayer. And secondly, Senator Sanders is exactly right. That a CEO, like Lloyd Blankfein, made mistakes, and led his company into deep trouble.

Now, other companies are in deeper trouble. His company was in deep trouble and had to be rescued at that moment. It’s absolutely the right way to pose the question. And the answer to Senator Sanders’ question is, in my opinion, yes. We should change the leadership of these major banks.

BILL MOYERS: And, yet, Secretary Geithner’s chief-of-staff is the former lobbyist for Goldman Sachs. How – serious question – how do they make a dispassionate judgment about how to deal with Goldman Sachs when they’re so intertwined with Goldman Sachs’ mindset?

SIMON JOHNSON: I have no idea. Of course, the administration, the new administration, has a lot of rules about lobbying. And they have rules that basically say, I think, as understood the rules, when they were first presented, I was very impressed. They basically said, “We’re not going to hire lobbyists into the administration. There has to be some sort of cooling off period.”

BILL MOYERS: And the next day Obama exempted a number of people from that very rule that he had just proclaimed.

SIMON JOHNSON: Yes. It’s a problem. It’s a huge problem.

BILL MOYERS: So here’s the trillion dollar question that I take from your blog, that I read at the beginning, quote, “Can this person,” your new economic strategist, in this case Geithner, “really break with the vested elite that got you into this much trouble?” Have you seen any evidence this week that he’s going to be tough with these guys?

SIMON JOHNSON: I’m trying to be positive. I’m trying to be supportive. I like the administration. I voted for the president. The answer to your question is, no, I haven’t seen anything. But you know, perhaps next week I will. But right now, as we speak, I have a bad feeling in my stomach.

My intuition, from crises, from situations that have improved, the situations that got worse, my intuition is that this is going to get a lot worse. It’s going to cost us a lot more money. And we are going down a long, dark, blind alley.”

And finally, the recommendation:

SIMON JOHNSON: ”We have no problem in this country shutting down small banks. In fact, the FDIC is world class at shutting down and managing the handover of deposits, for example, from small banks. They managed IndyMac, the closure of IndyMac, beautifully. People didn’t lose touch with their money for even a moment. But they can’t do it to big banks, because they don’t have the political power. Nobody has the political will to do it.

So you need to take an FDIC-type process. You scale it up. You say, “You haven’t raised the capital privately. The government is taking over your bank. You guys are out of business. Your bonuses are wiped out. Your golden parachutes are gone.” Okay? Because the bank has failed.

This is a government-supervised bankruptcy process. It’s called, in the terminology of the business, it’s called an intervention. The bank is intervened. You don’t go into Chapter 11 because in that’s too messy. Too complicated. There’s an intervention, you lose the right to operate as a bank. The FDIC takes you over. I think we agree, everyone agrees, we don’t want the government to run banks in this country.

That’s not what we’re going to do. That’s not what the Swedes did. That’s not the state of the art – it’s not what the real banking experts are going to tell you to do. They’re going to say, you set it up, you set up the government intervention, and there’s various technical ways to do this, so that you re-privatize very quickly.

Now, it might take three months, it might take six months. It’ll depend on the overall macro economy turning around. But there’s a lot of private money out there. Let’s call it private equity.

These people would like to come in and buy these re-privatized banks. You would attach antitrust provisions to this, so the banks are broken up as part of this transaction. Senator Sanders has a great saying. He says, “Any bank that is too big to fail is too big to exist.”