Posts By: Geoff Gannon

On the Geithner Plan

Yesterday, the stock market tanked as Treasury Secretary Geithner outlined his financial stability plan. Blogger Felix Salmon noticed the mirror image:

“I like the symmetry here. On November 21, when Barack Obama announced that he was nominating Tim Geithner to be his Treasury secretary, the Dow rose 494 points and broke through the 8,000 barrier. On February 10, when Geithner gave his first major speech as Treasury secretary, the Dow fell 273 points and broke through the 8,000 barrier.”

I once wrote that “the market is a lot like a fun house mirror”. New data affects prices indirectly. And sometimes the reflection comes out warped. Ben Graham said it best:

“…the influence of…analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.”

I’m not sure if the market decline had more to do with the substance of Geithner’s speech or the sentiments of traders. I certainly didn’t think it justified marking American businesses down a couple percentage points.

Personally, I didn’t find the plan especially bad. I thought it would have a lot more detail. I’m glad it didn’t. How could anyone come up with a detailed plan at this point?

Some banks – some very big banks – are going to have to be recapitalized. The only way to start that process is to look at the economic reality under the accounting fictions that are bank balance sheets.

It doesn’t matter if you use mark-to-market or mark-to-model, you’re still going to end up with some very inaccurate balance sheet numbers in times like these.

Markets – be they liquid or illiquid – value assets oddly from time to time. And models are as flawed as their makers.

At least Geithner is talking about a stress test. That sounds like the first step toward recapitalizations.

Unfortunately, he’s also talking about private money coming in to buy toxic assets. Unless there are ironclad government guarantees involved I’m not sure that will fly.

Some of these assets weren’t just overpriced the way houses were – they were inherently flawed.

Toxic Assets

Accountants record. They don’t analyze.

There isn’t a right number and a wrong number. There are just useful numbers and useless numbers.

For example, it makes not one iota of difference to me – as an investor – what dollar value public Company A assigns its 23% stake in public Company B, because public Company B files with the SEC. All I need to know is the number Company A put on its books and where I can read all about Company B. The rest is up to me.

Unfortunately, you can’t do this with “toxic assets”.

In her book Dear Mr. Buffett, Janet Tavakoli quotes an email from Warren Buffett:

“I’ve looked at the prospectuses, and they are not easy to read. If you want to

On Buffett and Derivatives

Review by Geoff Gannon

Janet Tavakoli’s Dear Mr. Buffett is an unusual amalgam of a simple, personal story and a complex, public one.

The personal story begins with an invitation from the Oracle himself:

“Be sure to stop by if you are ever in Omaha and want to talk credit derivatives…”

Buffett had just re-read Tavakoli’s Credit Derivatives & Synthetic Structures and noticed a letter from the author tucked between the book’s pages. With a quick apology and the above invitation, Buffett unknowingly set in motion a process that would give the public a rare glimpse inside his inner sanctum.

Tavakoli took Buffett up on his offer and recorded the ensuing encounter in Chapter 2 of Dear Mr. Buffett.

The promise of this tantalizing morsel will draw buyers in. But readers will find much more than another book on Warren Buffett.

The real story begins in 1998. That’s when Buffett’s Berkshire Hathaway bought General Re. Berkshire was a major insurer with a home-grown reinsurance business. General Re was considered the crème de la crème of reinsurers.

I say “considered”, because unbeknownst to Buffett there was a lot of crap among the crème. That crap came in the form of derivatives.

Meta-Bets

Derivatives are exactly what they sound like. The value of a plain vanilla security like a stock or bond is derived from the underlying business – its assets, earnings, and capacity to meet obligations. These are simple, straight bets.

Derivatives are meta-bets. Like an ironic narrator, they stand a level above the action. Instead of betting on a business, they bet on the betting on that business. Instead of betting on a borrower’s future income and collateral they bet on the bet a banker made on that borrower’s future income and collateral.

If the investment banks that created these derivatives used the same ad agency as BASF, their slogan would be: “We don’t make a lot of the securities you buy; we make a lot of the securities you buy riskier”.

Theory of Everything

Tavakoli has her own Theory of Everything in Finance:

“The value of any financial transaction is based on the timing of cash flows, the frequency of cash flows, the magnitude of cash flows, and the probability of receipt of those cash flows.”

It’s a simple theory. Derivatives are complex. But no amount of complexity can free a security from this iron clad rule.

“In finance, we make up a lot of fancy and difficult to pronounce names and create complicated models to erect a barrier to entry that keeps out lay people. High barriers tend to protect high pay. I’ve written about some of these esoteric products: credit derivatives, CDOs, and more, but before I look at the latest hot label dreamt up, I look at the cash to find out what is really going on.”

So does Warren Buffett.

Buffett Bets

As Tavakoli points out, financial journalists seized on Buffett’s description of derivatives as “financial weapons of mass destruction” while completely ignoring another …

On Buffett’s Big Blunder

Warren Buffett is getting a lot of criticism for a big blunder. He sold put options on four stock indexes – including the S&P; 500.

Buffett described these derivatives in his 2007 letter to shareholders:

“Last year I told you that Berkshire had 62 derivative contracts that I manage (We also have a few left in the General Re runoff book). Today, we have 94 of these…”

Financial Weapons of Mass Destruction

Before criticizing Buffett, we need to take a moment to praise him. After all, the guy had the foresight to clean out the General Re derivatives before the credit crisis hit.

Yes, Berkshire took a loss. And, yes, Buffett clearly overestimated both the rationality and morality of the human capital over at General Re – much as he had at Salomon.

Buffett was never well-liked at Salomon. And I’m sure there are some folks (or ex-folks) at General Re who don’t find him quite as avuncular as he is reputed to be.

I would say they simply don’t understand each other, if I didn’t think the truth was exactly the opposite. Buffett got to know Salomon and General Re better with time – and the better he knew them, the less he liked them.

The General Re derivatives were a disaster averted. Had Berkshire kept the book intact or never acquired General Re, we’d be hearing a lot more about what was in that book.

Is it a mere coincidence that Buffett, the CEO who made the decision to unwind the General Re book, called derivatives “financial weapons of mass destruction”?

No. Buffet saw something in that book. And he did something about it. Most CEOs did not.

Style Drift

Enough praise. Back to the blunder:

“Over the past five years, Buffett frequently called derivatives ‘financial weapons of mass destruction’, comparing derivates to ‘hell…easy to enter and almost impossible to exit.’ Yet, he has, very much out of character, immersed himself in a large and, thus far, unprofitable derivative transaction. His investment successes have not been in speculating in the market (something he has been critical of) but rather by purchasing easily understandable companies with dependable cash flows…”

That’s Doug Kass writing lasting year about Buffett’s style drift. He goes on to write:

“It immediately occurred to me after gazing at Buffett’s style drift (manifested in Berkshire Hathaway’s large first quarter derivate losses) that he might be increasingly viewed as the New Millennium’s Ben Franklin, a man who wrote ‘early to bed and early to rise’ but spent many of his evenings in France, whoring all night…”

Not surprisingly, Kass is negative on Berkshire stock. I won’t argue that point. Berkshire has fallen. And short sellers have made money.

Kass presents Buffett’s derivative transaction as “speculating in the market”.

Insurance

Let me offer an alternate explanation.

Berkshire Hathaway has substantial insurance operations. It is, in fact, a huge insurer of large, often unusual risks. In some cases, Berkshire prefers to keeps such risks to itself instead …

On Buffett Back Riding

Warren Buffett is best known for his work at Berkshire Hathaway (BRK.A) where he grew book value per share 21.1% a year over the last 42 years.

But Buffett was a money manager long before he was a CEO. He earned his super-investor stripes by running an investment partnership. Buffett Partnership Ltd. beat the Dow every year from 1957 to 1969, never had a down year, and posted annual returns of 29.5% a year. The Dow managed just 7.4%.

Those numbers are phenomenal. And Buffett’s record is all the more phenomenal for its length. How many investors have a track record stretching back half a century?

But past results are no guarantee of future returns. And Berkshire’s size is a guaranteed headwind.

So can you really Buffett-back ride your way to investment success?

Maybe.

But there is a right way to do it and a wrong way to do it.

Common Mistakes in Preferred Stock

The wrongest of the wrong is to buy common stock in companies where Buffett holds preferred shares.

Don’t buy General Electric (GE) and Goldman Sachs (GS) because Buffett told you to. He didn’t. He took a senior position with a double-digit yield. If he wanted to buy the common, he would have bought the common.

Buffett has bought preferred stock before. And, to be honest, it is not his strong suit. One of his worst investment decisions was buying preferred stock in US Air. Berkshire nearly lost everything. The investment worked out, but it was a big mistake – and Buffett knows it.

Another, lesser mistake was buying preferred stock in Gillette.

That investment worked out great. But it would have worked out even better if Buffett bought the common stock instead of the preferred.

For details read Buffett’s 1995 letter to shareholders.

Buffett says he “was far too clever” to take the easier, more profitable route – instead insisting on the more complex, and ultimately less profitable preferred stock.

When Buffett makes a preferred stock purchase, he is actually signaling that he does not like the common stock. He may like the company. He may not. But he certainly does not like the stock.

If he did, he would buy the common stock.

So why did Buffett take preferred shares in GE and Goldman?

Some will argue these are sweet-heart deals pure and simple – and that’s why Warren took them. Buffett certainly got in on special terms.

But, it’s not clear those terms were better than what he could get by buying common stock in a business he loves when market prices are low.

In fact, almost all of Buffett’s biggest successes were either common stock purchases or preferred stock purchases that would have worked out as well or better if Berkshire had bought the common stock instead.

I can think of only two exceptions. Berkshire got some GEICO (now fully owned) and some Freddie Mac (long ago sold) in ways that individual investors could not. Other institutions were offered the same …

On Keynes, the Stimulus, and Old Ideas

John Maynard Keynes was a genius. We can all learn from his example. And the first thing we should learn is to end our foolish love affair with his ideas.

Keynes would not have spent his days warming up some dead man’s leftovers. Keynes would have understood the importance of all we have learned in once disparate fields and what this means for macro-economics.

Complex Problems, Simple Solutions

Economies are complex. But macro-economic solutions remain stubbornly simple.

What exactly is the case for government stimulus?

I don’t mean generally. I mean in this specific situation – right now, today, what is the case for government stimulus?

Forget ideology. Forget theories. Forget models. Think only of the situation we face and the actions we might take.

There will be plenty of time for theories later. But to start by imposing a framework, especially a framework that assumes a special case belongs to a general population, is dangerous.

Why do we assume that special cases belong to populations we know something about?

Because that is what experience teaches us. Our everyday experiences teach us to expect normal distributions. More than that, our everyday experiences encourage us to think that all differences are merely quantitative differences – simply matters of degree – rather than qualitative, systematic differences.

To the extent that the problems, populations, and systems we are dealing with are simple and unplanned I have little problem with making such leaps of faith – extrapolating from a few specific cases to create sweeping general theories.

But when we are dealing with complex, planned systems – systems with actors who learn and adapt, systems with actors who make new mistakes, actors who remember pain and pleasure as vividly as we humans do – when we are dealing with such systems, general theories are dangerous precisely because they are so elegant.

In a complex science, general theories are just special theories that win wide acceptance. If wide acceptance within an academic community was convincing evidence of utility, I would say stick with general theories.

A quick check of human history shows that, no, popularity is not a good indicator of utility. A few bad ideas always slip through – and worse yet, most good ideas – ideas like Keynes’ – outlive their usefulness.

The Burden of a Great Idea

Intellectual lifecycles can be painfully long. First, a great man like Keynes leads the way. Then a lot of not so great men follow. They don’t how to think up the new and useful principles the way the great man did; instead they keep applying old principles to new problems – problems the poor, dead man never saw.

Had he seen different problems, he would have found different solutions. But, he’s dead and his ideas aren’t. So the best a follower can do is warm up the dead man’s leftovers.

Ideas are limiting. The great ones are the most limiting of all.

Warren Buffett was limited by Benjamin Graham’s thinking. He had to learn to …

Microsoft is Cheap

Go to 24/7 Wall St. and read great coverage of the Microsoft (MSFT) earnings call.

Here is what I wrote about Microsoft in May of 2006:

What price would I be buying Microsoft at? Like I said, this isn’t normally the kind of company I would be buying. It is definitely in an industry where there is a lot of uncertainty – at least beyond the Windows franchise (which I do think is completely secure).

For the most part, this is a stock I wouldn’t be able to value well enough to buy, because of the future and my lack of understanding of the business.

Having said that, I would certainly buy shares if they reached $17. Before that, I would have some trouble making a decision. The margin of safety simply wouldn’t be wide enough in an area I don’t understand that well. Maybe I will get a better feel for the company and its competitive position as I look into the stock some more (and write about it here). But, unless and until that happens, it would be hard for me to buy at a price much greater than $17 (where I think it would pretty much be a sure thing).

Because of share buybacks and other changes since 2006, my sure thing price would now be more like $17.50.

Earnings power in terms of free cash flow is probably around $1.75 a share.

No entrenched, wide-moat business this size trades for 10 times its cash earnings power.

Is Microsoft a growth stock?

No.

Is it cheap?

Yes.

If you need to buy a big cap stock, buy Microsoft at $17.50 or less.…

Random Thoughts

I haven’t posted in a while and thought I might begin with some random thoughts.

Rick Konrad of Value Discipline has posted after a (similarly) long absence. Value Discipline is one of the best investing blogs. If you’ve never read it – start now.

24/7 Wall St. recently posted on More Recession Carnage for Video Games. I would love to have posted on the video games industry (especially publishing) more often on this blog. I rarely have. The reason’s simple: video game stocks have been pricey for much of the life of this blog (2006-present). That’s not true anymore. Unfortunately, so many stocks are now so cheap on a normalized free cash flow (“earnings power”) basis that it’s hard to argue video game stocks deserve special mention.

Take toys. A basket of three of the largest U.S. toymakers: Mattel (MAT), Hasbro (HAS), and Jakks Pacific (JAKK) looks real reasonable. Do the math on what kind of free cash flow these businesses have produced over the years and what kind of prices you can buy them at today. Answer: You’re getting the American toy industry dirt cheap.

Are their risks? In the long-run, their may be greater risks in toys than video games, because toy companies run a greater risk of becoming inflexible enterprises. Regardless, mankind’s appetite for toys, video games, and just plain fun isn’t going to be permanently impaired by a recession or depression (no matter how “great”).

Are these businesses recession proof? Nothing’s recession proof. But businesses that make products people are passionate about aren’t a bad place to be in any economic environment. The fact that both industries can and have supported multiple, profitable players isn’t a bad sign either. Toys and video game stocks are both worth buying (even if you can’t separate the wheat from the chaff) when you can get an acceptable no-growth normalized FCF yield on your purchase price.

Focus on free cash flow. Not earnings. I don’t envy anyone who has to tell us what a video game company (or toy company) made this year much less what they’ll make next year. Current sales and expected (normalized) FCF margins are a better way to value these businesses than EPS. Be conservative but realistic. And either buy the best or buy them all whenever you get the right price. In other words, don’t rush out and buy a troubled, hurting quagmire (THQ) at the first twinkling of a turnaround. That’s not necessary when real quality is on sale the way it is today.

Note: Yes. THQ (THQI) is cheap. But ask yourself: do I really need that kind of cheap in my life, when real quality’s on sale.

Video game and toy stocks aren’t the only ones being offered at low prices to demonstrated free cash flow. See Microsoft (MSFT) or Energizer Holdings (ENR) for evidence of this market wide phenomenon.

But those are posts for another day.…

On a Return to Normalcy

It might not feel like it, but yesterday marked the Dow’s return to normal.

Normal valuations that is.

A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, “In Defense of Extraordinary Claims”, I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high:

Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.

That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century.

That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: ’96, ’97, ’98, ’99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than ’65.

As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 – 2007.

We were in unchartered territory.

Not any more.

Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.

So at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.

That may not sound like much to those weaned on the 1982 – 1999 bull market. However, it’s a lot better than the “new paradigm” market that began in 1996. Since we broke into unchartered territory twelve years ago, we’ve done something like 3.4% in point terms.

And over the last ten years: zilch.

Here’s what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained:

Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached “a permanently high plateau” now that a new paradigm has taken hold.

I won’t dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won’t enough investors wise up to this fact and cause the so-called “equity-risk premium” to disappear.

If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future

On Ben Graham, Bank Stocks, and Tom Brown

I wrote a response to Jason Zweig’s column on Ben Graham and bank stocks. Now, Tom Brown of Bankstocks.com has done the same. I have to admit, Tom’s article is better than mine. Both take Zweig to task for his explanation of why Ben Graham wouldn’t be a buyer of bank stocks today. However, Tom’s post does a better job of presenting the opportunities and challenges in analyzing bank stocks today:

Zweig’s premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution’s assets–particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock’s valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true.

Graham saw every investment as a black box – and that didn’t trouble him. A lot of investors spend a lot of their time worrying about the inner workings of the companies they own – Graham never did. He didn’t look inside the “system”, i.e. the company itself; instead he looked only at the outputs – the financial statements. He spent almost no time worrying about a business’s management, corporate culture, or future prospects. He didn’t worry about competitive advantages. He looked to the balance sheet first. When he moved on from there to consider earnings, his usual approach was to rely heavily on the past record in an attempt to discover what “normal” earnings might look like.

Graham was a rear view mirror guy. His margin of safety was based on making purchases at prices that would’ve worked well in the past. He liked sure things. For instance, he knew that NCAV stocks were sure things – and subsequent research continues to support that claim. I mentioned NCAV stocks in my previous post, because they are perhaps Graham’s most characteristic investment category. They combine elementary arithmetic and logic in a potentially lucrative but almost certainly safe investment operation. Also, unlike much of what he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV investments during his Wall Street career.

Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham’s principles were.

What Graham Practiced

In the Intelligent Investor, Graham lists the five successful techniques his partnership employed from 1926 – 1956: arbitrage, liquidations, related hedges, net-current asset issues, and control investments.

Control Investments
Graham does not discuss control investments in any of his books; however, GEICO is a well-known example of a Grahamian control investment.

Arbitrage
Buffett has discussed this techniques in some detail. See especially Buffett’s discussion of Berkshire’s purchase of Arcata …

Festival of Stocks #99

Welcome to the ninety-ninth Festival of Stocks. The Festival of Stocks is a weekly blog carnival dedicated to highlighting the best recent posts on stock market related topics.

I am proud to present this week’s best entries to the Festival of Stocks. The articles are listed by category. I have included my review of Don Keough’s new book “The Ten Commandments for Business Failure” among the links below.

Enjoy.

Stock Analysis

Number Check on Sears by Circle of Competence

“With its market price declining daily, giving me the opportunity to pick up even more shares, I thought I’d present a very rough look at how the market is valuing Sears (SHLD) right now, putting reasonable numbers to a rather abstract investment idea.”

USG Earnings Conference and Notes by College Analysts

“From a purely operational standpoint, USG’s results were objectively poor but very good contextually. Wallboard volume shipments were down 11% quarter-over-quarter and plant utilization sits just under 70%; until capacity recovers into the mid-80%s, USG won’t have the operating leverage to put up big EPS numbers, and that day is still far off.”

United Technologies Dividend Analysis by Dividend Growth Investor

“UTX is a dividend achiever as well as a component of the S&P; 500 and Dow Jones Industrials indexes. It has been increasing its dividends for the past 14 consecutive years. From 1998 up until 2007 this dividend growth stock has delivered an annual average total return of 17.20 % to its shareholders.”

A.H. Belo: A Value Stock or a Value Trap? by Lollapalooza Investing

The new Lollapalooza Investing blog provides a detailed analysis of A.H. Belo.

Have Your Cake…? By Bootstrap Investing

“I’ve actually been an owner of Cheesecake Factory shares for a couple of years now. But the recent market malaise (aka storm, destruction and rampaging bear as quoted in the financial press) has given us an opportunity to purchase shares at prices not seen since just after the new millennium.”

Commentary

“Dear Bill…” A Letter to Bill Miller by Cheap Stocks

“How is it possible that you are down 32% year to date, or 39% over the past year? Looking back, do you think that your positions were too concentrated in financials? Yes, Bill, I know hindsight is 20/20, and I sound a bit like Captain Obvious here, but Bear Stearns, Washington Mutual, Citigroup, Merrill Lynch, Freddie Mac, AIG, Countrywide? Where was your risk control?”

Jim Grant on the Absence of Outrage by Controlled Greed

Actually, I think people are so irked at $4.00 and up gas prices — and worried about further increases — that their focus is fixed there. And Grant suggests this could be the factor consuming populist anger at the moment.

My Strategies for Weathering a Bear Market by My Wealth Builder

Another way I hedge is to take some profits with a stock that has risen significantly, selling 20 to 50%, and sometimes 100%, of a position to lock in some gains. I recently did this with …