Gannon On Investing

There are two recent pieces on morality and credit worth reading. One is written by David Brooks; the other by Jim Grant.

Brook's piece is good; Grant’s is better. Brooks takes the matter as far as he can. He sees the importance of the everyday examples that constitute a culture; but fails to see the overwhelming importance of incentives – incentives that have been both perverse and pervasive throughout the third millennium.

(The borrower) and the lenders were not only shaped by deteriorating norms, they helped degrade them. Despite all the subterranean social influences, there still is that final stage of decision-making when individual choice matters. Each time an avid lender struck a deal with an avid borrower, it reinforced a new definition of acceptable behavior for neighbors, family and friends. In a community, behavior sets off ripples. Every decision is a public contribution or a destructive act.

Great.

Unfortunately, he goes on to write:

Meanwhile, social institutions are trying to re-right the norms. The government is sending some messages. The Treasury and the Fed are trying to stabilize the system while still ensuring that those who made mistakes feel the pain.

Brooks is out of his depths here.

Ultimately, the pain will come in the form of inflation. It has to. Either the Fed will realize it has assumed weaknesses that are mostly illusory – or the Fed will cure those weaknesses the only way it can. Either the Fed’s balance sheet will turn out to be solid, or the Fed will have to counterfeit that solidity.

Unlike Brooks, Grant resorts to numbers:

In June 2007, Treasury securities constituted 92% of the Fed’s earning assets. Nowadays, they amount to just 54%. In their place are, among other things, loans to the nation’s banks and brokerage firms, the very institutions whose share prices have been in a tail spin. Such lending has risen from no part of the Fed’s assets on the eve of the crisis to 22% today. Once upon a time, economists taught that a currency draws its strength from the balance sheet of the central bank that issues it. I expect that this doctrine, which went out with the gold standard, will have its day again.

John Bethel of Controlled Greed recalls a past phrase from Grant – “the democratization of credit and the socialization of risk”. There is no clearer example of this phenomenon than the weakening of a public balance sheet to strengthen private balance sheets.

The first part of that phrase is as important as the second. When do you hear someone told they shouldn’t buy that house or take out that student loan? Is anyone ever told they can’t afford to own a house, or attend a four-year school?

No. These are the new unalienable rights. Unfortunately, they still have to be paid for out of pocket. No amount of money is too much to spend on your education or your abode...

But if that’s true, what difference does the price make? If you’re going to buy the best – the absolute best you can (because you’re worth it) – then what difference does the price make?

None.

All that matters is whether you can afford it – and since you’ll be borrowing the money, whether or not you can afford it will depend (almost) entirely upon whether or not a lender thinks you can afford it – and whether or not a lender thinks you can afford it will depend (almost) entirely on how cheap he can get the money and how valuable he thinks your asset is – and since your house is a marketable asset all that really matters to your lender is how much he thinks other people are willing to pay for your house - and all that really matters to those other people is how much their lender thinks they can borrow at the current rate - and so far this millennium, that rate has been low, low, low.

And no one’s trying to take the addict to rehab.

In the third millennium, coming clean about your oil addiction is suddenly in vogue; but, cutting off a credit-whore remains a thankless job.

We talk a lot about loans and very little about balance sheets – especially personal balance sheets. An individual has one great earning asset: her labor. It’s a terrific asset. It can support a lot of debt. But, we mustn’t forget it can only support a finite amount of debt.

The housing bubble inflated by overburdening a more tangible asset. The ugliest truth of the mortgage mess – the truth everyone prefers to sidestep – is the bottom line: you can’t saddle an asset with more debt than it can bear. If a leveraged buyout can bankrupt a corporate cash cow (and it can) – why should we be surprised to find that loading a house up with debt can crush it?

Because it had never happened before – or, if it had – we hadn't measured it.

As is our custom, we didn’t let logic get in the way of the data.

Thankfully, we’ve now been proven empirically wrong, so this shouldn’t happen again.

We’ll come up with something new next time.

Brooks is right about one thing. In the end, it does come down to personal responsibility – and no where was there less personal responsibility than inside the housing bubble.

No distinction was made between price and value. Everyone trusted the market (and, of course, everyone was the market).

A house was worth what it could be sold for; a loan was worth what it could be sold for.

It was one big Keynesian beauty contest.

You didn’t have to appraise a liquid asset; everyone else did it for you.

No one needed to know what anything was worth.

And now no one does.

Greed has been unfairly singled out as our nation's greatest vice. Greed may be a sin, but it isn’t deadly.

Being greedy, lazy, and stupid all at once – now that can kill you.

We drank a little too deeply of this newfangled liquidity. We did some things we aren't too proud of. And slowly, slowly, we’re beginning to remember just what those things were.

In his 2002 letter to shareholders, Warren Buffett wrote that despite several years of falling prices, he wasn’t finding many stocks to buy; evidence, he said, of just how crazy “The Great Bubble” valuations had been. He went on to make a prediction:

“Unfortunately, the hangover may prove to be proportional to the binge”.

Now that our liquid courage has left us, that kind of thinking is all you hear.

Visit Controlled Greed

Posted by Geoff Gannon at 09:58 AM | Permalink | Comments (4) | TrackBacks (0)

Jeff, author of Circle of Competence, is a young and learning investor not yet out of college. He derives his investing framework from Superinvestors ranging from Ben Graham and John Maynard Keynes to Joel Greenblatt and Eddie Lampert. Jeff believes the most effective approach to investing is that of a business owner and entrepreneur looking for misunderstood businesses selling very cheaply with little risk of capital impairment.

Visit Circle of Competence

1. Are you a value investor?

No doubt. There’s no other approach I’ve ever been comfortable with. The thing is, value investing, as we tend to think of it, is not the only path to investing success. I’ve read about plenty of individuals who have been successful trading, making macro calls, and reading tea leaves for all I know. Value investing, business investing, is the one I hit it off with, so I’m with it for better or worse.

2. What is value investing?

Value investing is this really simple approach that’s not so easy to practice. In my eyes, value investing is a mentality that assets have some value independent of their selling price. They might be the same, they might not be, but if you can find the ones selling for some large amount less than they’re worth, there’s an opportunity to make a ton of money down the road. Buffett, Graham, Klarman, I mean these guys have proved this thesis true over and over with their successes. It takes some hubris, a confidence that you’re right and everyone else is wrong, and the courage to basically not let your humanity interfere with rationality. That’s the toughest part of value investing.

3. What is your approach to investing?

I’m basically just looking to own a small handful of companies that I know pretty well, selling for way less than they are worth. I want to find 5-10 companies where I can be extremely confident that I know what the heck is going on. It’s the only approach to investing that makes sense to me. I approach investing like I was a control investor, a buy-out specialist, or an entrepreneur. To find these opportunities, I’m search for companies that are being subject to some devil: neglect, myopia, or misunderstanding. If I can find a solid business with a solid balance sheet, run by competent management, being subject to one of those devils, and it’s something that I understand, I’m probably researching or buying it. That means spinoffs, small caps, distressed businesses, companies with multiple divisions; all of these are fair game. I want to find situations where the risk I’m being asked to take is out of whack with the potential upside. I’m okay with an investment that doesn’t make me any money. I’m not okay with losing money.

4. How do you evaluate a stock?

I don’t really evaluate stocks. I (try to) evaluate businesses. As I said before, I’m thinking like a control investor. What is the company worth now, and what is it going to be worth 3 or 4 years out? I’m willing to hold something for 5 or 10 years, absolutely, but only if there is a compensatory reward, and little downside. If the business passes my first two filters, I’m reading everything I can on the business. I’m evaluating the strength of the business, the strength of their balance sheet, their performance versus competitors, the words coming from the mouth of management, the price of the shares, everything. I’m either going to value the company based on the salable assets it has today, or the present value of its future cash flows. Something selling for a 20% sustainable free cash flow yield is as cheap as something selling for half of liquidation value. I just want to know all I can know about this business from an outside perspective, given the limited resources at my disposal. It’s necessary if you’re going to have 80% of your portfolio in 5 holdings, or even 4 holdings.

5. Why do you buy a stock?

I’ve figured out that I don’t have the time or intelligence to evaluate every security, so I’m only buying the companies I’ve taken the time to understand. Did Sam Walton care that Bill Gates got rich building Microsoft? I doubt it, because he was too busy getting rich building Wal-Mart. When I’ve strayed from this mentality, I’ve bought into the wrong companies, trust me. I don’t want to see a small price disconnect, either. I’m looking for a price that’s way off considering the value and economics of the business. GARP is a good term, except not the way it’s traditionally used. I like Growth at a Ridiculous Price. My early experiences losing money helped me develop that sort of thinking. Lastly, though I’m thinking like a 100% owner, I don’t have the money to actually do it, so I have to have faith that management won’t kill my company and cause me to lose money. In some cases, management is a key part of the thesis. At minimum, I’m just betting that they’ll maintain the value that is already there. I’m running a very concentrated portfolio, so I can’t afford to be wrong very often. One big mistake could do some serious damage, so I keep that in mind before I buy anything.

6. Why do you sell a stock?

I’ll sell something for a couple of reasons. Number one, I was wrong. Either I didn’t understand the business well enough, or my analysis was off. Unless there is a compelling new reason to hold on, say the business is now selling for less than net cash or something, I’ll sell. Number 2, the business becomes overvalued. I don’t want to risk permanent capital loss at the point. Lastly, if I have a much better opportunity to invest in, I’ll sell. However, the burden of proof is on the new idea, as Eddie Lampert has said.

7. What investment decision are you most proud of?

I’m proud of my decision to hold off on buying Delta Financial last year. I’d already gotten killed on another, similar, company, and I started analyzing DFC in a similar way. I’m looking at this company, saying to myself “OK, here’s a better than average mortgage originator, they’ve done a great job securitizing…” I mean I almost rationalized buying this company after losing my shirt on American Home Mortgage. Somehow, I was able to catch myself and not invest. I knew that it was outside of my circle of competence, even though it looked cheap and somewhat understandable at the time. I’m a huge fan of Mohnish Pabrai, but he made an admitted mistake and I was able to say no ahead of time. A rare good decision for me.

8. What investment decision do you most regret?

Since I’ve made lots of mistakes, I’ll give you two. First, I bought American Home Mortgage, as I just mentioned, and it went Chapter 11 a week or two later. I was trying to catch the falling knife, and I did shallow, shoddy, analysis. Bad times. Second, I bought 6 month calls on Discover after its spinoff from Morgan Stanley. Lost it all. Those two were awful investments, but I learned a good deal from each of them. One was that I needed to overhaul the quality of my research. The other was a pretty firm rule: no short term options.

9. Why do you blog?

I began blogging for two reasons. One, I am an avid reader of financial blogs myself, and I couldn’t help it. Two, I desired the opportunity to get my words down on paper and in the view of public scrutiny. It would allow me to improve my analysis and my framework, because if I’m wrong or sloppy, someone will hopefully notice and call me on it. Plus, I have to keep writing to keep readers reading. That means I have to spend time researching stocks, reading good articles, and really thinking about what I’m reading so I can write about it on the blog. There’s some obvious positives in there for someone looking to improve as an investor.

10. What's your best post?

Even though, by far, I focus most of my attention on the business I discussed
above, I very occasionally do little arbitrage situations, I mean like 3 of them ever. I think my best post was one called Jaclyn: Arbitrage for the Little Guys. I like it because I got to go, point by point, through the relevant materials in their filings, with direct information and my own analysis to back it up. The arbitrage worked out perfectly, and my analysis was on point. If only all of my investments, and public analyses, went so well. Also, my readers seemed to really enjoy it, got a lot of positive feedback.

11. What's your worst post?

I try to put my best foot forward every time I post, so this is a tough question. I’d give it to Of Toads and Princes: The Yahoo! Deal Falls Apart. Not necessarily because it was a bad post, it was fine, but that type of post is not what my blog is really for. I kind of just grabbed a news headline that stuck me and ran with my own criticism. Search technology is not in my circle of competence, so I shouldn’t be commenting on it in the blog. It’s called the Circle of Competence. For all I know, that transaction has the potential to create a search leader out of Microsoft. I won’t be commenting on it in the future, needless to say. I should be sticking to analyzing the handful of companies I understand, writing about mental models and intelligent investing, and commenting on Superinvestors. The Yahoo! post broke that mold.

12. What financial publications do you read?

I enjoy the WSJ every day, Barron’s every week, Fortune, Forbes, SmartMoney. I also read Bloomberg and the Financial Times online, often. I just recently ordered the Economist and I’ll be reading that weekly as well, replacing Forbes and SmartMoney. I’m switching off of Forbes and SmartMoney to get away from reading the same opinions over and over. Forbes is a great magazine, no doubt, but given a limited resource (my time), I think I’m better off reading a broader and better written publication like The Economist. After reading Fortune, Barron’s, the WSJ, the New York Times, you start getting sucked into groupthink, which can be dangerous. The Economist will help broaden my thinking and push it in other directions. For instance, if you stick to those publications, all you’ll currently read about is housing, energy, the election, the falling market. I’d like to stay abreast of all that, but I need more perspective. Buffett has an uncanny ability to filter noise from signal. I’m not nearly as good at doing so, and thus I need to filter out some of that noise out before it even gets to me. Information overload is a real thing if it’s not usable information.

13. What investing blogs do you read?

Besides newspaper run blogs, like DealBook, I read a ton of value investing blogs. In addition to yours, some of my favorites are NoiseFreeInvesting, Valueplays, Controlled Greed, Cheap Stocks, and Reflections on Value Investing, which I also contribute to. My blogroll has the entire list. I find good ideas and enjoyable reading in these blogs. I’m a fan of Going Private as of recent. She is a great writer.

14. What's the best investment book you've read?

If you’re talking about investing how-to’s, it’s The Intelligent Investor. I derive the base of my thinking from that book, no doubt. The Dhando Investor is close as a modern treatise. If we’re talking everything investing related, then it’s easily Buffett: The Making of an American Capitalist. I’ve read that about 6 or 7 times probably, in two years. It goes without saying that Alice Schroeder’s book this fall is going to cause me a few sleepless nights. Regarding The Dhando Investor, that book hit some nerve in my brain. I must’ve read that one 6 or 7 times as well. Buffett and Graham talk a lot about business-like investing, that mantra we’ve all heard. But, it wasn’t until I read Pabrai that I began thinking of investing like an entrepreneur thinks about running a business, which is at the core of my framework now. If Graham is the Old Testament and Buffett is the New Testament, Pabrai is like CCD or Sunday School for me, clarifying some already established concepts. Low risk of capital impairment, uncertain future outcomes; that framework hit me like a ton of bricks. It just made a lot of sense.

15. What's the last investment book you've read?

I just finished reading a book called Extreme Value Hedging by Ron Orol. It’s about the tactics and strategies of activist hedge funds in this day and age, and where they came from. It’s a very detailed book that takes this subject from many different angles. Some of it I already knew, but I learned a ton, from activist strategies to required disclosures.

An interesting thing about EVH is that it connects value investors genetically to activist investors. To me, that makes a whole bunch of sense. If you owned a private business, wouldn’t you try to protect it if the managers were screwing up? I believe that activism is necessary at times. You own the business, after all, and one of the privileges of ownership is (partial) control. Even the 1950’s Buffett and Graham would go in and shake things up when they weren’t happy. So while I would never wish to run an “activist fund,” I think it’s wise to speak up when your managers are misbehaving with your capital. Good book.

16. When did you start investing?

I didn’t start investing, really, until a bit over a year ago. I’d been learning about it, reading about it, dreaming about it, for a couple of years. Last year I decided that even though I’d probably lose some money, which I did, it was worth to it to start experiencing investing rather than reading about it. Incidentally, I began investing right near the top of the market. That was a nice, quick proof that market timing isn’t a good approach for me. I’m getting better, slowly.

17. How have you improved as an investor?

The major thing was recognizing my fallibility and inexperience. It’s easy to read up on things and think you’re a real smart guy who’ll do 30% a year for the next 30 years. Then you get in there and lose a whole bunch of money and say, what happened to the smart guy I thought I was? I’ve progressed in learning where my circle of competence lies, how I can expand it, and being patient until that happens. Concentrated value investing involves some serious price swings for your portfolio. I’ve seen some huge volatility in what I own. From that, I’ve learned that I won’t be able to hang in there and buy more unless I’m really comfortable with my holdings. Writing publicly about them helps more than I anticipated, another reason I enjoy blogging.

18. How do you need to improve as an investor?

More of the same I spoke about above. I still need to work on patience and understanding. They are interrelated in more ways than most people realize. Without understanding, you’ll have serious trouble being patient. If I founded and owned some private business, I sure wouldn’t let some idiot tell me what it was worth every day. I really need to take that mantra and apply it 100% to investing in public securities. I can gain understanding through reading about companies and talking to knowledgeable people. I can only gain patience through introspection. It helps to have read Munger, Zweig, and all these guys who point out our psychological flaws. I’d also love to learn more about bankruptcy and real estate investing some day, as I believe that, periodically, there will opportunities in both areas to make a ton of money.

19. Where are the bargains in today's market?

At first, I was thinking to myself “If you don’t have much capital, there are bargains everywhere.” To heck with that. Even if you do have five or six billion, there are bargains everywhere. Financial stocks, restaurants, retailers, healthcare… pick a sector you think you can understand and get working. There are companies being left for dead that won’t die. Sears is a $50B retailer selling for less than $10B. The market is saying, “This isn’t gonna work, Eddie.” Well, it might, and we don’t have to pay up to see it through; in fact we’re probably being paid to see it through. I’m finding stuff like that everywhere. That’s very true with financial stocks, as well, except that 99% of them are outstanding my realm of understanding. This is not the time to be clutching gold and treasury bonds, sucking your thumb until it’s all better. Just know that the recovery won’t be immediate, and you won’t know when it’s going to happen. At some point, though, people will return to the retail stores and restaurants, return to the credit markets, and need some serious help staying healthy as they get older. I’d structure my portfolio knowing these things will eventually happen.

20. What's the most interesting company we haven't heard of?

Primus Guaranty (PRS). They sell CDS on corporate single names and tranches. Basically, 95% of their revenue is just receiving quarterly premiums for insuring default on investment-grade corporate bonds and tranches. The GAAP numbers look awful due to marks, but the business is as good as ever. The company will never have to post collateral for falling CDS values, and they hold 98% of the contracts to maturity. The stock has cratered from over 12 to under 3, for no rational economic reason. It’s simply fear and misunderstanding. They’ve been thrown out with MBIA and Ambac, but unlike the bond insurers, they don’t owe people all kinds of money, and none of their counterparties can demand collateral. There’s no exposure to structured finance insurance. The only situation where Primus is murdered is if investment grade corporate bonds start defaulting at unbelievable rates. Meanwhile, the stock sells about 2x economic earnings and less than a third of solid book value. I know, here I am talking about all the mistakes I’ve made owning financial companies and now I’m recommending one. But I understand Primus the way I didn’t understand a bunch of those other companies I lost my marbles trying to make money on. Primus is a very simple company, one I’m comfortable owning. In any case, I’ll either have a big smile or lots of mud on my face in a couple years.

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Posted by Geoff Gannon at 05:29 AM | Permalink | Comments (0) | TrackBacks (0)

Note: My continuing weekly commentary on Benjamin Graham’s Security Analysis is being bumped for this roundtable; the commentary will appear here tomorrow morning. Sorry for the inconvenience.

This is a new format for Gannon On Investing – a pseudo-roundtable, where the same questions were posed to different bloggers simultaneously (via email). In this first post, we have answers from the authors of four of my favorite blogs: Fat Pitch Financials (GEORGE), Cheap Stocks (JON), Bill Rempel (BILL), and Controlled Greed (JOHN).

Performance

How have you fared so far in '08?

George: It’s been a rough year for my portfolios so far. My Fat Pitch Financials Portfolio, which tracks my longer term value investment picks, is down 15.9% year to date (as of July 11th). My Special Situations Real Money Portfolio is down 6.7% year to date.

Jon: It's been very challenging, especially the past month. Even some of the illiquid names I hold have started to come under pressure.

Bill: YTD as of 7/18 close, -1.67%.

John: My portfolio is down 12% through June 30th of this year.

What's been your greatest success this year?

Bill: I'm not viewing the individual trade results as being composed of individual successes or failures. I view the process as one of methodology applied consistently, with individual trade results being somewhat randomly distributed over time, around an average result for that system. That holds true for relative value traders, GARP traders, cigar-butt traders, special situation traders, and other types of system traders. Sticking to a chosen system is the "success." Currently I trade one of the four systems I track; in time, with a larger account, I'll probably trade two simultaneously.

George: In my Fat Pitch Financials Portfolio, my position in Western Union (WU) seems to be holding up the best so far.

My greatest success this year in my Special Situations Real Money Portfolio was my investment in JACLYN INC (JLN) that I bought for $7.65 on April 4, 2008 and I was cashed out (since this company went private) for $10.21 per share on May 22nd.

John: ArmorGroup International, which traded in London, got taken over by a UK company called G4S for a gain this year of 147%. You’ll remember I talked about ArmorGroup in the “20 Questions” interview we did previously. I originally bought the company in September 2006. My gain from start to finish was 61.3%, or more than 36% on an annualized basis.

Jon: The launch of the Cheap Stocks 21 Net/Net Index, the first index that tracks a basket of companies trading below net current asset value has had some very interesting results. Since inception (2/12/08), it’s up more than 9%, while the closest benchmark, The Russell Microcap Index is down 10%. Pico Holdings has also made a very nice recovery

What's been your greatest failure this year?

John: General Motors (GM), down 51.8% through June 30.

George: I recently made a big mistake not selling a stock immediately when its tender offer terms were modified and lowered. That stock, Sunstone Hotel (SHO) has plummeted since. I consider this my greatest failure since it was do to poor judgment. I believe this behavior is called anchoring.

Jon: Premier Exhibitions (PRXI), and 4 Kids Entertainment (KDE) have been big disappointments. I still hold both, and will likely continue to buy Premier.

Market

On the U.S. stock market, are you a bull, a bear, or a chicken?

Bill: On the U.S. market, my Timing system for the SPY has been 25% stocks, 25% bonds, and 50% cash since pretty much the beginning of the year. Looking outside the system, at indicators not included in it, I still think that the general level set by the January (and now the July) lows will be a multi-year bottom.

Jon: Believe it or not, I am still a bull. I believe oil, not housing, not the financial crisis is the single biggest risk factor in the market

George: I’m starting to get bullish on the U.S. stock market. For the past few months, I’ve been a chicken, lol. The market has been pretty scary this year. The bursting of the housing bubble, depreciating dollar and increasing oil prices is a tough combination.

John: Oh, I’m bullish longer term. Shorter term, things are lousy and could even get worse. But I don’t invest for the short term

Are stocks cheap, expensive, or fairly valued?

Bill: How you look at "stocks" depends on how you aggregate the index, how you weight the components, etc. If the question is, "how is the S&P 500 valued?", I dunno. I haven't done the math on it, and don't really care. Certainly some individual stocks are fairly valued, some are cheap, and some are dear, by methods that I would consider using.

John: I don’t look from a top-down perspective. But bottom-up, there are lots of cheap stocks. If a buyer is willing to wait and suffer lower prices between now and when things recover down the road, he or she could see significant gains.

George: Stocks are starting to look cheap.

Jon: Cheap, at least where I am looking--the smallest of the small

Where is the market headed? What should investors do?

George: I don’t know where the market is headed, but with the failure of IndyMac last week and the turmoil that is coming Monday due to auctions for Fannie Mae and Freddie Mac bonds, I doubt the we will see any significant market gains next week.

Now is the time to find cash. Look under those couch cushions, shake the piggy bank, and save as much as you can. Plow that cash into value opportunities.

Jon: Investors should stay on course, and use some of their dry powder to pick up some bargains. I believe that we are at or near the point of there being blood in the street,

John: For a value guy with a long-term view, I think you buy inexpensive stocks if you’re willing to hold for several years, suffer any price declines, and not worry about the market.

Bill: I think individual traders should find a system (or systems) that work(s) over the long haul, and apply it (them) relentlessly. Even if they use the system as a screen for discretionary trades, provided the system itself is robust, they'll do OK over time. Don't worry about the day-to-day market moves, because in the long run, they're irrelevant.

Oil

Why are oil prices where they are?

John: We’re hitting an area outside my circle of competence. I suspect it’s a combination of greater demand, refinery capacity not having kept pace over the past couple of decades or longer, and a “terror” premium added to oil prices. My hunch is that all the crying we hear about speculators is bull.

Jon: The declining dollar, hot spots in the Middle East, and speculation. We are in a vicious cycle, and each of these factors feeds the other. I believe Iran has no intention of attacking Israel, but is rather trying to disrupt our economy, with success, I might add.

George: Demand for oil continues to grow worldwide. Production may have peaked. The risk of supply disruptions is perceived to be high. Most importantly, buyers continue to be willing to pay the current high prices.

If you are interested in learning more about why the price of oil is established, I recommend studying Hotelling's rule.

Bill: Oil prices are where they are (or were where they were) because of speculation. That's the answer for all prices, SPECULATION. All market participants speculate, even those that are end-users or producers of commodities, even those not using leverage, even those buying "value" stocks with the intention of holding them for years.

Where are oil prices headed?

George: I think in the short term oil prices may continue to climb a bit higher to $150 per barrel. However, society is starting to make changes to confront higher oil prices. People are buying more efficient vehicles and driving less. Companies are investing more in energy efficiency and alternative fuel sources. I believe that next year we will see lower prices than we have today. Of course, this is really all just speculation, but it is what I think may be the most likely outcome.

Jon: Ultimately lower, perhaps the $60-$80 range. That presumes a stronger dollar, decreasing tensions in the hotspots, and that offshore drilling, and reduced consumer demand all become a reality. A tall order, I know.

Bill: The sarcastic answer is "they will fluctuate." I think we saw a blow-off top in oil prices just now. Long-term, I think the cycle of gasoline prices is topped as well, and GM's boneheaded too little, too late moves probably marked the top as well as any capitulation ever could.

John: My guess is lower this fall. I think there’s been a “bubble” effect with prices lately. But if America and/or Israel attack Iran, or another event happens in the Middle East, who knows?

What do oil prices mean to investors? Should they care? And what should they do today?

Bill: What should traders do about oil? The same thing they should do about the market, find and apply a methodology and stop "reacting."

John: I believe investors like me should invest in undervalued companies. Spread your bets and let the chips fall where they may. Basing investments on oil prices strikes me as too much “top-down” investing. Of course, if gas suddenly shot up it could have a bad impact on a whole host of industries. But we’d adapt over time. I have relatives in England. They tell me they’re paying right around the equivalent of US$10 a gallon (a lot of that is taxes). They don’t like it, but life is going on over there.

George: As an investor, it is hard to completely dismiss oil prices. I think most investors should consider the macro impact of oil prices and also how it impacts their individual holdings.

As for what investors should do today, I think they should think about what value opportunities may exist in excellent companies that may have been overly discounted due to current oil prices.

Jon: Oil is the single biggest factor weighing on the markets, they should care, but need to be able to weather the storm. It is very difficult to do so psychologically, though

Economy

How bad is the economy?

Jon: Housing is bottoming, there are some positive signs there, unemployment is benign ( but may worsen), the credit crisis was improving, but Fannie and Freddie situation is of concern. I believe it's not as bad as the pundits suggest. What frightens me most is one big shock to the system, i.e. oil supply shock, terrorist attack, etc, that really shuts things down, and frightens consumers worse than they already are. That aside, its not as bad as some think.

Bill: The economy is never as bad or good as you think it is. Certainly the rate of "real GDP" (which ISN'T "the economy") change isn't going to be as low as the consensus projection (read: it ain't gonna be negative).

John: We’re definitely in the midst of an economic downturn. Whether it meets the textbook definition of a recession I’ll leave to others to decide, but things aren’t great, that’s for sure.

George: All I know is that the health of the economy is not good. Thing could end up a lot worse next week if the IndyMac takeover and the handling of Fannie Mae and Freddie Mac crisis is not handled properly.

How bad will it get?

Bill: I doubt we'll see an overall "recession" (as called by the NBER) this year.

Jon: Fundamentals will improve, but elections are scary. I fear an Obama Presidency from an economic standpoint. His policies, if enacted will damage the free markets, and flow of capital. He makes George McGovern look like Ronald Reagan.

George: I hope not much worse, but if more major financial institutions fail that could get real ugly (see my previous answer). Inflation is also one of my biggest concerns right now.

John: I have no idea. When I read a smart guy like Francis Chou telling his investors that even the CEOs of these big financial firms have no idea if the bad stuff is on their own balance sheets, I pay attention. Then I recently read Ted Forstman, another smart fellow, saying in The Wall Street Journal the credit crisis is bad and that we’re only in the second inning of this mess. So it could get much worse. I’m hoping the second half of this year will tell us a lot, so that prospects for 2009 will look brighter. But what do I know? We might be muddling along another year or more after that.

Where does today's economic environment fit in a historical context?

George: To some degree today’s economic environment is fairly unique. However, there appears to be some similarities to the 70s fuel crises era.

Bill: In historical context, this current "downturn" is milquetoast.

John: If it stays like it is, it certainly won’t rank among the worst downturns in American history, broadly speaking. In 1973-1974 and 1980-1982 things were worse with unemployment much higher. But if housing prices keep going down, and then the crisis moves on to credit cards, auto loans, etc., as some forecast -- it could be a doozy.

Jon: Reminiscent in some ways, of the early 70's, although not as bad

What does the macro economy mean to investors? Should they care? What should they do today?

Jon: They should care, but not to the point that it forces them to make a mistake. There are values out there. If they have dry powder, they should deploy some of it at current levels. They should be concerned about inflation, and hedge it (exposure to TIPS, Metals, perhaps REITS, even HY bonds). They should be well diversified across and within asset classes

George: Investors should try to have some understanding of the current macro environment. However, the focus should still be at the specific company level when analyzing various investment opportunities.

John: John Templeton died recently. Think of all the stuff that happened from the time John Templeton started the Templeton Growth Fund in 1954, to when he gave up daily management in 1987. Cold wars, hot wars, assassinations, scandals, Bull markets and Bear markets, you name it. Sure, the macro economy is important and I care about it. But the investor in me doesn’t let macro stuff get in the way. It’s mostly just noise.

Bill: Unless their system is based on macro projections, individual traders shouldn't care. I think it's unwise to base trading decisions on macro data, because it involves overlaying another set of assumptions and calculations, which gives just one more source for error. Certainly "value" based traders should IGNORE the macro data, or if they pay attention, run CONTRARY to the macro data, because the premise of "value" is that the market OVER-reacts to data. Follow the methodology.

Opportunity

Do you see any opportunities in financials? Housing? Real Estate?

George: I think it is still to early to invest in financials. It is hard to say any investment in this sector provides a margin of safety as the financial crisis continues to spread.

Jon: Definitely in real estate. I'd look at depressed companies that own land, and are not highly leveraged. Financials are still too scary for my blood.

Bill: I don't usually look at individual stocks by sectors or industry group. I'm sure there are some fine opportunities in those areas, but for individual stocks I focus on the characteristics of the stock regardless of industry. When I look at Rotational next week, I'll give an update on where I think the groups are headed, but I try to look at that in detail only once every four weeks - the picture really doesn't change that quickly.

John: Non-bank financials, yes. I like some of the property and casualty insurance companies and the reinsurance companies. I own Tokio Marine Holdings ADRs (TKOMY) and Fairfax Financial Holdings (FFH), though I’ve sold enough Fairfax when it doubled in price to get my original capital back. So it’s a free ride for me. And there are some others I don’t own now, but may at some point -- such as Munich Re and Montpelier Re (MRH) -- that are attractive.

I’d stay away from the banks for now, though I’m sure you saw that Barron’s ran a Bullish cover story on them. I imagine we’ll see bargains at some point, like investors did during the savings and loan crisis in the early 1990s, but I don’t know if you can trust the balance sheets right now.

What's the best general decision investors can make? Where should investors be looking today?

John: I believe the best general decision an investor can make is to stick it out and stand up to the headwinds we’re facing. I don’t invest by sector or country. I just try to find undervalued stocks. I’m based in the US and most of my stocks are based here. But there are lots of cheap stocks in Japan -- though you really have to be careful about whether or not the managements are shareholder-friendly. We’re in a global economic downturn, so there are probably inexpensive stocks to be found most places.

Bill: Traders should execute their chosen methodology. If they don't have one yet, they should find one.

George: The best general decision an investor can make today is to maintain a margin of safety. Investors should look broadly for opportunities but also acknowledge the limits of their circle of competence.

Jon: Small cap value for the long haul---I know that will surprise you. Look for depressed companies (from a price standpoint) with cash and little debt.

What stock do you like most today?

Jon: CBRL Group (CBRL) -- does not fit the above definition to a T (does have leverage), but is extremely cheap, nice dividend yield (3.6%) and owns a lot of its real estate.

Bill: Choosing ONE for RIGHT NOW is a random process. It's much more telling to see how the cumulative results of many different choices play out over years at a time.

John: I don’t like one most of all, but I’ll say King Pharmaceuticals (KG). I bought King in June at $9.98 and it’s been trading over $10 or $11 lately. King traded for more than $21 a share last year. The stock got hammered, primarily because it lost patent protection for its largest drug (a heart drug called Altace) in 2007.

King's strategy is to acquire older branded drugs no longer being promoted by their originators. King then uses its salesforce to increase sales of these drugs through effective marketing. Look for the company to use its significant financial resources to seek new product opportunities.

At the current stock price, investors assume the worst-case scenario for King: that it will lose patent protections for its major profit makers while achieving no replacement revenues. I don't believe that will happen and have placed my bet. But there are no guarantees.

George: I am still very happy with my investment in Sotheby's (BID). This company has an impressive economic moat and is trading at a price lower than it deserves given its current performance.

Visit Fat Pitch Financials

Visit Cheap Stocks

Visit Bill Rempel

Visit Controlled Greed

Posted by Geoff Gannon at 04:40 AM | Permalink | Comments (0) | TrackBacks (0)

This book is intended for all those who have a serious interest in security values. It is not addressed to the complete novice, however, for it presupposes some acquaintance with the terminology and the simpler concepts of finance. The scope of the work is wider than its title may suggest. It deals not only with the methods of analyzing individual issues, but also with the establishment of general principles of selection and protection of security holdings. Hence much emphasis has been laid upon distinguishing the investment from the speculative approach, upon setting up sound and workable tests of safety, and upon an understanding of the rights and true interests of investors in senior securities and owners of common stocks.

(Preface to the First Edition)

And so Graham begins his magnum opus – or at least the preface to its first edition. Here we have a full introduction to the entire work – much fuller than a first-time reader might suspect. First, we are introduced to Graham’s ideal reader (“…have a serious interest in security values…not…a complete novice…some acquaintance with the terminology and the simpler concepts of finance.”) Next, the scope of the work is delimited. We are told that it shall encompass not only analysis proper, but the related issues of “selection” and “protection”. Finally, Graham informs us of his own special concerns: the distinction between investment and speculation, practical methods, and shareholder rights.

This last – and in 1940, most peculiar – concern of Graham’s will be explored in two ways: 1) through an exhaustive – and for some readers exhausting – discussion of senior securities (e.g., corporate debt) and 2) through glimpses of shareholder activism.

Graham was an early pioneer of shareholder activism. For more information, see On the Northern Pipeline Contest.

The two prefaces also introduce us to Graham’s idiosyncratic – and to some readers intimidating – writing style. I’ll take up this subject in my next commentary post. For now, just read over the two prefaces (or the passage above) and note how the writing is neither confused nor convoluted. It may be stylistically unfamiliar, but it is very easy to follow. Graham’s sentences are not especially long and they are syntactically streamlined for the modern American reader. Words and clauses appear exactly where you would expect them to appear to perform their standard functions.

Therefore, you’re unlikely to get lost in one of Graham’s sentences. However, you may get lost in one of his paragraphs.

As a general rule, you should not back-track when reading Graham, because his prose is strung together more logically than most people’s. If you don’t think you understand something perfectly, just keep reading. However, if you find you’re truly lost, go back to the first sentence in the paragraph. Even back up another entire paragraph if you must, but don’t try to back-track within a paragraph, because Graham’s paragraphs are threaded together with a logical strand that’s hard to pick up without a good reference point.

Again, my best advice is to keep reading without ever stopping, back-tracking, etc. The best way to read Graham (and probably the best way to read anyone) is to read entire sections straight through and then re-read them if necessary, but never stop and hack them up just to make yourself more confident in your comprehension.

The next commentary post will discuss Graham’s writing style in greater depth. Next Monday’s post will cover the Introduction (pg. 1 – 17). So, please read that for Monday.

Now, who has questions or comments about this first commentary post or either preface?

Posted by Geoff Gannon at 05:00 AM | Permalink | Comments (4) | TrackBacks (0)

It's no longer a rumor; it's now news. IndyMac (IMB) has failed.

From Reuters:

The FDIC said the estimated cost of the California-based bank's failure to its insurance fund is between $4 billion and $8 billion. The regulator said it will operate IndyMac to maximize the value of the firm for future sale.

IndyMac's primary regulator, the Office of Thrift Supervision, blamed a senior lawmaker's comments for causing a run on the deposits at the largest independent publicly traded U.S. mortgage lender.

From Bloomberg:

IndyMac came under fire last month from U.S. Senator Charles Schumer, who said lax lending standards and deposits purchased from third parties left it on the brink of failure. In the 11 business days after Schumer explained his concerns in a June 26 letter, depositors withdrew more than $1.3 billion, the OTS said.

``This institution failed due to a liquidity crisis,'' OTS Director John Reich said in the statement. ``Although this institution was already in distress, I am troubled by any interference in the regulatory process.''

Office of Thrift Supervision Shuts Down IndyMac (AP)

IndyMac Seized (Bloomberg)

IndyMac Taken Over By Regulators (Reuters)

Federal Regulators Take Control of IndyMac (LA Times)

IndyMac Bancorp Is Seized By Federal Regulators (WSJ PREVIEW)

Posted by Geoff Gannon at 05:53 PM | Permalink | Comments (0) | TrackBacks (0)

According to this post at Seeking Alpha, Whitney Tilson is short Hanesbrands (HBI). I mentioned Hanes (which was then my favorite stock) during a "roundtable" discussion on October 20, 2006:

However, there are many situations (and here is usually where you find some bargains) where the EV/EBIT measure is not the most useful. When I can predict a high free cash flow margin with confidence, I use a very long-term discounted cash flows calculation. For instance, this is what I would do with HanesBrands (HBI), which was recently spun-off from Sara Lee (SLE). On an EV/EBIT basis, it may not look cheap. But, looking truly long-term, I'm convinced the intrinsic value of each share is much closer to the $45 - $65 range than the roughly $23.00 a share at which it now trades. But, that's a special case – Hanes is a special business.

I wrote a post on Hanes back on July 23, 2007. That’s also where I mentioned that Hanes had been the sole idea slated for the October 2006 issue of my newsletter, but I shut down the newsletter because I felt one idea couldn’t justify the $75 price tag.

Three days earlier (July 20th, 2007) I had written:

If you're looking for a stock where leverage will amplify your returns, I still like Hanes Brands (HBI). It's not as leveraged as Journal Register (though it has plenty of leverage) and it's a much better business. Hanes was the most interesting spin-off of last year and the stock did well enough but has since cooled off a bit.

I loved Hanes at the spin-off price. I still like it at today's price. It's probably not ridiculously undervalued as a business, but the debt will amplify the difference that does exist. Last October, I wrote that Hanes was probably worth more like $45 - $65 a share than $25 a share. I still think that's true; however, the spin-off, plant closings, and debt might obscure the business value for a time. Be patient.

My only post focused solely on Hanes was written on July 20th, 2007 and is basically a collage made from the much longer newsletter piece I had written for October of 2006.

That issue was never published, so I made a blog post out of the scraps.

Although it’s an old post; you may enjoy reading it.

Regardless, you should definitely read Tilson’s Seeking Alpha post and the accompanying PDF.

They’re both good.

Posted by Geoff Gannon at 03:29 AM | Permalink | Comments (3) | TrackBacks (0)

Get

Security Analysis: The Classic 1940 Edition

The Interpretation of Financial Statements

Read
Security Analysis: Preface to the Second Edition, Preface to the First Edition (pg. vii – x)

The Interpretation of Financial Statements: Introduction to Chapter XX (read to pg. 48)

Note

I will post the first commentaries on Monday. The chapter commentary will only cover the two prefaces to give everyone an extra week to acquire a copy of Security Analysis.

There will also be commentaries on general subjects interspersed with the chapter specific commentaries. The entire Security Analysis “course” will be collected together and made available through a Security Analysis link under the CATEGORIES heading on the right sidebar starting Monday.

By the way, if you have any accounting background, you can skip The Interpretation of Financial Statements.

Posted by Geoff Gannon at 10:47 AM | Permalink | Comments (5) | TrackBacks (0)

Reading a thread over at GuruFocus reminded me of a common problem people have:

Have you actually read Security Analysis cover-to-cover? Has anyone on here?

I have. Several editions, several times.

A lot of people haven’t. I don’t think it’s a matter of dedication, enthusiasm, intellectual curiosity, etc. I think it’s a matter of being or not being a certain kind of reader.

I’m sure many, many people read a lot more than I do. But, I’m also sure I’m well-suited to reading Security Analysis on my own, because:

1) I never stop reading a book I enjoy

3) I routinely read books written by dead guys

If this doesn’t describe you and you’ve never read Security Analysis cover-to-cover and you’d really, really like to – I have an idea.

I’m willing to do a weekly post on Security Analysis, taking anyone who wants to go on the journey through every chapter of the book. I’ll give you my best commentary on the text, and I’ll answer any questions you have. In return, I ask that you get the book and read a chapter a week.

Is anyone up for this?

If you'd like to join me, this is the required text:

Security Analysis: The Classic 1940 Edition

If you've neither taken a financial accounting course nor read Graham before, you'll need this one as well:

The Interpretation of Financial Statements

***

To whet your appetite, here’s a previous comment I made about a passage in Security Analysis, in a post On Technical Analysis:

“…the influence of what we call 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. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”

I’ve seen a lot of people cite this quote, without bothering to notice what’s really being said. Graham had a very broad mind, much broader than say someone like Buffett. That’s both a blessing and a curse. At several points in Security Analysis (and to a lesser extent in his other works), Graham can not help but explore an interesting topic more deeply than is strictly necessary for his primary purpose. In this case, Graham could have said what many have since interpreted him as saying: in the short run, stock prices often get out of whack; in the long run, they are governed by the intrinsic value of the underlying business. Of course, Graham didn’t say that. Instead he chose to describe the stock market in a way that should have been of great interest to economists as well as investors.

Data affects prices indirectly. The market is a lot like a fun house mirror. The resulting reflection is caused in part by the original data, but that does not mean the reflection is an accurate representation of the original data. To take this metaphor a step further, the Efficient Market Hypothesis is based on the idea that the original image acts on the mirror to create the reflection. It does not recognize the unpleasant truth that one can interpret the same process in a very different way. One could say it is the mirror that acts on the original image to create the reflection. In fact, that is often how we interpret the process.

Posted by Geoff Gannon at 02:20 PM | Permalink | Comments (5) | TrackBacks (0)

John Bethel of Controlled Greed has a post on John Templeton.

He links to a 1997 interview with Charlie Rose.

This interview reminds me how good Charlie is interviewing an investor. Many financial journalists don't manage to get as much out of their subjects as Charlie does.

Value Discipline also has a post.

Posted by Geoff Gannon at 12:08 AM | Permalink | Comments (0) | TrackBacks (0)

One of the world’s greatest investors has died.

"In almost every activity in life people try to go where the outlook is best…However, my contention is that if you are selecting publicly traded investments, you have to do the opposite. You are trying to buy a share at the lowest possible price in relation to what a corporation is worth. There is only one reason a stock is being offered at a bargain price: because other people are selling. There is no other reason."

(From the Preface to Investing the Templeton Way)

There are already countless articles out there. Here are just a few:

Articles and Obits

Bloomberg

New York Times

Daily Telegraph

Washington Post

Globe and Mail

Books

Investing the Templeton Way: The Market-Beating Strategies of Value Investing's Legendary Bargain Hunter

Templeton Plan: 21 Steps to Personal Success and Real Happiness

Worldwide Laws of Life: 200 Eternal Spiritual Principles

Discovering the Laws of Life

And remarkably, a negative post from a nasty, little blog that uses quotation marks in place of conversation, and preaches to the choir on the evils of preaching and choirs.

Posted by Geoff Gannon at 12:11 PM | Permalink | Comments (0) | TrackBacks (0)

No links – just headlines. If you subscribe to The Wall Street Journal in print, online, or by Kindle and don’t have time to read the whole paper, here’s a list of some of today’s articles you shouldn’t miss.

GM Weighs Layoffs, Sale of Brands

Merrill May Sell Bloomberg Stake, Some of BlackRock

Glaxo Seeks Guidance from Health Systems

Immelt Defends GE’s Wide Reach

Firms Train for EU Raids Amid Price-Fixing Probes

Pay Your Own Way: Firm Lets Workers Pick Salary

Gas Stations Hit Skids

Retro Ploy on Wall Street

Why Bother?

GM Weighs Layoffs, Sale of Brands

Only if you’re interested in General Motors (GM) or automakers. The branding thing has always baffled me, not just for GM but for carmakers generally. It seems poorly done, confusing, bound to lead to cannibalization, etc. – but I’m not a marketer.

By the way, John Bethel’s Controlled Greed is the best blog for GM shareholders.

Merrill May Sell Bloomberg Stake, Some of BlackRock

Shows the cost of being in a position where you need to make a deal. Who will buy the Bloomberg stake? Don’t know. Probably not Berkshire – it’s likely Bloomberg will be too expensive for Buffett’s taste, though I imagine it’s the kind of company he’d like to own at the right price (it’s also sized right).

Glaxo Seeks Guidance from Health Systems

Read for a sense of the trends in government and medicine.

Immelt Defends GE’s Wide Reach

Combine with 24/7 Wall St’s post and enjoy a GE twofer.

Firms Train for EU Raids Amid Price-Fixing Probes

Funnier than fiction.

Pay Your Own Way: Firm Lets Workers Pick Salary

Neat idea.

Gas Stations Hit Skids

Can you believe it? An article involving gas prices that contains info you probably didn’t know.

Retro Ploy on Wall Street

Because I’ve always thought rights offerings were underutilized and overstigmatized.

Posted by Geoff Gannon at 05:43 AM | Permalink | Comments (0) | TrackBacks (0)

News

With $35bn to Spare, Buffett is Poised to Feed Off the Bear

Blogs

GE’s Earnings, Immelt, And Jack’s Ghost (24/7 Wall St)

Controlled Greed: Life of the Blog (Controlled Greed)

Six Flags Is No Bargain Even at a Buck (Seeking Alpha)

Posted by Geoff Gannon at 08:58 PM | Permalink | Comments (0) | TrackBacks (0)

John Bethel of Controlled Greed has posted that blog's latest results. He gives the individual performance of every stock pick.

Don't be surprised if you see posts from me on some of these stocks, especially note Whirlpool (WHR), American Eagle (AEO), and Capital Southwest (CSWC).

Read Controlled Greed's "Life of the Blog"

Posted by Geoff Gannon at 04:45 PM | Permalink | Comments (0) | TrackBacks (0)

I've recently returned to blogging after a more than three month absence with my post “On Blogging”. In that post, I discussed some of the problems that come along with blogging. Having explored the downside of blogging, I’m asking for some help exploring the upside.

What did you like most about this site? The blog? The podcast? Which posts? Which episodes? What kinds of subjects? What would you like me to do that I haven’t yet done?

How can I make this site better for you?

Thanks.

Posted by Geoff Gannon at 04:45 PM | Permalink | Comments (7) | TrackBacks (0)

News

King of Beers? Only in America

Is Merrill Shopping Its Bloomberg Stake?

Is Bill Miller Toast?

Nightly Business Report Transcript: James Grant Interview

Blogs

BCE Reaches Final Buyout Agreement: What Next? (Controlled Greed)

A Flurry of Appearances for Bruce Berkowitz (Circle of Competence)

Posted by Geoff Gannon at 02:25 PM | Permalink | Comments (0) | TrackBacks (0)

News

My $650,100 Lunch with Warren Buffett

UnitedHealth Ends Options Suit, Cuts 4,000 Jobs

Circuit City Shares Fall as Blockbuster Yanks Bid

GM Shares Fall to Lowest Price since 1954; Merrill Suggests Bankruptcy

Microsoft, Yahoo’s Winding Road

Blogs

OneBeacon, White Mountain File Shelf Registration (24/7 Wall St.)

Fat Pitch Financials Portfolio Mid-Year Update (Fat Pitch Financials)

Some Blogging-Related Quick-Hits (Controlled Greed)

Posted by Geoff Gannon at 05:24 PM | Permalink | Comments (0) | TrackBacks (0)

News

Starbucks to Close 600 Stores; Cut Up to 12,000 jobs

Steak N’ Shake Appoints Biglari Chairman

Seeking Alpha / Micovision Story

Posted by Geoff Gannon at 03:55 PM | Permalink | Comments (0) | TrackBacks (0)