The Inoculated Investor

Occupy Yahoo

2011-11-15T12:26:00.001-05:00

Readers,

Cove Street Capital's latest strategy letter is now available on the firm's website. I highly recommend checking out the new piece to see portfolio manager Jeff Bronchick's comments on the corporate governance debacle that is Yahoo (YHOO). In addition, included with the posting is what has to be one of the most poignant and perfectly fitting pieces of artwork (also shown on the right had side of this page) you are going to see this year. I believe our in-house artist Kelli Manthei has captured the management acumen of Chief Yahoo Jerry Yang (note the incredible irony embedded in that title) and HP's former CEO Leo Apotheker amazingly well by portraying Yang as Beavis and Apotheker as Butt-Head. For those of you who might not be familiar with the famous characters created by Mike Judge, spending 5 minutes on YouTube should be enough to explain why no corporate CEO would ever want to be compared to these two cultural icons.

I hope you enjoy the piece and will continue to follow Cove Street's blog.

Sincerely,

The Inoculated Investor

Earnings Per Share Myopia

2011-11-05T12:22:00.003-04:00

My newest piece, entitled Earnings Per Share Myopia, is now exclusively available on Cove Street Capital's blog site. You can access the posting by clicking this link. After listening to a number of company conferences calls during the Q3 earnings season, I was struck by how many of the questions posed to the executives hosting the call had nothing to do with trying to ascertain the intrinsic value of the company. Instead, the focus was inevitably (and unfortunately) on gathering data that will help the sell-side analysts forecast the next quarter's earnings per share number. While this practice is frustrating for the listener, I firmly believe that patient value investors can find a way to benefit from such myopia. Please use the above link to access the piece if you want to know more of my thoughts. (Don't forget to see the disclosure statement located at the bottom as well.)

As a reminder, all new content generated by me will be posted on Cove Street's site from now on. We are in the process of migrating people who have sign up for the RSS feed to this site. If for some reason you do not want to be signed up to receive emails updating you when new material is posted on Cove Street's site, please send us an email at Questions@CoveStreetCapital.com. If you are new to this site or are not a subscriber and want to have access to Cove Street's blog, just click this link and sign up in the box located in the top right corner of the page.

I hope you will take the time to explore the new site and read my latest piece.

The Inoculated Investor is Moving!

2011-10-25T13:17:00.000-04:00

DearReaders,

Afterabout two and half years using Blogger as the primary medium for sharing mythoughts, notes and links, The Inoculated Investor has found a new home.Specifically, the change is being made due to some compliance concerns and,most importantly, my overwhelming desire to have the time I spend bloggingbenefit my new firm, Cove Street Capital, as well.

The good news is thatnothing is going to change other than the website. In fact, I may even beposting more often than I was in the past. In addition to commentary pieces andnotes from the seminal events of the year—the Berkshire annual meeting forexample—I hope to also post notes from industry conferences and managementmeetings. Further, readers will also have access to material from portfoliomanager Jeff Bronchick, who used to write for TheStreet.com, and Eugene Robin,my partner in crime on the analyst side. I personally believe that theintegrated site will offer additional content that makes it more valuable thanmy site alone.

So, theobvious question is, if you want to continue to follow The Inoculated Investor,how should you sign up? Well, there are a number of ways and we want to make itvery convenient for people because the goal is to transition as many readers aspossible to the Cove Street site.

First,you can bookmark the site on your web browser. Click here for the homepage of the CoveStreet blog and here for my new homepage. If you clickeither link you will be able to sign up for our mailing list in the box locatedon the right-hand side of the page. In order to not inundate people, we makesure to only send out emails to subscribers that highlight recent blog contentonce a week. At that point you will be able to pick and choose what you want toread but I hope that you will sample material from all of the members of theCove Street team.

Next,for those of you who are more used to using programs such as Google Reader toaccess blog sites’ RSS feeds, you can sign up for Cove Street’s RSS feed byclicking this link(try using Internet Explorer if Google Chrome or Firefox won’t access the link).For those of you who are already subscribers to The Inoculated Investor’s RSS feed,we will take the liberty of signing you up for Cove Street’s RSS feed as well.I hope you do not feel that this is an intrusion of your privacy and Iapologize for any inconvenience. I am just passionate about not losing thepeople who have followed me over the past few years. If you do not want to viewCove Street content through your RSS reader, feel free to delete theconfirmation email you receive or simply email us at Questions@CoveStreetCapital.com.

Finally,I want to assure you that the current site is not going anywhere. For anyonewho wants to access old postings, they will remain available. In fact, I willcontinue to post links to the newest content—that will be exclusively availableon Cove Street’s site—on the front page of The Inoculated Investor site.However, as of December 1^st, 2011, I will post a permanent link tomy new home and cease posting on the Blogger site.

My goalhas always been the same: to post valuable content that both informs readersand resonates with them. As such, the change in locations will not alter myobjectives. I sincerely you hope you will follow me in this new endeavor. Ifyou have any questions or comments, feel free to email me at inoculatedinvestor@gmail.com (this email will remain in useas well).

Thankyou for all of your support. I leave with a link to my newest thought piece,officially available on Cove Street’s blog site: Ina Zero Hedge World, Investors Must Stay Nimble.

Sincerely,

Ben Claremon

The Inoculated Investor

Analyst, Cove Street Capital

Exclusive Notes from a BB&T 1-on-1 Conference

2011-08-23T20:31:00.003-04:00

(Disclaimer: The opinions included in the following posting belong to me and do not necessarily reflect those of Cove Street Capital “CSC” or any of its employees. The information in this posting should not be considered as a recommendation to buy or sell any particular security or to encourage anyone to invest with CSC. Past performance of CSC is not a guarantee or indicator of future results.)

Now that I am working on the buy-side on a full time basis again, I get to employ my note taking skills in variety of new mediums. Specifically, one of the perks of having relationships with sell-side firms is that it affords Cove Street Capital the opportunity to have its analysts meet with management teams from all over the country and world. In this case I had the opportunity to attend the recent BB&T 1-on-1 conference held in San Francisco. What I like about these types of conferences is the intimacy. In my former life on the buy-side I attended dozens of sell-side conferences in which 30 or 40 people packed into a small room to hear a pre-canned pitch by the management team of a specific company. While such conferences can be valuable and enlightening, I happen to believe that I learn a lot more when I have a chance to sit down in front of a CEO or CFO and ask targeted questions.

Not only does a 1-on-1 conference make me perform a significant amount of diligence on the companies I am scheduled to meet with, but it also allows me gain a granular knowledge that is often not accessible at less intimate affairs. So, kudos and a big thanks to BB&T for putting on a very well-run and informative conference at the Ritz-Carlton in downtown San Francisco.

On the day of the conference, I met with the management teams of eight different companies. Most of the meetings were 1-on-1’s but a couple were 2-on-1’s. Given that I only had a few days to prepare to meet with eight new (to me at least) companies, I was unable to perform the level of diligence I would have liked. However, in each case I had at least read the company’s most recent 10-K and 10-Q filings and had come up with a list of value-investor-oriented questions. The notes I took solely include my impressions of what was discussed and certainly do not represent the opinions of Cove Street or BB&T.

The list of companies and my notes are included in the Scribd document attached to this post and the Google Doc available here. However, I wanted to make some brief comments about each of the companies as a preview of what is included in the notes. You will notice that I have only posted the notes from seven of the firms as we are holding back on releasing the notes from one unnamed smart metering company that looks compelling on a secular trend and valuation basis.

Diamond Foods: A company in the midst of a very interesting and profound expansion after the acquisitions of Kettle Foods in 2010 and Pringles this year. Diamond is transforming itself from a low margin, nut-focused company to a higher margin, chip and popcorn producer.

CIBER: An IT consulting company in the midst of a turnaround after a change in management. The long struggling US operations are being centralized in an attempt to improve profitability and leverage the knowledge and skills transferred from the very successful European operations.

Perficient: Another IT consulting company that, unlike CIBER, is not focused on ERP implementation. Perficient is uniquely focused on continuing to grow in the US while maintaining its pristine (debt free) balance sheet.

Kansas City Southern: The smallest remaining independent Class 1 railroad company left in the US. KSU has some very interesting opportunities in Mexico and has what looks like a monopoly granted by the Mexican government. Also, read the notes for the CFO’s comments on Berkshire’s purchase of BNSF.

Tyson Foods: A meat protein company that is also very involved in prepared foods such as pizza crusts. The stock is trading at a low multiple because the chicken business has been hit by an oversupply of chickens and rising grain costs. However, the company thinks the chicken opportunity in China is huge (see KFC’s success in that country) and that the higher margin beef and pork businesses are being overlooked by investors.

Gorman-Rupp: A pump company that does nothing but keep its head down, execute, and make targeted acquisitions to help with growth. Accordingly, the company trades a much deserved premium. Gorman-Rupp is a Buffett-like company that investors should look to own at the bottom of an economic cycle when the market is sure the global economy will never recover.

Kirby Corp.: The largest marine transportation barge company in the US with about 28% market share. This size and scale allows the company to make money when the rest of the industry is struggling. Kirby strives to be one of the only rational players in an industry prone to overbuilding that causes utilization rates and prices to plunge.

As usual, if you have trouble with the Scribd document or the Google Doc, feel free to email me for a PDF copy of the notes. This site has been built through the posting of exclusive and unique content and even though my circumstances have changed a bit I hope to keep creating content that readers find valuable and informative. I hope you enjoy the notes!

Notes from BB&T 1-on-1 Conference

2011 South Central Scholars Charity Idea Dinner

2011-07-28T00:24:00.002-04:00

(Disclaimer: The opinions included in the following posting belong to me and do not necessarily reflect those of Cove Street Capital “CSC” or any of its employees. The information in this posting should not be considered as a recommendation to buy or sell any particular security or to encourage anyone to invest with CSC. Past performance of CSC is not a guarantee or indicator of future results.)

I recently had the distinct pleasure of co-hosting a charity idea dinner with my friend Alex Rubalcava of Rubalcava Capital Management. Alex is on the board of an incredible organization named South Central Scholars (SCS) and he asked me to help him plan the event. Right off the bat, I really liked the idea of participating in an event that involved two things that are quite important to me: investing and education. If you ask me what the one major threat to the continued prosperity of the United States is, my immediate response would surround my concern for the state of public education in America. As such, I gladly offered to help plan and promote an event that had the goal of raising money for underprivileged students and also provided an opportunity to talk about investing.

The format was simple: attendees were asked to contribute a charitable donation to SCS in exchange for a three course meal and exposure to the investment ideas of some of the brightest minds in Southern California.

The impressive list of presenters included:

Ryan Morris of Meson Capital Partners who discussed First Marblehead (FMD)
Matt Peterson of Peterson Capital Management who discussed option strategies on Coca Cola (KO) and Kraft (KFT)
UCLA Anderson Professor Eric Sussman who discussed his top 16 accounting red flags
My co-host Alex Rubalcava who discussed Clear Channel Outdoor (CCO)
Toby Carlisle of Eyquem Fund Management and author of the popular blog Greenbackd who spoke about Xyratex (XRTX)
Robert Wollendorf of Western Standard who discussed MI Developments (MIM)
Brian Massey of Mar Vista Investments who spoke about First American Financial (FAF)

Also attending as an interested observer was Chuck Gillman of Boston Avenue Family Office. Finally, there were a number of people who were kind enough to donate but were unable to attend: John Schwartz (organizer of the Value Investing Congress), Lance Helfert of West Coast Asset Management (my former employer), Alan Schram of WellCap Partners, Dan Anglin of Prince Henry Group, and John Dash of Dash Acquisitions.

Most importantly, we were privileged to have the founders of SCS, Dr. Jim London and his wife Trisha, at the event. I personally found it motivating to see how two people who were inspired by a book (And Still We Rise by Miles Corwin) could turn a little idea into an impactful organization. Furthermore, I really enjoyed listening to Jose Rodriguez, a member of the SCS alumni community who shared real life anecdotes about the difference that SCS has made in his life. The value proposition of SCS becomes much more real and relevant when you meet someone who has directly benefitted from the work of the Londons and all of the other supporters of SCS.

Alex and I wanted to thank everyone for helping SCS achieve its goals. It was a wonderful night and I feel very fortunate to have had the chance to be involved with helping to raise money for such a great cause.

In addition, aside from acknowledging the generous participants of the event, the purpose of this post is to increase awareness of SCS. I know that many of the people who read this blog are not from California—or even from the US— and may not be particularly concerned about the plight of kids from South Central LA. Clearly, there are serious problems and deserving charities in every country around the world. As such, my hope in discussing the merits of SCS is not necessarily to entice people to contribute to this specific cause. If you think the value that SCS adds to the LA community is worthwhile, by all means I encourage you to become involved or help the organization raise money. But, for everyone else who would rather support causes a little closer to home, my hope is that the details of this event and description of SCS encourage you to look for ways to reach out to the educational community in your home state or country.

As mentioned above, SCS was founded by Dr. London and his wife after reading about the difficulties hard-working students from South Central LA were having escaping blighted neighborhoods and going to college. Accordingly, the goal of SCS is to help motivated high school students from inner city schools become successful in college and graduate school. These talented students are often from dysfunctional families and communities impacted by drugs and violence. Sadly, the high schools in such areas often only graduate 25% of their students and even those who do graduate may not have the financial means to attend college or are not aware of their options.

This is where SCS steps in to provide information, outreach and financial support to students from 39 high schools in the area. The main strategy is to try to get the strongest students to apply to private colleges, specifically the Ivy League schools and other small liberal arts colleges. The reason for this focus is that these schools are not only some of the top schools in the US, but they also provide the most generous financial packages; with some even guaranteeing that students will not graduate with any student loan debt. Once they are in college, SCS supports these students and their goals by:

Putting on seminars that help students bridge any gaps between themselves and other college-ready students.
Offering bridge scholarships that close void between the financial packages offered by the colleges and the actual total cost of the education.

SCS supports approximately 300 currently enrolled college students

Creating a mentoring program in which students are paired with people who have had success in careers that the students are interested in pursuing.
Trying to help students work around obstacles such as financial, family, academic and psychological problems that may hinder them from succeeding in college.

A number of students are also homeless and SCS works to find places for these young people to stay during holidays and summers.

Helping students obtain valuable jobs and internships in fields that interest them.

It is hard to argue that giving these students the opportunity to go to college is not a worthy goal. In fact, the success of SCS makes the organization and ones like it look compelling destinations for charitable donations. But, anyone who approaches the world from an investor’s point of view likely wants to get the most bang for his or her buck. There are thousands of deserving charities out there. So, why is SCS any more deserving than the others? Well, given that I believe a failing educational system represents a real threat to this country’s long-term prosperity, what sold me on SCS was its ability to scale. When I asked the question about what prevented SCS from providing yearly bridge scholarships to 200 or 500 students instead of 74, the answer had nothing to do with personnel, staff or overhead. Simply, what prohibits SCS from expanding is funding. My understanding is that a large percentage of every dollar that SCS receives ends up supporting students as opposed to bloated infrastructures or administrative salaries. Further, after meeting a group of board members and founders whose only concern is helping underprivileged students, I became very comfortable making a donation.

Thus, if you share some of my concerns about the American educational system and want to donate or become involved, please visit SCS’s website at southcentralscholars.org. On that site you can find a place to make online donations and can learn more about volunteering opportunities or becoming an employer of these gifted students. I hope you will consider helping SCS expand its reach. If you have any questions or comments, please feel free to contact me or info@southcentralscholars.org.

Introduction to Cove Street Capital

2011-07-08T10:33:00.004-04:00

(Disclaimer: The opinions included in the following posting belong to me and do not necessarily reflect those of Cove Street Capital “CSC” or any of its employees. The purpose of the post is to introduce the firm I will be working for as of July 1^st, 2011. The information in this letter should not be considered as a recommendation to buy or sell any particular security or to encourage anyone to invest with CSC. Past performance of CSC is not a guarantee or indicator of future results.)

Dear Readers,

First, I wanted to thank everyone for the amazing response to my request for help in finding a full-time position in the investment management industry. I received emails from people from New York, Boston, and Chicago as well as Germany and Singapore (to name a few). I really appreciate the support and encouragement I received. What I have found is despite the fact that we are located all around the world, there is a cohesive group within the value investing community that is available to assist its members. I owe a special debt of gratitude to a gentleman in New York who enjoyed my notes from this year’s Markel Breakfast so much that he decided to recommend me to a friend of his, Jeff Bronchick.

Jeff Bronchick is the former CIO of a well-known asset manager in Los Angeles. After 22 years at the firm, Jeff left this firm to start up Cove Street Capital. For those of you interested in the name, Cove Street was the street that was home to Berkshire Hathaway’s original offices. However, unlike Berkshire, Cove Street has decided to locate its offices in El Segundo, CA, less than 2 miles from the Pacific Ocean. Thanks to a tip from the above-mentioned gentleman and my newly defined persuasion skills, I convinced Jeff to hire me to be one of two analysts that will help manage $400mm of assets for both institutions and high net worth individuals.

Jeff is a bottom-up value investor in the mold of Warren Buffett who runs a concentrated portfolio of stocks that he believes are trading below intrinsic value. He focuses on establishing a margin of safety in order to win by avoiding big losers. While Jeff pays attention to the macro environment and has written extensively about his top-down view of the world, he primarily relies on company fundamentals to make buy and sell decisions. Thanks to the wonderful Internet age we live in, Jeff’s strategy letters going back to the year 2000 are available at http://www.rcbinvest.com/resources/letters.html.

Accordingly, I was able to perform a good deal of due diligence on Jeff and subsequently became comfortable that we approached investing from the same point of view. For example, what impressed me the most was how clear it was that Jeff views the money management process as a fiduciary responsibility. As such, he refuses to become an asset gatherer or chaser of short-term performance. Instead, he is willing to invest with a multi-year outlook and is comfortable assuming the role of a contrarian, both of which are important to me.

I also have a soft spot for people who like to write and who are articulate, as I have made myself a very minor star in the value investing world through my writings. Similarly, Jeff wrote for TheStreet.com in the 1990s and for Grant’s Interest Rate Observer. It also doesn’t hurt that he is a Penn guy as well. Our relationship continues to build but my initial impression is that we have a lot in common, especially our passion for investing and love of security analysis. I have told everyone who has asked me about the position that this is a dream job for me and I am excited to start contributing.

I don’t think this is the place to talk much more about Cove Street’s strategies. That information is available on the firm’s website at http://www.covestreetcapital.com/Default.aspx. However, I do want to say that we will be looking for value and market inefficiencies in both small and large companies and will not shun international opportunities that arise. If you are interested in learning more about me, Jeff or any of the other team members, please visit the “About Us” tab on the website. Additionally, if you are an investor capable of making the Cove Street minimum investment and would like to inquire about investing with the firm, please contact Daniele Beasley at dbeasley@covestreetcapital.com.

Finally, we are still contemplating precisely what will become of The Inoculated Investor blog but I assure you that I am not done writing. I have far too much to say. Most likely, my thoughts on stocks and the markets in general will appear on Cove Street’s site while this site will continue to be dedicated to unique content (event notes, interviews, etc.) that I hope people will find compelling.

Thanks again for your support and for making running the blog an extremely positive experience. I hope that you will continue to follow my career on this site as well as on that of Cove Street.

Sincerely,

Ben Claremon

The Inoculated Investor

Cove Street Capital

Notes from the Final Conversation with Charlie Munger

2011-07-04T15:03:00.004-04:00

Dear Readers,

I surmise that many of you have heard the unfortunate news that last Friday's event at the Pasadena Convention Center will most likely represent the last opportunity for the value investing community to have a semi-intimate conversation with Charlie Munger. Now that Wesco is a part of Berkshire Hathaway and given that Charlie is hoping that we will find a new cult hero, those of us who long to hear words of wisdom from Charlie will have to make the trek to Omaha for the Berkshire Annual Meeting.

For those of you who could not make it out to Pasadena this year, I was fortunate enough to attend the event and have compiled my notes. As usual, they were taken in real time without the use of a recording device. Therefore, I cannot promise that I was able to capture everything that Munger said. However, my goal with the notes is to recreate the narrative in a way that both provides context and captures the sentiment of Charlie's remarks. I apologize in advance for any errors or ommisions.

I have embedded a Scribd version of the document to this post to retain the formatting. But, I understand that many people have trouble accessing Scribd for a variety of reasons. As such, I have also created a Google Doc that can be accessed by clicking this link. However, I am also happy to email a PDF copy to anyone who contacts me at inoculatedinvestor@gmail.com.

I apologize in advance for any delay in responding. A new and exciting thing in my life is starting tomorrow and I hope you will stay tuned to my blog for details regarding this endeavor.

Thanks again for following this site and I hope you enjoy the notes.

Sincerely,

Ben Claremon

The Inoculated Investor

Conversation With Charlie Munger

Notes from Creighton Value Investing Panel

2011-06-08T16:34:00.004-04:00

Dear Readers,

I have finally gotten around to editing my notes from the Creighton Value Investing Panel that was held the day before the 2011 Berkshire Annual Meeting in Omaha. I was initially focused on getting my notes posted from the events I know people are really interested in: the BRK meeting, the Value Investing Congress, and the Markel Breakfast. However, after reviewing and editing the notes from the Creighton Panel, I remembered that the discussion had actually been quite interesting.

Given that the event is held on a college campus, the focus was more on high-level, philosophy of investing-type questions and less on individual security analysis. However, the panelists (listed below) discussed a number of stock ideas and provided a lot of detail regarding their approach to investing. All of the panelists are true value investors but clearly have distinctly different styles and types of companies they are attracted to. As such, I highly recommend reading through the notes if you are interested in the various approaches to value investing.

Panelists:

Whitney Tilson of T2 Partners

Vitaliy Katsenelson of Investment Management Associates

Michael Green of Evergreen Capital Management

Patrick Brennan of RBO & C0.

As usual, I have embedded a Scribd document of my notes to this post. If you have trouble using Scribd, click this link and you can access the notes through Google Docs. Finally, if neither of those avenues works, please feel free to email me at inoculatedinvestor@gmail.com and I will send you a PDF copy.

I hope you enjoy the notes and will stay tuned to the blog for a couple interviews with great investors.

Sincerely,

Ben "I Finally Graduate this Friday" Claremon

Creighton Value Investing Panel

2011 Markel Breakfast Notes

2011-05-11T02:22:00.005-04:00

Dear Readers,

I hope everyone has enjoyed the notes from the Berkshire Meeting and from the Value Investing Congress. I have heard from a lot of people and so far the consensus has been that the notes were pretty comprehensive. I feel very fortunate to have readers all around the world who I can communicate with and get to know. This has been a very busy time of year for me and I wanted to make sure I took the time to thank everyone for following my blog and my career. I am still looking for the right full-time opportunity for after graduation so feel free to email me if you know of any equity value funds who are looking for a research analyst.

Before I move on I wanted to apologize again. For about a 6 hour period on Sunday night the version of the Value Investing Congress notes available through Scribd was not a complete version. Accordingly, if you downloaded a version that is missing stock charts for each of the companies, please feel free to email me and I will send you the polished version.

I know that you all have a lot to read right now but I wanted to post my notes from the 2011 Markel Breakfast while the comments and content were still very relevant and timely. For those of you who have not been to Omaha during the Berkshire weekend, the Markel Breakfast is held the Sunday after the Berkshire meeting and is a standing room only event. I was lucky enough to get a seat right in front and had the opportunity to hear CIO Tom Gayner and Vice Chairman of the Board Steve Markel discuss a number of topics, including:

The state of the municipal bond market
The state of the property and casualty insurance market
Markel's approach to buying whole companies
Inflation, hedging and currency risk
The David Sokol affair

As usual, I have embedded a Scribd document of my notes in this post. While they are only a little over 8 pages, they are a bit too long to read on a regular blog post. If you have any trouble with Scribd, click this link to access a Google Docs copy (with no sign-in required). If neither of those options works, feel free to email me at inoculatedinvestor@gmail.com and I will gladly send you a PDF copy of the notes.

Finally, I wanted to let you know that there is still one more set of notes yet to be released. I attended the Creighton Value Investing Panel in Omaha and got to hear investors such as Vitaliy Katsenelson and Whitney Tilson answer questions from two moderators. It was an interesting event and I encourage you to stay tuned for the notes.

Thanks again for all of your support and I hope you enjoy the Markel notes.

Sincerely,

Ben Claremon

UCLA Anderson 2011

The Inoculated Investor

Markel Breakfast 2011 Notes

Detailed Notes from the 2011 Value Investing Congress

2011-05-08T14:09:00.006-04:00

Dear Readers,

It has been a very busy 10 days and I am not even done editing all of my notes yet. However, after 24 pages of Berkshire annual meeting notes, I am now posting over 70 pages of notes from this past week's Value Investing Congress in Pasadena. Unlike the BRK meeting notes, these are in bullet point form because there are far too many data points and the speakers often move too fast for me to type the notes in paragraph form. These were taken in real time and I apologize for any errors or omissions. In any case, I think they provide a very comprehensive summary of what was discussed at the event.

For those of you who do not have the time to go through all of the notes, I have highlighted the companies that were pitched and discussed. I also included tickers and stock charts for most of the companies that were extensively analyzed. I think there were a number of compelling ideas pitched and I will briefly highlight a few that stood out in my mind as deserving some more research:

Guy Gottfried of Rational Investment Group pitched Morguard Corp (TSE: MRC), a Toronto-listed real estate company that is run by a great investor and whose stock looks to be trading a fraction of the value of its real estate properties. Not to take anything away from the other great speakers, but I think Guy made the best presentation.
Ori Eyal of Emerging Value Capital Management discussed a share arbitrage opportunity with PRISA (NYSE: PRIS) A and B shares. His compelling analysis made it seem unlikely that an investor could lose money and very likely that there would be significant upside in the next 6 months.

Aside from those two, there were also a number of interesting international and domestic stocks and other securities discussed. Some of you may notice that a few of the speakers have started their funds very recently and do not have long track records. As such, some people I spoke to voiced their concerns that it is hard to know if these guys are truly great investors. However, I have noticed that the young guys who run their own funds perform some of the most comprehensive and thoughtful research of any investors I know. As such, I highly recommend reading through the notes to see if anything piques your interest.

Also, if you like what you see in the notes, I suggest signing up to attend the next Value Investing Congress. The event will be held in New York on October 17th and 18th and the organizers are offering a very attractive early bird special for those who can commit to attending early. Please visit http://www.valueinvestingcongress.com/register/ if you would like to take part. I cannot promise that I will be there so there may not be much in terms of notes published in the blogosphere.

As always, I am unable to attach a PDF of the notes to this posting. However, I have created a Google Doc that anyone who clicks this link can access. Also, I have embedded the Scribd copy of the notes below. If neither of those works for you, feel free to send me an email at inoculatedinvestor@gmail.com and I will send you a PDF copy.

I hope you enjoy the notes. I appreciate all of the emails and offers to help me in my job search that I have received. I am looking forward to hearing more from all of you in the future.

Sincerely,

Ben Claremon

UCLA Anderson 2011

The Inoculated Investor

*****Update: The Scribd document attached is the correct one. My apologies, for a little while last night (between 2am and 8am LA time) a not-complete version was available on Scribd. I am sorry if anyone downloaded a non-polished copy and would be happy to send you an updated PDF version if you email me.
2011 Value Investing Congress Notes

Comprehensive 2011 Berkshire Meeting Notes

2011-05-02T20:49:00.005-04:00

Dear Readers,

After 6 hours of continuous typing and close to 15 hours of editing, my notes from this year's Berkshire Hathaway annual meeting are complete. At the end of it all, the total tally is over 18,000 words and over 24 pages of wisdom from Buffett and Munger. As always, these notes were taken by hand, without the use of a recorder. For those of you who were not able to make it to the meeting this year, I hope the notes serve as an adequate substitute. For those of you who were in attendance, I hope the notes provide a comprehensive review of what was said.

Unfortunately, Blogger does not allow me to attach PDFs to posts. But, to make it easier on everyone I have created two ways for you to view the notes. First, you can click this link and access the notes through Google Docs. You don't even need an account with Google. Also, I have embedded a Scribd document to this post for those of you who like Scribd. However, as always, I am happy to email out PDF versions upon request. Just shoot me an email at inoculatedinvestor@gmail.com if you want a PDF copy.

Lastly, I am asking the value investing community for some assistance. I will be graduating from the Anderson School of Business at UCLA in June. Accordingly, I have been selectively looking for the right full-time position. Ideally, I would like to work as an equity research analyst for a value-focused buy-side firm. If you know of anyone who is looking for a diligent analyst with a passion for stocks, I would really appreciate it if you would think of me. You can view examples of my research on this site under the "Equity Research" link on the right side of the page. I am also happy to provide a copy of my resume upon request. Thanks so much for any help you can provide.

Enjoy the notes and please stay tuned for notes from other Omaha events and the upcoming Value Investing Congress.

Sincerely,

Ben Claremon

The Inoculated Investor

2011 Berkshire Annual Meeting Notes

Book Review: The Most Important Thing by Howard Marks

2011-04-24T21:13:00.005-04:00

I was very fortunate to receive an advance copy of Howard Marks's new book, The Most Important Thing, directly from Howard himself. I then asked Howard if he would mind if I reviewed the book for my blog. Knowing how popular the memos he writes on behalf of Oaktree Capital Management are with members of the value investing community, I thought my readers would really enjoy learning more about his investment philosophy. Howard agreed to let me review the book on one condition: that I do so objectively and without hesitating from articulating any criticisms I had. The ultimate product is the following analysis of The Most Important Thing, in Scribd format because it is a little too long for a blog post. If you have any troubles with Scribd or would like a PDF copy, just email me at inoculatedinvestor@gmail.com and I will happily send it to you.

According to the link to the book on Amazon.com, it will be available on May 1st and can be pre-ordered now. I won't take any time here (read the review!) to explain why, but I highly recommend that readers with an interest in investing consider purchasing the book in order to further your own knowledge and gain a new appreciation for both Howard's writing and approach to investing.

Book Review- The Most Important Thing by Howard Marks

Stay Tuned for the Best Posts of the Year

2011-04-21T15:12:00.003-04:00

Dear Readers,

I certainly have a busy few weeks coming up. No, I am not talking about the last 6 weeks of school work that are required for me to actually graduate in June. I am talking about the equivalent of Super Bowl week for value investors. Specifically, over the next 3 weeks, I will be attending the following events:

1. April 30th: Berkshire Hathaway Annual Meeting in Omaha

2. May 1st: Markel Breakfast in Omaha

3. May 3rd and 4th: Value Investing Congress in Pasadena

4. May 12th: 2011 South Central Scholars Value Investing Idea Dinner in LA- I am co-hosting this event with Alex Rubalcava and we are donating all of the excess proceeds to South Central Scholars, a nonprofit that helps kids from South Central LA realize their dreams of attending college and grad school. If you would like to learn more or make a donation, please visit the organization's website at: http://www.southcentralscholars.org/

As in previous years, I plan to blog about all of these events and hope that I will be able to produce my usually comprehensive notes for the Berkshire meeting and the Value Investing Congress. If you are planning to be at any of these events and want to meet up, feel free to email me. I would love to meet more of you in person. However, if you are not able attend, I hope my notes will serve as a good substitute. So, stay tuned for a series of posts that should be the best ones of the year.

Thank you for following my blog and I look forward to sharing my content with you.

Sincerely,

Ben

Equity Research Piece: Sterling Construction Co. (STRL)

2011-03-28T02:38:00.005-04:00

I came across Sterling Construction Co. (STRL) after running a screen on Capital IQ for companies with: low debt levels, market caps between $100M and $500M and trailing EV/EBITDA multiples below 7x. I happen to believe that there is a lot more inefficiency in the small cap space and thus I often dig in that arena. What I quickly saw was that companies reliant on government infrastructure spending were trading at very low EV/EBITDA multiples. In fact, during my research I also came across Orion Marine Group (ORN), a company that operates in similar markets to STRL. At first I was intrigued by the valuation of ORN, but after more digging, STRL became the more compelling research candidate.

Unfortunately, I discovered the company a few weeks too late. On March 14th, 2011, the stock closed at $12.48, a price that implied a trailing free cash flow yield over 18%. Since then the stock has jumped to a price above $16 and no longer offers a sufficient margin of safety for my taste. However, I do think the stock bears watching because of the uncertainty surrounding state infrastructure spending. It is possible that the pessimism regarding states' ability to fund capital expenditures will drive the stock price down to a level that more than compensates for the inherent risks. Plus, I believe that STRL is a takeout candidate because the larger players such as Fluor and KBR may only be able to achieve growth through acquisitions over the next few years.

I should mention that this is my own personal research and the analysis and opinions presented should not be attributed to West Coast Asset Management. I hope you enjoy the piece as a I think it is representative of the type of research I like to do. For those of you who do not have time time read all 12 pages, I have included an executive summary in the first two pages of the write up. Please feel free to make comments or suggestions. I am always looking for feedback on my research, both positive and constructive.

As usual, I have put the write up in Scribd format to preserve the formatting of the charts. However, if you have trouble downloading the piece, feel free to email me and I will happily send you a copy.

Sterling Construction Co. Write Up

Please Help Japan

2011-03-14T17:53:00.006-04:00

Readers,

For anyone who has been following the events in Japan over the past week, it has been a very painful time. But, there are people there who are really suffering and need as much help as we can provide. I happen to be a member of the Japan America Business Association (JABA) at UCLA Anderson. As such, I know many students who are from Japan and are likely going to return there after graduation. Sadly, I find myself not knowing what to say to people or how to console them. How can you really convey how sorry you are after watching the images of the tsunami wiping out everything in its path? The before and after pictures of the Sendai area are breathtaking in their brutality. Personally, I feel helpless to extent that it causes a sort of paralysis. So, I have been trying to find a way to help that has the greatest potential impact. Therefore, I am hoping to use my position as a very minor celebrity in the value investing world to raise money for those affected and increase awareness of the ongoing situation in Japan.

So, this is what I am asking from you:

Please help the MBA programs at UCLA Anderson, Pepperdine, and USC support the disaster relief effort by making a donation at http://socalmbahelpjapan.wordpress.com/. All of the proceeds will be donated to the the US Red Cross. The acute crisis may be nearing an end (at least we all hope), but the devastation is ongoing and, as citizens of the world, we can't just forget about the people of Japan once the news cycle shifts to another topic.
Keep informed about what is going on in Japan. Read newspapers, watch the news, keep up with your favorite blogs, follow Twitter. Do something to prevent yourself from moving on with your life just because the disaster didn't happen in your backyard. Because, especially if you live in California, one day it might happen here. The point is that the people of Japan deserve our empathy and for us to realize that we have an obligation to understand their plight.
Finally, reach out to anyone you know who has roots in Japan. I am living vicariously through someone who is very close to me and is currently in Japan. I have to say it is so difficult that I can't imagine how hard it would be if my family, friends, and the place where I grew up were going through so much turmoil. Believe me, they need your support.

Let us all hope that the earthquake and volcanic activity subsides and that the situation with the nuclear facilities becomes more manageable soon. The Japanese people need some indication of hope so that they can move forward. In the meantime, please help any way you can.

Sincerely,

Ben C.

The Inoculated Investor

Santangel's Review Strikes Again!

2011-03-14T04:04:00.009-04:00

My friends at Santangel's Review are back at it again. Apparently, aside from working day and night on the upcoming newsletter, they somehow find the time to listen to the interviews recently conducted by the Financial Crisis Inquiry Commission and transcribe them for our reading pleasure. From the guys who brought us the transcript of David Einhorn's testimony, the newest transcription includes the wisdom of none other than the Oracle of Omaha himself. I don't want to spoil it for you, but I think everyone will want to hear what Warren Buffett said about what single act saved the entire financial system during the depths of the crisis. No, it wasn't the bogus bank stress tests or TARP. And is wasn't the FASB relaxing the rules on mark-to-market accounting. Have a read and see if you agree...

I also wanted to get in another shameless plug for Santangel's Review. I have inside knowledge regarding the subject of their soon-to-be-released newsletter. In fact, I expect to have a chance to read a draft this week. As such, for those of you who are high net worth individuals or who work for funds of funds, I highly recommend that you visit the website, read the free issue available there and strongly consider subscribing.

Now, without further ado, here is the transcript:

Transcript of Warren Buffett Interview With FCIC

Lance Helfert on CNBC Last Friday

2011-03-02T14:01:00.002-05:00

My boss at West Coast Asset Management continues to be fixture on the TV circuit. Last Friday he was on CNBC discussing some of our research on rising input prices and the ultimate impact on clothing retailers. The question we are interested in answering is which retailers are going to be able to pass on higher input costs to consumers, assuming cotton prices stay at elevated levels for a while. Our thesis is that investors in clothing retail stocks should make sure the companies that they own have pricing power and are not dependent on discounting. See if you agree...

Introduction to Santangel's Review

2011-02-28T20:20:00.003-05:00

Readers,

For those of you who are not yet familiar with Santangel's Review, now is a great time to become acquainted with the site. Santangel's Review is a quarterly newsletter that profiles emerging and undiscovered value investors. But, it is different from Value Investor Insight in that it is not focused on Q&A sessions with managers. Instead, the authors provide a narrative of the history of the firms, the people who run them, and the key investment decisions. In reality, the publication reads much more like a short story than a simple profile. However, since it is written by two security analysts, the descriptions of the investments are robust and very in-depth.

For anyone interested in understanding the investment process of managers who have generated exceptional returns over a long period of time (but who operate under the radar), I highly recommend going to the site and downloading the free copy of the first issue. If you like what you see (and I truly believe that you will), please click on the link provided on the site and think about subscribing to the newsletter.

In addition, aside from the newsletter and subscription materials, the site also has a blog that is now up and running. As such, I wanted to call your attention to a piece that was posted today on the site. The authors have transcribed the presentation to the Financial Crisis Inquiry Commission by David Einhorn of Greenlight Capital. I have not seen this posted anywhere else on the web and it is a fascinating read. Here is the link to the posting if you are interested: http://www.santangelsreview.com/2011/02/28/david-einhorn-financial-crisis-inquiry-commission-interview-transcript/

I suggest bookmarking the site as the authors have a knack for finding material that is not available anywhere else. I also hope that you will consider subscribing. You will not be disappointed.

Enjoy the site,

The Inoculated Investor

(Disclosure: I have a close friendship with the authors of the site. I also have helped in the editing of the newsletter. However, I have no financial stake in the endeavor and truly believe that the publication is like no other investment newsletter I have ever seen.)

Exclusive Notes from Howard Marks Presentation

2011-02-17T18:15:00.007-05:00

Readers,

One of the perks of being in school again is that I get access to a number of great investors who take time out of their busy schedules to speak to the UCLA Anderson Student Investment Fund. As a group, we are very fortunate that our advisor has a relationship with the President of Oaktree Capital, Howard Marks. Mr. Marks was gracious enough to spend close to 90 minutes with me and my classmates this past Monday.

I first became aware of Oaktree in March of 2008 when a copy of the latest memo from Howard Marks came across my desk. The memo was entitled "The Tide Goes Out" and after reading it I decided to email the contact person listed on the Oaktree website, begging her to allow the investment community to have access to all of previous memos. While she was reluctant at first, all of them are now available.

At the time, I was living in New York and was working for an equity-focused hedge fund. Consequently, I had no idea how prominent a firm Oaktree was in the fixed income world. However, since moving out to LA and meeting investors who live and work in the area, I have learned just how well-respected Oaktree is. Not surprisingly, I have read every memo released since March of 2008.

Further, my first opportunity to hear Mr. Marks speak was at a Wharton Hedge Fund event in New York. I have been lucky enough in my young career to have met and listened to a good number of very savvy investors discuss their investment philosophies. However, to this day one particular comment from Mr. Marks has stuck with me. He said that his main job is to manage risk and to protect capital. As a value investor, that mandate really resonated with me. I think it fits in perfectly with the margin of safety concept that I try to incorporate in all of my stock analysis.

Fortunately, Mr. Marks' wisdom will soon be available for all of us to consume. He has written a book called The Most Important Thing that can be pre-ordered on Amazon now and will be available on May 1st. I have already put it on my Amazon wish list and humbly suggest that you do as well. However, if you cannot wait that long, check out this interview on the Financial Times' website with Howard Marks (Update: link is fixed) from last November.

Finally, Mr. Marks has graciously allowed me to post the notes from the event last Monday. Given the length (no, the notes are not quite as long as those from the Berkshire Annual Meeting), I have put the notes into a Scribd format. The settings should allow you to download a PDF copy. But, if you have any trouble, feel free to email me and I will send you a copy.

I have to say that even after following Mr. Marks for the last few years, in person, his temperament and the way he articulates his investment philosophy far exceeded my expectations. I hope you enjoy the notes.

Sincerely,

Ben

(Picture of Howard Marks was taken from his bio page on Oaktree's website)

Howard Marks Presentation to UCLA Student Investment Fund

My Second Article on MarketWatch

2011-02-08T21:11:00.003-05:00

On February 1st, the second article that I co-wrote with WCAM President Lance Helfert appeared on MarketWatch. The article is about just how international the S&P 500 companies have become. My point is that even if the US continues to be in an economic funk, companies with operations all over the world and that have access to growing economies may continue to prosper. In reality, this is my attempt to temper my currently bearish stance on US stocks. See if you agree with my premise...

http://www.marketwatch.com/story/sp-500-is-the-best-international-play-2011-02-01

By Lance Helfert

SANTA BARBARA, Calif. (MarketWatch) — The U.S. economy is toast and prudent investors should stay away from U.S. stocks.

At least that is the belief espoused by a number of bearish market commentators who see the U.S. budget deficit, troubled housing market, and dependence on consumer spending as reasons that economic malaise will continue for years to come. And what if they are right? What does that mean for a stock market index such as the S&P 500 Index(SPX 1,325, +5.52, +0.42%) going forward? Perhaps not as much as one would think.

The reason is that many companies in the S&P 500 generate a substantial amount of revenue outside the U.S. According to Standard and Poor’s, of the 250 S&P 500 companies that report detailed information on foreign income, 47% of sales were generated outside the U.S. in 2009. This represents a 7% increase from 2006 with growth primarily coming from Asia. Accordingly, most investors have significantly more international exposure than they are aware of. In fact, the S&P 500 is positioned well to benefit from a major international secular trend that is likely to accelerate in the coming decade.

Specifically, the development that will drive spending growth across the world is improved living standards. Residents of the U.S. live in a modern country with seemingly endless amenities and access to a dizzying array of goods and services. As such, it is often easy to forget that developing nations do not necessarily have the same access to the goods that Americans take for granted.

However, as incomes rise and emerging economies become more advanced, citizens of these countries are going to demand the same standard of living enjoyed by their counterparts in developed nations. They will eat more meat, burn more fuel, buy more luxury goods, and desire the most advanced drugs and new technologies.

Populations of countries such as China and India dwarf that of the U.S. Even a small increase in the percentage of people who can afford more goods leads to a huge jump in the number of potential customers available to U.S. companies that have overseas operations.

For example, according to an October 2010 release from China’s Ministry of Security, the total number of automobiles in China is around 85 million. In contrast, according to the U.S.’s Bureau of Transportation Statistics, in 2008 there were approximately 137 million passenger cars in the U.S. This means that there are approximately 0.45 cars per person in the U.S and only 0.065 cars per person in China. If the ratio in China were to reach even one-third of the U.S. ratio, there would be nearly 200 million cars in China. Any material increase in this ratio for China would have a profound impact on energy consumption, global energy prices, and the global economy. Does anyone doubt that this ratio won’t increase?

None of this should come as a surprise to those who follow the global equity markets. Since the U.S. is expected to be stuck in a slow growth environment for a number of years, it is only logical that investors will continue to seek international exposure. But what is the best way to gain such exposure, and is the anticipated growth already reflected in foreign company valuations?

For the average investor, the answer to the first question is not to go directly to the source. While betting directly on emerging markets through their local stock exchanges may sound exciting, there are many risks that have to be taken into consideration. Such risks include lower liquidity and regulation, as well as higher volatility, currency risk, political risk, and risk of fraud. Second, many high-growth companies are already priced to perfection and assume that aggressive growth targets are met.

Despite the fact that the secular growth story in the emerging markets is so well known, many world class companies in the S&P 500 trade at cash flow multiples that do not reflect their significant exposure to these trends.

Take personal and health-care company Kimberly-Clark Corp. (KMB 65.01, -0.06, -0.09%)Aside from a slight blip in 2009, KMB has achieved consistent revenue and earnings growth since 2005. More importantly, revenue in Asia and Latin America increased more than 52%. KMB is an attractive company because of its exposure to international markets and the fact that its products are associated with a better quality of life. Irrespective of those positive aspects, KMB is currently trading at approximately nine times trailing cash flow with a dividend yield of 4.1%. Thus, KMB is precisely the type of company that should be enticing to investors looking for exposure to growth in developing markets.

Bears may be right and the U.S. economy may stagnate for the foreseeable future, but this concern should not cause investors to shy away from select U.S. companies with attractive valuations and international growth prospects.

Lance Helfert is president of West Coast Asset Management , and the co-author of “The Entrepreneurial Investor — The Art, Science and Business of Value Investing.” West Coast Asset Management does own Kimberly-Clark (KMB) in their portfolio. Ben Claremon contributed to this article.

Lance Helfert on CNBC Again

2011-01-26T14:52:00.002-05:00

My boss at West Coast Asset Management was on CNBC again last week discussing some of our recent research on two of WCAM's positions, Clorox (CLX) and Kimberly-Clark (KMB). While I am certainly not bullish on the S&P 500 as whole (given that it is trading at a Shiller P/E ratio around 23x), it is remarkable how much consumer staples have been left behind in this rally. Everything that is cyclical and small has gone straight up since the announcement of QE2 and everything that is safe and stable has lagged by a large margin. These are tough times for value investors but if you believe in reversion to the mean it is unlikely that the current return disparity will last much longer.

1 Million Home Foreclosures: Just the Beginning

2011-01-24T20:24:00.001-05:00

The recent numbers released by RealtyTrac¹ are startling. The fact that 1 million homes were foreclosed upon in 2010 is clearly quite troubling. However, I believe that the full impact of the supply glut of foreclosed houses on the market is still yet to come. The reason is that there is a huge “shadow inventory” of homes that are either in the foreclosure pipeline or are now held on the banks’ balance sheets. As discussed in an article² from CNNMoney.com, Standard and Poor’s estimates the shadow inventory by adding the number of houses whose borrowers are 90 days or more delinquent on their payments to those that are in foreclosure or are now owned by the banks. How many houses fit this description? Well, according to S&P, there are 1.7 million homes in this category, an inventory so large that based on the current rate of home sales, it apparently could take up to 44 months to work off.

Ok then; housing prices won’t rise for a few years until the excess supply is absorbed. So what? Actually, my concern is that these numbers only represent a fraction of the total foreclosures that will occur during this painful housing cycle. Specifically, the trouble lies in the number of homeowners who are underwater on their mortgages. Simply, if a person’s outstanding mortgage balance is nominally higher than the current value of the associated house, that person is deemed to be underwater or have negative equity in his or her home. Recently, there has been a back and forth between Zillow, a firm that tries to estimate the number of homes that have negative equity, and the so-called Numbers Guy, Paul Bialik, of the Wall Street Journal. As many people are undoubtebly aware, it is not uncommon to hear a talking head on venerable stations such as CNBC assert that one in four US homeowners is underwater. In fact, Zillow.com estimates³ that the appropriate figure was 23.2% at the end of Q3 2010. However, the article in the WSJ⁴ makes some valid points that suggest that such disturbing estimates may be a tad high. In response, the people at Zillow acknowledge the fallibility of their estimates but claim is that the true number is closer to 23% than it is to 15%, as Mr. Bialik suggests.

So, what does seemingly harmless argument have to do with future housing prices? Well, the important thing to consider is not necessarily the total number of homeowners who are underwater but instead by how much the balance of an individual mortgage exceeds the value of the property. For example, if a person owns a house worth $90K and has an outstanding balance of $100K, chances are the person will hesitate before exercising his put option on the house. But, what if housing prices see another large leg down? According to the most recent Case-Shiller housing data from October 2010⁵, national housing prices have already started to double dip. Thus, given an already weak housing market, my worry is that when the shadow inventory of homes eventually comes onto the market (even if it occurs at a snail’s pace), prices will see even more weakness. Then, the fact that there are already so many homes with negative equity suggests that people will find themselves even further underwater in the near future.

What if a number of borrowers are currently at a tipping point from which a renewed decline in home prices will cause a cascade of strategic defaults? Going back to the hypothetical borrower discussed above; if the house price falls by another 10% and he is now $19K underwater, is that enough to push him over the edge? If it is, then the foreclosure pipeline will continue to increase and there will be a structural overhang that limits home price stabilization for years to come. If you were wondering why some professional investors are still so bearish on the housing market, you now know why.

Sources:

Value Investors Unite!

2011-01-16T21:48:00.002-05:00

Readers,

This past weekend I hosted an event that included 14 other value investors, most of whom are from the Los Angeles area. The dinner went very well and in an attempt to keep our momentum going I have created a LinkedIn group for the value investors in Southern California. The group is called SoCal Value Investors. If you would like to join and be on the list for upcoming events such as idea and 10-K review dinners, please email me or search for the group on LinkedIn. For right now, we are trying to limit the group to people who either are currently working in the investment management industry or have in the past. However, I view value investing as a non-exclusive discipline. As such, if you don't fit the above criteria please email me at inoculatedinvestor@gmail.com and maybe we can figure something out.

Of course, regardless of what I try to do to build my network, I am always being outdone by my good friend Miguel Barbosa of Simoleonsense. Miguel is organizing an event for January 27th at 6pm for value investors who work on the buyside in Chicago. Here is the link to the event if you are in the area and want to attend. You can also email Miguel at miguel@simoleonsense.com if you want details. It sounds like he is expecting a lot of people so it will probably be a great networking event. I encourage anyone who can to attend.

In any case I really like this trend of value investors getting together. Despite what you may hear on CNBC or from US government officials, the global economy and financial markets are still on a little bit of thin ice. Accordingly, every investor should be looking for ways to protect his or her investments from unexpected events. Therefore, I think establishing a network of people to bounce ideas off of is invaluable.

Good luck in 2011,

Ben

My M&A Article on MarketWatch

2011-01-13T19:18:00.004-05:00

The following is an article I co-wrote with Lance Helfert of West Coast Asset Management about M&A. It appeared on MarketWatch starting January 3rd, 2011:

http://www.marketwatch.com/story/four-ways-to-bet-on-ma-2011-01-03?pagenumber=1

Four ways to bet on M&A

Commentary: Likely candidates are in tech, financials, consumer

By Lance Helfert

SANTA BARBARA, Calif. (MarketWatch) — Economic forces have come into play, making a wave of mergers and acquisitions a very real possibility in the near future.

First, with corporate bond yields near historical lows, companies have the ability to raise cheap debt to help facilitate deals. Second, as reported in a recent Wall Street Journal article, non-financial firms were sitting on $1.93 trillion of cash and other liquid assets as of the end of September. Many large firms have amassed war chests that can be used to supplement organic growth with acquisitions.

Furthermore, many private-equity funds are holding large sums of cash that were raised prior to the Great Recession, and this money is starting to burn a hole in their pockets.

According to another Wall Street Journal article, buyout firms are holding more than $450 billion in capital that has yet to be committed to new deals, and these firms are most certainly feeling pressure from their investors to put the money to work.

Firms that are speculated to be takeout candidates often trade at premium valuations. Consequently, investing solely in anticipation of a company being taken over is risky business. A more prudent approach may be to identify undervalued companies with attractive fundamentals that represent logical acquisition candidates but are not currently the subject of takeover speculation.

This strategy provides a win-win scenario, regardless of whether an attractive buyout offer surfaces. Here are four companies that fit the mold:

Yahoo

Many investors may recall that in early 2008, Microsoft Corp. (NASDAQ:MSFT) offered $33 a share to buy Yahoo Inc. (NASDAQ:YHOO), but the company eventually rejected the price and Microsoft walked away. However, Yahoo still has a number of attractive assets.

Specifically, Yahoo Search could still be an interesting asset for Microsoft as it tries to compete with Google. Additionally, the company’s large investments in Alibaba (THE:HK:1688) of China and Yahoo Japan offer a potential acquirer a way to tap growth of Internet advertising revenues in Asia. These two stakes are carried on the balance sheet at about $3.78 billion, but the market value of the Yahoo Japan investment alone is around $6.6 billion at the current stock price.

Despite these positive factors, Yahoo seems to be trading at a very reasonable valuation. The company has an enterprise value of about $19.4 billion. But if $636 million in long-term marketable securities and a conservative $9 billion estimate for the value of the Asian investments are subtracted out, the enterprise value falls to $9.76 billion. Given that the company has generated about $1.399 billion in EBITDA over the last 12 months, the stock is trading at less than 7 times EBITDA.

As such, Yahoo may begin to attract both strategic and private-equity buyers once again.

Molson Coors

In recent years, there has been a lot of consolidation in the global alcoholic-beverages industry. The largest example was InBev’s purchase of Anheuser-Busch (NYSE:BUD) . Given all of the activity, it is not hard to imagine an acquirer being interested in controlling Molson Coors Brewing Co.’s (NYSE:TAP) portfolio of beers.

The world-class beers under the Molson Coors umbrella include names such as Coors Light, Blue Moon and Carling. Clearly, at the right price these brands would be a great addition to any product line.

Furthermore, the company has been making inroads into growing international markets. In China, Molson Coors entered into a joint venture with the Hebei Si`hai Beer Co. Then in Russia, the company launched Coors Light. But investors should not forget that the company also owns 42% of MillerCoors LLC — a stake that gives TAP a foothold in the U.S. market that could be attractive to a foreign company like SABMiller (LONDON:UK:SAB) that is interested in expanding its U.S. exposure.

Given these factors, it is hard to believe that the company is only trading at about 12 times trailing 12-month earnings. Shares of TAP appear to offer great value and with a 2.2% dividend yield, investors get paid to wait for the market or strategic buyers to recognize the opportunity.

Broadridge Financial

Even though Broadridge Financial Solutions Inc. (THE:BR) is not a household name, the company has a dominant position in the investor-communications niche. In fact, in fiscal 2010 the company processed approximately 66% of the outstanding shares in the United States in the performance of proxy services. In addition, the company has a very stable and sustainable business model that might make it an ideal private-equity takeout candidate.

For instance, BR’s position as the industry leader leads to large barriers to entry and a durable competitive advantage that shows up in its robust operating margins in the mid-teens. Therefore, a larger firm with similar businesses such as Fiserv Inc. (NASDAQ:FISV) or a trust bank that already offers shareholder services such as State Street Corp. (NYSE:STT) may be interested in adding BR to its portfolio.

Even though the company pays a healthy dividend (2.7% yield and growing), the shares only trade at about 14.3 times trailing earnings. BR’s management team clearly believes the stock is undervalued. So far this year it has bought back close to 4.5 million shares and the board recently authorized the purchase of another 10 million shares.

Live Nation

Live Nation Entertainment Inc. (NYSE:LYV) is the largest entertainment company in the world, connecting millions of fans to thousands of events all over the globe. Early this year, the company merged with Ticketmaster, which is the largest live-event ticketing firm in the world. The combined entity now has a dominant position in the North American concert-ticket market.

According to a Pollstar report cited in the company’s filings, in 2009 North American gross concert revenue increased to $4.6 billion, a 9% compounded increase over 2007. As such, the company now has a near-monopoly position in a growing market with very little opportunity for competitors to steal away market share.

Furthermore, the largest shareholder of the company is Liberty Media Corp. (NASDAQ:LINTA), the John Malone-led company that holds more than 18% of the total shares. Malone proposed to double his company’s stake with a $12 tender offer, but was rejected by shareholders who wanted a higher price.

Currently, the stock trades below Malone’s tender offer. Given Malone’s past interest in owning more of the company and his obvious desire to turn Liberty Media into a dominant media conglomerate, it would not be surprising to see him attempt to gain control of the entire business by offering a premium large enough to entice current shareholders to relinquish their shares.

None of these companies is guaranteed to be bought out in the future. However, all of them have attractive features that make them strong candidates to be taken out. In the meantime, shareholders of these companies can take comfort in the fact that all of them appear to be undervalued and may appreciate, even if a buyout never materializes.

Lance Helfert is president of West Coast Asset Management and the co-author of “The Entrepreneurial Investor — The Art, Science and Business of Value Investing.”

Disclosure: The stocks identified above do not represent all of the securities purchased, sold or recommended for advisory clients; West Coast Asset Management maintains a list of all recommendations made in the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities that were discussed in this article. Past performance does not guarantee future results.

WCAM's Lance Helfert on Fast Money (12/29/2010)

2011-01-03T01:55:00.002-05:00

Dear Readers,

First off, I wanted to wish everyone a Happy New Year. I hope that 2011 is a prosperous year for all of you.

My boss, Lance Helfert, was on CNBC again this past week discussing smart, value-biased stock picks for 2011. These are companies that are in WCAM's portfolio and for which I continue to be involved in the research process. It sure is nice to see the fruits of my labor on national television!

Switzerland: A Safe Haven No More?

2010-12-23T19:41:00.008-05:00

The Backdrop

Anyone who has been following the currency markets recently has probably noticed that the Swiss franc (CHF) has been appreciated against the Euro at a pretty sustained pace. Specifically, check out the following chart from Xorte.com. What it shows is that since last year at this time the EUR/CHF ratio has fallen from about 1.5 to 1.25, a 16.7% drop.

Ostensibly, the appreciation of the CHF versus the Euro has to do with investors’ perceptions of the strength of the Swiss economy relative to that of the Euro Zone as a whole. Switzerland has certainly for a long time been associated with financial stability and conservatism. Additionally, Swiss banks have traditionally been viewed as a safe haven in an uncertain banking world. But is this still true today? What would happen if the Swiss government was forced to bail out its banks again? Does it have the resources? What would be the impact on the country’s bonds?

The current issue

The reason I began to think about these issues is that I was contacted by a wealthy friend and mentor of mine who owns a very large real estate company. After years of hard work, he is now concerned about US dollar-denominated assets and has invested some of his wealth into Swiss bonds and the Swiss franc. He also owns some physical gold that is held at a Swiss bank. When we started to talk about the issues that the Euro Zone faced, he asked me if he should be worried about his gold and his Swiss bonds. While I am inclined to think that his assets are safe, I do believe that the recent troubles with the European banks have caused the number of potential economic and fiscal outcomes to increase. So, while I am certainly not an expert on Europe, currencies or sovereign debt, it is not hard to justify being a little concerned about Swiss bonds and Swiss banks if some admittedly unlikely, but certainly possible scenarios actually play out.

Given that context, the following represents a brief analysis of the current state of Switzerland. My goal is not to scare or alarm anyone. I have no ability to predict how Swiss bonds or the franc will perform under different economic circumstances. But, based on my initial research, there are a few things that investors who own Swiss bonds and Swiss francs should analyze with a skeptical eye:

Swiss Debt/GDP

The good news is that Switzerland’s government debt to GDP ratio does not look disturbingly high. According to an October 2010 report from the IMF¹, the 2010 baseline debt to GDP ratio for Switzerland is projected to be 39.5% and even in a low growth scenario that number only would jump to 44.5% by 2015. This is compared to 2010 baseline projections of 92.7% in the US (yikes!), 130.2% in Greece and an astonishing 225.5% in Japan. So, in the event that the Swiss needed to borrow money to help bail out the banking system, there is definitely some room to add

government debt. Although, I would make the argument that the country should do everything it can to avoid maintaining anywhere near the debt to GDP levels of the US, Greece and Japan.

European sovereign debt

I was not sure how much sovereign debt the traditionally conservative Swiss banks had accumulated but if they were like other European banks, I suspected that they had gotten stuck with a lot of Spanish, Greek, Irish, Italian and Portuguese bonds that may eventually trade at less than 100 cents on the dollar. For example, any default on or restructuring of these countries debt would force banks to realize losses on their holdings. However, according to the latest release from the Bank of International Settlements², as of June 2010 the numbers weren’t too bad. Here is the total Swiss bank exposure (according to the BIS) to the debt of the PIIGS countries:

Portugal: $2,780 million

Ireland: $17,602 million

Italy: $11,382 million

Greece: $2,403 million

Spain: $11,758 million

Total PIIGS Exposure: $25,543 million or about 5.2% of the country’s 2009 GDP of $494.6 billion³

Now, $25.5 billion may sound like a lot, but it is nothing in comparison to the exposure of the UK banks. Specifically, the UK banks owned about $360.5 billion in PIIGS’s debt as of June 2010. This figure represents an astounding 16.6% of UK GDP that amounted to $2.175 trillion in 2009⁴. Let’s all hope that the UK never has to bail out its entire banking system by borrowing money from investors and thus placing the burden of the private sector on taxpayers. With government debt to GDP projected to be 76.7% in 2010¹, the UK may not have the capacity to add much more debt before interest rates spike and investors begin to get nervous.

Total bank assets

Take a look at this chart I found from last January on Forbes’s website⁵:

It shows that Switzerland had the 3rd highest bank assets to GDP ratio (only behind that of Ireland and Iceland!). Just eyeballing the chart indicates that the banks’ assets represent somewhere near 750% of the country’s GDP. So, if the banks were ever forced to write down more assets (sovereign debt, real estate loans, securities tied to the US housing market) they might subsequently have to be bailed as a result of their consistent inability to avoid bad assets. Given the worldwide aversion to letting bondholders lose penny, a bailout would likely require a ton of government borrowing that could represent a large portion of GDP. If the borrowing got to be too high (Reinhart and Rogoff suggest that the debt to GDP tipping point is around 90%) then the ultimate ability of the Swiss to repay their debt might come into question, an event that would certainly not be good for Swiss bonds.

Physical Gold

The other thing investors need to think about the security and liquidity of physical gold held at the once impenetrable Swiss banks. I have heard some (admittedly anecdotal) stories recently from gold bugsJames Turk of Goldmoney.com⁶ and Jim Rickards of Omnis⁷ that indicate that people who thought they had allocated gold holdings in Swiss banks have not been able to get their gold in a timely manner. The implication is that the banks either lent out or sold the gold but still continued to charge the storage fee. Aside from potentially being fraudulent behavior, these stories highlight the dangers of depending on the banks to act in the best interest of their customers.

Accordingly, I think that it makes sense for all investors to look at their arrangements with the banks and see if they have the ability to lend or sell your gold, a situation that essentially leads the bank to be short gold. In a rising price, high demand environment banks might not have the ability to locate an ample supply of physical gold. At that point owners wouldn't have the protection they wanted. As such, the recommendation from the gold bugs referenced above is to hold gold outside the banking system with a company like Brink's.

Takeaways

For people who still look at Switzerland as a safe haven and a suitable place to park assets, I don't exactly know what the takeaway of the information presented above should be. I guess I just want people to be aware of the downside risks. I think that it is very unlikely that Swiss bonds will be not be paid in full. While a rising interest rate environment could lead to mark to market losses on recently purchased bonds, as long as they are held to maturity investors are still likely to get their full principal back.

Furthermore, I think that there is only a remote chance that investors would not eventually be able to get their gold if they wanted it. However, as the price rises and physical supply gets tighter, there is always the risk that it might take longer than anticipated to obtain physical gold. This is always the problem with gold. It is a store of value, but it is not free to store and it is very difficult to transport and protect. Gold bulls always say that there is no counterparty risk with gold. That is true if you own your own vault. But, in the case of an investor who holds his or her gold with a bank, there is always the risk that the bank will not be able to live up to its end of the bargain. At that point, an investor might have to wait years to receive just compensation for the breach of contract and by that time the benefits he or she hoped to accrue from gold ownership may no longer be applicable.

I know we all have plenty to worry about right now but I want to caution everyone from getting lulled to sleep to by the apparent security and long history of stability of Switzerland. Just like Iceland and Ireland, it has let it banks get to be far too large relative to the size of the economy. It is probably true that if the global economy improves and the contagion in Europe never fully materializes, Switzerland is a smart place to shift dollar-based assets to. However, if there are any bumps in the road, the extremely high bank asset to GDP ratio represents a type of leverage that makes the whole financial system unstable.

Where do we go from here?

The sad thing is that I don't know where to find a true safe haven right now. I wish I did. Therefore, if I were very wealthy and running my own fund I would buy some catastrophe insurance. There are two ways to think about such insurance. The first is as a hedge against risks that individual investors are exposed to. My friend owns a large commercial real estate company so buying out of the money puts on publicly traded REITs could be a decent hedge against price and rental declines in the real estate markets. Second, investors can identify situations in the world that seem unlikely to remain static. For instance, given Japan’s projected 2010 government debt to GDP ratio of 225.5%, it is shocking to see that the 10 year JGB only yields 1.2%¹⁰. With a declining population, an interest expense that continues to make up a large percentage of revenue, and a strong Yen that is killing exports, at some point investors are going to start to get nervous that the Japanese may not even have the capacity to repay their debts.

With this in mind, here are some examples of both types of hedges:

Constant Maturity Swap Rate Caps that make a lot of money if the yield on Japanese bonds (finally) increases (see Julian Robertson’s similar bet against US Treasuries⁸)
Credit default swaps on Swiss bonds (to protect any Swiss bond holdings)
Credit default swaps on the Swiss banks that hold investors’ gold
Far out of the money puts on the S&P 500
Out of the money calls on commodity ETFs just in case inflation ever kicks in and commodities sky rocket

If the world recovers and sovereign debt issues disappear, then by investing in some of the above hedges all that would be lost is what amounted to an insurance premium. With the S&P VIX as low as it is (look at this amazing chart of the roller coaster ride that is the VIX⁹) and clear over-optimism about the situations in the Euro Zone and Japan, some of these hedges might not even be that expensive. But, if we go back into financial crisis then investors have the opportunity to make multiples of their premiums and thus offset losses in other arenas. The point is that the perfect time to protect assets and initiate hedges is precisely when other people are dismissive of risk. This is one case in which waiting for more information or for another shoe to drop could be very costly.

References

My Boss Lance Helfert on CNBC

2010-12-16T14:57:00.003-05:00

My boss and West Coast Asset Management co-founder, Lance Helfert, was on CNBC this morning. He discussed 3 stocks, Broadridge Financial (BR), Molson Coors (TAP) and Yahoo! (YHOO), that we think could be takeover candidates. We are also working on an article for a well-known financial website in which we will discuss these companies in more depth. For now, check out Lance talking about the research he and I did on these companies:

The Darkside of QE2

2010-12-08T01:13:00.004-05:00

(A version of this posting was sent out to clients of West Coast Asset Management as a part of the firm's monthly letter)

“The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt. This is risky business. We know that history is littered with the economic carcasses of nations that incorporated this as a regular central bank practice.”

-Federal Reserve Bank of Dallas President Richard Fisher (November 8, 2010)¹

The Backdrop

The US financial discourse over the past few months has been dominated by analysis of what has been deemed QE2. For those of you who are unfamiliar with the concept, QE2 is simply an acronym for Quantitative Easing 2. The first round of QE began in March of 2009 when the Federal Reserve embarked on a plan to buy $1.25 trillion in agency mortgage backed securities (those securitized by Fannie Mae and Freddie Mac) and $300 billion of longer term US treasuries. However, with unemployment still uncomfortably high and the perception that there is only a trivial risk of inflation on the horizon, the Fed is at it again; this time vowing to buy $600 billion of US Treasuries over the next eight months.

Specifically, the Fed’s goal is to reduce interest rates available to individuals and businesses even further. Usually, when it wants to achieve that objective, the Fed uses its Fed Funds Rate (FFR) to manipulate interest rates. The FFR is a rate at which depository institutions (primarily banks) lend money to each other (at the Fed) on an overnight basis. During its periodic meetings, the Fed determines the target Fed Funds Rate based on its views regarding the economy. Then, if the Fed wants to slow down growth or contain inflation, the remedy is often to increase the FFR. By making it more expensive to borrow, banks will be less likely to borrow money that they can then lend to customers and excess credit creation will be forestalled. However, if the Fed wants to stimulate growth or prevent inflation from being too low, the protocol is to reduce the FFR. In other words, by making it less expensive to borrow, banks are incentivized to borrow and lend more freely, a dynamic that increases credit availability. However, the current problem is that the Fed can’t lower the FFR any further. Accordingly, as will be discussed more in depth later, the Fed has decided to purchase other assets in an attempt to prompt an incremental reduction in economy-wide interest rates.

For people who are not professional investors or economists and are not following the markets day to day, the Fed’s recent maneuverings likely elicit a lot of questions. For instance, isn’t inflation generally a bad thing? If, so why is it that the Fed thinks inflation is too low and why in the world would it want to create inflation? Additionally, people may be wondering what exactly the Fed is trying to accomplish by buying more Treasuries. If interest rates are near historical lows, what is the benefit of slightly lower interest rates? Finally, another logical question has to do with what the Fed plans to do with all of the Treasuries and mortgage backed securities it has bought over the last year and a half. If it eventually tries to sell them in the open market, won’t that push up interest rates and impact the economic recovery? But, if the securities cannot be sold without affecting interest rates, couldn’t the increased money supply and credit availability lead to inflation when the economy starts picking up again?

Clearly, there is a lot of uncertainty regarding the quantitative easing initiative and the goal of the article is to address some of those concerns. Specifically, by trying to answer the questions posed above, we hope to shed some much needed light on the inner workings and intentions of the Fed.

Why is the Fed trying to create inflation?

The Merriam-Webster online dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.”² In more simplistic terms, as the money supply increases, prices of goods and services tend to rise as well. On the flip side, deflation is defined as “a contraction in the volume of available money or credit that results in a general decline in prices.”³ Deflation occurred in the US during the 1930’s and many historians and economists believe it was a contributor the length and severity of the Great Depression. The kind of deflation that the Fed worries about is not the falling prices of electronics due to technological innovation. Instead, the Fed is determined to prevent falling asset prices and declining wages that lead business to stop investing, consumers to stop spending and the economy to grind to a halt.

Thus, there are a number of metrics that the Fed uses to monitor the level of inflation, especially the Consumer Price Index (CPI) and the Producer Price Index (PPI). Usually, in a stable and growing economy with a moderately increasing money supply, both these and other metrics reflect the fact that wages and the prices of goods increase a little bit each year. But, as a result of the financial crisis and the ongoing unemployment epidemic, Ben Bernanke and a number of his fellow Fed Governors believe that the inflation rate is too low and that destabilizing deflation is a real possibility.

The Fed has a mandate to foster both maximum employment and price stability. But, when it comes to price stability, the truth of the matter is that Bernanke is much more concerned about deflation than inflation. Therefore, in order to prevent a severe bout of deflation, he is more than willing to take measures that stoke minimal inflation but keep inflation expectations from getting out of line with the current rate. In normal times, the Fed can achieve these goals by adjusting interest rates. However, the current Fed Funds Rate is so low (0%-.25%) that the Fed no longer has the ability to cut interest rates in order to stimulate the economy or cause inflation.

We have nothing to fear though, because the Fed has a number of other tools at its disposal. In fact, long before the financial crisis, Ben Bernanke addressed the issue of what to do when interest rates hit what is known as the “zero bound.” In a speech entitled “Deflation: Making Sure “It” Doesn’t Happen Here⁴,” the future Fed Chairman outlined a number of measures the Fed could take if traditional monetary policy was no longer effective. First, he suggested creating an inflation buffer by officially or unofficially targeting a specific rate of inflation, somewhere between 1% and 3%. Next, he proposed using the Fed’s regulatory powers to make sure the financial system remained both stable and functioning in a normal fashion. And finally, Bernanke presented the following as a potential remedy:

“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys… For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt.”

As you can see, during this speech way back in 2002, Bernanke telegraphed exactly what he would do if inflation ever got too low for his tastes and interest rate policy solutions were limited. But, the important question is why is he so preoccupied with preventing deflation? Here is a simple example from that same speech that explains the issue:

“To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.”

Fast forwarding to the present, given the severity of the downturn we have already experienced, Bernanke and his cohorts are worried that deflation would damage investment and spending and thus push unemployment even higher and the US into a depression. Unfortunately, what this fear of deflation means is that the Fed is likely to err on the side of inflation, which history has shown can get out of control if the monetary authorities are not extremely careful.

What is the Fed’s goal in reducing interest rates further?

This topic has received a great deal of debate recently. Bernanke’s problem is that rates are already so depressed that much of the stimulative benefits of historically low interest rates have already been felt by the economy. Would another .25% decline in mortgage rates cause a wave of refinancing and home buying? Would another .5% decline in Treasury rates lead businesses to start investing and hiring again? Someone skeptical of the Fed’s intentions would argue that the impact of QE2 might be very subdued given the uncertainties regarding the housing market, consumer spending, and the viability of business investments. One such critic is John Hussman of the Hussman Funds, who stated the issue quite eloquently in one of his latest missives⁵:

“With no permanent effect on wealth, and no ability to materially shift incentives for productive investment, research, development or infrastructure (as fiscal policy might), the economic impact of QE2 is likely to be weak or even counterproductive, because it doesn't relax any constraints that are binding in the first place. Interest rates are already low. There is already well over a trillion in idle reserves in the banking system. Businesses and consumers, rationally, are trying to reduce their indebtedness rather than expand it, because the basis for their previous borrowing (the expectation of ever rising home prices and the hope of raising return on equity indefinitely through leverage) turned out to be misguided. The Fed can't fix that, although Bernanke is clearly trying to promote a similarly misguided assessment of consumer "wealth."”

What Hussman is saying is that by reducing interest rates even lower, the Fed actually has the peripheral goal of inflating asset prices with the hope that the associated “wealth effect” will cause widespread confidence to increase and eventually lead people to start spending and businesses to start hiring. One could also argue that the Fed is enticing investors to take more risk. With yields on government and corporate bonds so low, investors who are looking for returns are forced to buy riskier assets such as stocks. Given that backdrop, it is no surprise that the S&P 500 is up so much since Bernanke signaled the QE2 was likely during his Jackson Hole speech at the end of August. But, just focusing on the S&P obscures the fact that just about everything is up in price. If you are curious, take a look at the price charts for gold, silver, corn, cotton and copper over the last year. For example, gold is up about 23%, silver is up 64% and cotton is up an amazing 75.6%!⁶

Not only is the Fed helping to inflate stock market prices and to push people into riskier assets, but the near zero Fed Funds Rate and the buying of other assets is forcing people to buy hard assets as an inflation hedge. So, while the Fed believes that inflation is too low, at some point the dramatic price increases in commodities are going to flow through to consumers. And, with stagnant wages, unemployment clearly not declining fast enough and fiscal stimulus winding down, the people who spend a disproportionate percentage of their income on daily necessities (food, clothing, household items) are going to really feel the pain when prices begin to rise.

We also should point out that zero interest rate policy has been a godsend for the banks. First off, the banks can borrow at basically 0% from the Fed and immediately turn around and buy 10 year US Treasuries that yield north of 3%. In essence, the banks can choose to receive a risk free spread of 2.6% on their money as opposed to lending it to consumers and businesses to help jumpstart the economy. In addition, by holding interest rates down the Fed has induced large corporations to issue billions of dollars of long term debt at very attractive rates. Obviously, this is great for shareholders of these companies but it has also led to huge revenues for the banks who underwrite these debt offerings. In summary, it certainly appears that the Fed’s asset purchases have benefited those with large investments in stocks, large banks, and big corporations at the expense of the rest of America.

How is the Fed going to sell all of the assets it has bought?

This, ladies and gentlemen, is the million dollar question. To accurately assess the situation, it is necessary to analyze the Fed’s balance sheet. As of the most recent data available on the Fed’s website, the dollar amount of assets on the Fed’s balance sheet was just about $2.35 trillion⁷. To that number, you can at least add the $600 billion of Treasuries that will be purchased over the next eight months, bringing the total near $3 trillion. Compare that to the $914.8 billion in assets the Fed held at the end of 2007 and it is possible that the Fed will have more than tripled its balance sheet in three and a half years⁸. The liability side of the balance sheet consists mostly of balances that banks hold on reserve with the Fed. At the end of 2007 these deposits amounted to $20.77 billion and are now about $1.26 trillion. This is what John Hussman meant when he said that that there are over $1 trillion in idle reserves in the banking system. In other words, banks are hoarding money and leaving it with the Fed instead of lending it out.

In any case, the Fed is going to have to sell assets unless it wants to see the money supply explode when the economy starts to improve on a sustainable basis and banks start lending out those reserves. As a hypothetical, let’s say the Fed wants to get its balance sheet back to where it was at the end of 2007. This would entail selling somewhere around between $1.5 and $2 trillion in assets, assuming the Fed follows through on its most recent promises and then refrains from more quantitative easing (the latter being a very dangerous assumption). Clearly, if the Fed tried to sell these assets all at once the market would not be able to absorb the sale and interest rates would likely go through the roof. So, unless inflation had accelerated to very uncomfortable levels, the Fed would probably try to wind down its balance sheet over a number of years in order to avoid killing a nascent economic recovery and to ensure a somewhat orderly rise in interest rates.

Bernanke did actually hint at the unwinding issue in his speech from 2002. Specifically, he indicated that “[b]ecause some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects.” So, it appears that Bernanke was aware of the potential pitfalls at the time of his unfortunately prescient speech. However, the magnitude of the necessary asset sales was likely not even a possible outcome in Bernanke’s mind but unquestionably needs to be addressed sooner rather than later.

Let me try to explain why. As of December 1st, 2010 the Fed had a net worth (total assets minus total liabilities) of $56.02 billion. In addition, the majority of the Fed’s assets base consists of securities held outright, which total about $2.088 trillion. Now, let’s say the Fed wants to sell $1.5 trillion of those assets to reduce the size of its balance sheet. This is not the forum to dive into a deep discussion of bond math and the duration of the Fed’s security holdings. However, the important thing to understand is that if market forces cause interest rates to rise, the value of the previously purchased assets on the Fed’s balance sheet will fall. The Fed likes to claim that it has the ability to hold assets to maturity, a fact that implies that the Fed should not have to mark its balance sheet to current market prices. However, in the event that the Fed was forced to sell in order to combat potential inflation, it could realize losses on those sales. Specifically, with about $56 billion in equity, the Fed would only have to realize a 3.7% loss on the sale of the $1.5 trillion in securities to wipe out 100% of its equity. And you thought Bear Stearns and Lehman Brothers had a lot of leverage.

Smart people can argue about whether or not the Fed can actually be insolvent, but the idea that America’s central bank could have assets worth less than its liabilities does not inspire a lot of confidence. There is no way to know how much interest rates will have risen when the Fed wants to unwind its balance sheet, but the truth remains that a 3.7% realized loss on asset sales is certainly not that farfetched. Thus, the Fed may be unable to sell securities when it wants to increase interest rates unless it wants to realize substantial losses. Then, the fact that the Fed’s balance sheet could be locked in at the current size is very troubling, especially given the implications for inflation.

Will quantitative easing work?

The purpose of this piece is to illuminate some of the risks of quantitative easing. Many talking heads have taken the stock market rise that came about after rumors of QE2 emerged to mean that most investors approve of what the Fed is doing. But recently, two luminaries of the investment world, Bill Gross of PIMCO and Jeremy Grantham of GMO, have published scathing critiques of the Fed’s policies (see link’s below).

However, we should all be careful to not underestimate Ben Bernanke and the Fed. As a group, the members have a lot of influence and a number of tools at their disposal. As such, I am certainly not saying that quantitative easing will unequivocally not work or that the US is on a dangerous path that cannot be reversed. I am also not implying that the stock and bond markets are poised for large declines. Specifically, what I do believe is that the Fed’s attempts to inflate assets may not be sustainable unless the economic fundamentals improve as well. Accordingly, my humble advice is to watch the developing situation very closely, especially when it comes to commodity inflation and rising interest rates.

America is in uncharted territory. It looks as though we will live through at least a tripling of the central bank’s balance sheet in just a few short years. Such a circumstance is unprecedented in modern US history. As such, whether or not QE2 is “working” may depend on who you are and what you are invested in. Therefore, it is the job of investment managers to understand the risks and position their clients in a way that protects them from both the intended and unintended consequences of QE.

3^rd Quarter Letter for Jeremy Grantham of GMO: http://www.gurufocus.com/news.php?id=110465

November letter from Bill Gross of PIMCO: http://www.pimco.com/Pages/RunTurkeyRun.aspx

References:

What Political Gridlock in Washington Means to You

2010-11-02T14:38:00.004-04:00

(A version of the follow post was included in a newsletter sent out to clients of West Coast Asset Management.)

Just about every media outlet imaginable has reported the widely held belief that Republicans (or anyone who is not an incumbent) are going to have a very good day this coming November 2^nd. While it may be true that the current Democrats inherited an economy that was falling off a cliff, the common refrain is that voters want change. This desire may come from any number of initiatives and events that have apparently been damaging to the White House and Congressional Democrats. Whether the topic is ObamaCare, the continued pandering to large banks, the Dodd-Frank legislation or the increasing size and importance of the US government, suddenly the Democrats who now hold a majority have become very unpopular, at least according to the polls. Specifically, Gallup’s website shows Obama’s approval rating at an uninspiring 48%¹. Additionally, among likely voters, Gallup reports that Republican candidates look to be favored by a very large 11-17% margin in the upcoming election².

What this means is that there is likely to be even more gridlock in Washington in the coming years. Regardless of whether or not the Republicans take over the majority in the House and Senate, it appears that they will gain some seats. Consequently, Congress will likely be unable to pass meaningful legislation that does not command the ever-elusive and increasingly rare bipartisan support. Thus, when this inconvenient fact is combined with an increasingly less powerful and popular President, chances are the kinds of reforms that the country really needs are not going to pass in the near future.

Now, we are probably not saying anything that most people do not already know. But, what is important are the specific details regarding which issues may remain unaddressed due to the impending logjam in Washington. As such, the purpose of this piece is to outline three specific items that may unfortunately not be resolved and then pontificate on the subsequent effect on investors and markets. The goal is not to offer policy solutions; we will leave that to politicians and those who run macro hedge funds. We also have no interest in blaming either party; we are just interested in the effect of a political stalemate on investors globally. In fact, our main objective is to highlight some of the risks and opportunities for our investors if there is to be a prolonged impasse when it comes to legislation in Congress.

The Bush Tax Cuts

To extend or not to extend? That is the question. The Obama administration wants to extend the cuts to those who make less than $250,000 a year. To that the Republicans contend that any tax increase, even if just for the wealthy, will deter consumption and investment and thus delay economic recovery. But, therein lies the conundrum. What if the Democrats are only willing to vote to extend the tax cuts to some and the Republicans will only accept a full extension of the current rates? In that case no legislation is likely to pass and the tax cuts will just expire on their own. What happens then?

Well, marginal income tax rates will increase, the estate tax will come back in full force, and capital gains tax rates will rise. In other words, investors will be faced with the trifecta of reduced income after taxes, having to re-think or adjust their estate plans and lower profits on successful investments that have yet to be realized. Additionally, if capital gain taxes are going to increase, the stock market may see a significant amount of selling at the end of the year as investors move to lock in the 2010 rates. Clearly, for an economy struggling to find its footing, the impact of an expiration of the Bush tax cuts could be quite destabilizing. As such, while the Bush tax cuts may have increased the government’s deficit problem (since they were not “paid for” by a reduction in government spending), the unfortunate truth is that any tax increase of this scale could derail the recovery and have a detrimental impact on the equity markets.

The Burgeoning Deficit

Of course, the flip side to extending the Bush tax cuts is that government needs revenue to help bring down the deficit. Specifically, the budget deficit for fiscal year 2010, which ended September 30^th, came in at an astounding $1.29 trillion³. Therefore, by forgoing the opportunity to increase taxes, the powers that be in Washington are basically guaranteeing that the shortfall will remain at $1 trillion levels. For some, this is necessary given the malaise in the economy. In fact, many of those who believe in the policy prescriptions developed by John Maynard Keynes continue to suggest that even greater government spending is needed to get the economy humming again. However, even the Neo-Keynesians agree on the un-sustainability of the fiscal path the US has embarked upon since the beginning of the financial crisis.

Specifically, an ongoing deficit could impact financial markets down the road. For example, if the politicians in the nation’s capital are unable to agree on and effectuate a credible plan to reduce the deficit, there could be some severe consequences for those who have flocked to fixed income securities over the last year or so. Even though long term Treasury rates remain near historical lows, this situation is not guaranteed to last. If the US’s creditors begin to believe that Washington’s spending has gotten out of control and that inflation is likely as a result, they may start to demand higher rates to compensate them for the risk of accumulating and holding US Treasuries. If this happens, interest rates are likely to rise across the board. That means that mortgage rates, corporate borrowing rates and even rates on consumer credit could increase. Also, as rates rise, investors who bought fixed income securities could see the value of those investments drop. Furthermore, higher interest rates are likely to impact already strained consumers and eat into the profit margins of businesses. As such, it is unlikely that these developments would be seen as positive by stock market investors and the equity markets could see some near term selling pressure.

However, individuals and corporations holding cash or short term fixed income securities could be beneficiaries of an increase in interest rates. Currently, when inflation is factored in, the real yield on most cash accounts is slightly negative. Accordingly, savers are being punished in the low rate environment that persists today, especially retirees who live off of income produced by their savings and investments. But, in a perverse sort of way, if fears regarding the deficit serve to push rates up, millions of people who have limited exposure to the risky assets that have been rising in price and are sitting on cash will be the beneficiaries (at least in the short run).

Unemployment Blues

The recent September unemployment data was rather dismal. The headline unemployment rate remained stubbornly high at 9.6% as the economy shed an estimated 95,000 jobs in September. Even more troubling was the fact that the U-6 unemployment rate, which captures the under-employed as well, jumped to 17.1% in September. Further, 41.7% of unemployed people had been out of work for 27 weeks or more⁴. As a response to this specific problem, Congress has passed extensions of unemployment benefits a number of times over the last year. However, the votes are becoming more contentious. The most recent bill that passed in July saw support from 272 House members while 152 opposed the bill⁵. But, even though the final Senate vote was 59-39 in favor of the extension, it took months to pass the bill in the Senate as a result of bickering between the parties regarding how to pay for the benefits⁶. Accordingly, if the Republicans were to gain seats, there is certainly the risk that future extensions would not be feasible. Regardless of one’s views on the merits of unemployment benefits, the truth remains that as people’s benefits lapse, they are unable to spend, invest or make rental or mortgage payments. Unfortunately, the population at risk includes 2.5 million people so the impact of their reduced income could have a meaningful impact on the economy, especially since the unemployment situation does not look like it is bound to improve anytime soon.

The question Americans must ask themselves is whether the government is doing enough to help stimulate the economy and create jobs? Unemployment benefits are clearly just a temporary solution to what looks like a structural problem within the economy. If it is true that certain financial services, retail, and construction-related jobs are not going to come back for many years, how are we going to reduce the unemployment rate? Infrastructure investment by the government to replace the US’s crumbling roads and bridges has been suggested as an option. Also, clean energy is often cited as a source of many new jobs in the coming years. The problem seems to be that the leaders in Washington cannot figure out how to agree on a way forward. Accordingly, virtually nothing is being done to either spur job creation in the private sector or create government work programs. This is at least partially a function of the gridlock in D.C. that may only become more pronounced if the Republicans win big in early November. But, in addition, there is no denying the fact that the huge number of manufacturing jobs that have been outsourced to lower labor countries has contributed to the current unemployment problem.

The Light at the End of the Tunnel

Given the circumstances cited above, it is hard to see much of a silver lining for equity investors. However, it is times of heightened and seemingly insurmountable uncertainty that provide unique opportunities to make long term investments. Many investors are extrapolating the current economic troubles years into the future. This has caused the stocks of world-class companies with fortress-like balance sheets and durable competitive advantages to trade at prices that imply a perpetual state of turmoil. Accordingly, while many people view the previously discussed problems as intractable, long term investors believe that global economies and markets are very dynamic and adaptable. Therefore, we believe in reversion to the mean and that a strategy of investing with a sufficient margin of safety and a multi-year time horizon is the best way to generate excess returns for our investors. So, while the media and politicians myopically focus on the next few months or weeks, we will continue to build positions in companies that we believe have the ability to excel and prosper in just about any economic environment.

Sources:

Must Read Interview with Alice Schroeder

2010-11-01T12:54:00.001-04:00

Readers,

I usually refrain from shameless promotion, but my good friend Miguel Barbosa of the world-class site Simoleonsense just released the first installment of his lengthy interview with Buffett biographer Alice Schroeder. Anyone who has read her book, The Snowball, knows that it provided readers with an intimate depiction of Warren Buffett's relationships that had not been available elsewhere. We had long known Buffett the investor and thanks to Ms. Schroeder, we now better understand Buffett the man, father and husband.

Miguel has promised me that this interview will provide even more insight for those who are interested in what makes the world’s greatest investor tick. Please take this opportunity to read the interview linked below. I personally am looking forward to the rest of the series as well.

http://www.simoleonsense.com/simoleonsense-interviews-warren-buffetts-biographer-alice-schroeder-part-1-the-forging-of-a-skeptic-from-accountant-to-buffetts-voice-on-wall-st/

America's New Risk: Regulatory Risk

2010-10-28T01:27:00.005-04:00

With the elections only a few days away, it seems to me that the US political system has reached an important crossroads. The question that many people are currently asking themselves is: what will happen if the Republicans take a number of seats in the House and Senate? Will the logjam in Washington D.C. just get worse?

The following piece examines the uncertainty surrounding future regulations that would only be exacerbated if we end up with with a Congress that refuses to be on the same page as the President. As always, my point of view is that of an investor. As such, my concern is that many companies currently have no way to plan for potential new regulations and as a consequence, investors have little ability to price in the changes that may be coming. My thesis is that this nebulous future many companies are facing is only holding back the economic recovery because investment and hiring decisions are being postponed. In highlighting three industries that I feel are uniquely susceptible to being hit by further regulations, I hope to illustrate that point. Let me know what you think.

(Disclaimer: The opinions expressed in this article are my own and do not necessarily reflect those of West Coast Asset Management or any employees of the firm.)

America’s New Risk: Regulatory Risk

When assessing the stocks of companies domiciled in emerging markets, the risk that the home government will take monetary, fiscal, legal or even military actions that undermine the value of the equity market is usually called country or regime risk. This concept comes with the implication that investors should demand a higher rate of return to compensate them for the risk that the government will do something capricious, misguided, or even unethical. For example, if you run an oil company with assets in Venezuela you are concerned about regime risk because the government might nationalize your assets. Or, if you are investing in the nascent equity market in a war-torn African country, you should price in the risk that war breaks out once again or that there is some sort of coup. The point is that investors and companies who are familiar with regime risk can act appropriately by making sure the potential returns are worth all of the uncertainty.

Fortunately, over the last number of decades, investors who focus on the US have not needed to price in any regime risk. The US hasn’t experienced a Civil War since the 1860s. Aside from the impact of going off the gold standard during the Nixon administration and intentionally devaluing the dollar versus gold in the 1930s, the US has never defaulted on its debt obligations. Furthermore, what has made the US the safest country to invest in over the last 60 years is the strict adherence to the rule of law. When all of this is combined with the economic stability that the US has enjoyed, many investors have rightfully not felt the need to demand a premium return for country risk. In most people’s minds, such considerations only applied to “frontier” or “emerging” markets.

Unfortunately, a new risk is emerging in the US that investors should take note of. It is my position that it is not as severe as country risk or regime risk. However, I do believe that there is more potential for what is known as regulatory risk to affect equity markets than in recent history. For a simple definition of regulatory risk, we turn to Investopedia.com¹:

“The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape.”

Could it be that this risk has become a real threat to companies and investors in the US? Sadly, I believe it has. Let’s look at three very distinct industries to illustrate the uncertainty caused by increased regulatory risk: (Examples of potentially affected companies are included in the adjacent parenthesis)

Retail Pharmacies (CVS, WAG, RAD): Just about no one questions the need to reduce health care costs and expenditures in the US. With an aging population, health care spending will represent a larger and larger percentage of US GDP and this increase threatens to put states and the US government in very difficult fiscal positions due to their responsibilities to Medicaid and Medicare patients. Unfortunately for retail pharmacies, they have been caught in the crossfire even though they do not appear to be part of the cost inflation problem. Specifically, pharmacies are reimbursed based on their cost of acquiring drugs. They are paid a slight premium to their cost along with a flat fee for dispensing the drugs. However, reimbursement rates are under pressure as many states are now unable to cope with prescription drugs needs of Medicaid patients.

As such, there is a battle looming over reimbursement rates that unfortunately could lead the pharmacies to stop filling prescriptions for Medicaid patients. This is exactly what happened in Washington state in January of this year when rates were reduced to a level that no longer covered Walgreen’s cost. Not only is the uncertainty regarding reimbursement bad for patients, but it is also a problem for pharmacies in that the ambiguity makes hiring and expansion decisions very difficult. This is on top of the fact that a change in reimbursement rates could decimate the already low operating margins for these companies and likely cause a further drop in their stock prices.

Finally, an important question for these companies has to do with which party has the power to influence and pass legislation in Congress. If the Republicans gain enough seats in the House and Senate to repeal the Obamacare initiative, then 32 million people who were going to have access to prescription drug coverage will no longer have that luxury. No matter what your beliefs are about the merits of the health care reform bill, the potential for it to be reversed makes pharmacies unable to forecast demand or execute their expansion policies. Cleary, this is not a recipe for job creation in the industry.

Oil and gas-related companies (XOM, APC, DO): The damage done by the BP oil spill has clearly affected the environment and the local economy of the Gulf of Mexico region. What is also noteworthy is the impact it has had on the offshore drilling (especially deepwater) and oil and gas exploration industry. As a result of the government’s response to the spill, the companies that operate in this space have no idea how to budget for the coming year. Probably the most important question is: are there going to be moratoriums on offshore drilling? To that question I recently came across a comparison to the airline industry that I thought was interesting. The idea is that enacting a moratorium on offshore drilling is like grounding all the airline flights in the US because one plane crashed. Said another way, while the images of the oil spill were horrifying, a moratorium looks like an attempt to indiscriminately punish an entire industry for one company’s apparent negligence.

Additionally, what happens if the Republicans win the House or the Senate in the November elections? Could they find a way to eliminate the potential for a prolonged moratorium? Would a windfall tax on oil profits be off the table? As you can see, the uncertainty makes it impossible for companies to know how much to invest, what to do with idle equipment, or how to make hiring decisions. Unfortunately, in an environment in which the US economy desperately needs businesses to start investing and hiring once again, this regulatory risk could serve to postpone a legitimate recovery.

Financial institutions (GS, JPM, BAC): The financial regulation bill that just passed was widely seen as a victory for the major commercial and investment banks as the most draconian proposed measures were not included into the final bill. However, what must not be forgotten is the fact that much of the rules of the industry are going to be set by (unelected) regulators in the coming years. Specifically, the bill left an incredible amount of discretion in the hands of the FDIC, the consumer protection agency and the Federal Reserve. In fact, law firm Davis Polk counted 243 rulemaking decision and 67 studies that the bill authorizes regulators to be involved in². I will spare you most of the details of what actually is left to be decided, but how to approach the threat created by derivatives, appropriate capital levels, and exactly how to handle the risks of too big to fail institutions will be figured out over the next few years. In other words what we got was a framework for a financial regulation bill (with many exclusions and exemptions embedded in it) without a whole lot of additional certainty as to the eventual details.

Financial institutions can adjust to bad news. They can shut down operations, sell assets, and fire people if necessary. What they cannot plan for in prolonged uncertainty. So, if you are wondering why banks are not lending to consumers and businesses, you can be sure that their inability to predict what the eventual legislation will entail has caused them to be very cautious. Unfortunately, there will be no sustainable recovery until the banks re-start the credit intermediation process. Making the situation even worse, in addition to the impediments listed above, there is also the risk that whoever controls Congress or White House will try to influence the regulators to make decisions that are favorable to their constituents. The fact that the rules could change dramatically depending on who voters favor at any given moment means that financial institutions will have to continuously adjust their operations in order to comply with the shifting regulations. Given the lack of stability in the financial sector over the last few years, increasing regulatory risk just makes it harder for companies to figure out what their “new normal” reality will be.

These are just a few examples among many. Credit rating agencies, for profit education firms and utilities trying to figure out if Cap and Trade is a reality, all are facing similarly uncertain circumstances. It should be noted that I am not arguing the regulation is not necessary. In fact, I believe that many industries were long overdue for legislation aimed at protecting customers, investors and taxpayers. My point is that the gridlock in Congress and the number of companies that could see their industries undergo dramatic changes have created ambiguity that no company can properly plan for. While this is not the first time in US history companies have had to be prepared for major shifts in regulation, I feel as though the number of sectors and companies that could be impacted is larger than it has been anytime in the recent past.

As an investors, I just want to know what the rules are going to be so I can figure how to play the game. I am not used to and do not liking discounting the value of the companies I research just because of some lingering regulatory risk. I know that this situation will eventually be resolved and that American will hopefully get back to its prosperous ways. However, I believe that it is imperative that regulators decisively set policies and the let the private sector get back to focusing on reinvigorating the economy through prudent investment and hiring. Excessive government intervention is inefficient and costly, especially when the US is facing strained economic circumstances. I look forward to a time when regulatory risk and regime risk is more prevalent within the usual emerging market suspects, not at home in the US.

Sources:

http://www.investopedia.com/terms/r/regulatory_risk.asp

http://www.zerohedge.com/article/davis-polk-summarizes-fin-reg-reform-130-pages

High Frequency Traders are Stealing from You

2010-10-20T10:27:00.003-04:00

Readers,

I would like to provide a brief update on my life and post an article I wrote for clients of West Coast Asset Management. I am back in school but have luckily been able to continue my relationship with WCAM. I am working a few days a week from LA doing research and creating content for quarterly letters and blogs.

However, what takes up most of my time is this field study I am performing with a number of my colleagues on the Student Investment Fund at Anderson. We are attempting to come up with a proposal to improve the investment management (IM) program at Anderson. We are contemplating a number of suggestions, including a yearly speaker series, an IM conference (like the one Columbia hosts each year), a stock pitching challenge, a curriculum refresh that includes more practical investing classes and maybe even a separate track for IM like those offered by Columbia and Kellogg. Additionally, we are looking for support from UCLA alumni and any asset managers in the LA area. So, if you or anyone you know would like to be involved, please email me.

Without further ado, the following is an article I wrote about high frequency trading (HFT). The subject was getting a lot of press until ForeclosureGate started dominating the newswires. But, despite the lack of headlines, mini flash crashes continue to happen in certain securities on a weekly basis. This is a warning sign that the system itself is very unstable and that we may be at risk of another crash like the one we saw in May of this year. For those who are still unclear on what HFT is and what risks it may pose, I tried to put together a simple primer on the subject. I am not an expert on this subject but I hope this adds to people's understanding of what I believe is an undesirable trend towards more computer control of the stock market.

High Frequency Traders are Stealing from You

The history and backdrop

Most people are well acquainted with the stock market crash that occurred on October 19^th,1987 in which the Dow Jones dropped by 508 points or 22.61%. After the fact, the largest one day percentage decline in the market’s history was mainly blamed on portfolio insurance. This was a risk management tool that employed stop losses through automatic, computer-based selling. Unfortunately, the prevalent use of this strategy caused a cascade of selling once the market started to drop. Hindsight being 20/20, commentators who opined on the events of the day of course claimed that the outcome was obvious and predictable. Clearly it should not have been a surprise that indiscriminate selling by computers could cause the market to plunge. How could anyone have believed that thoughtless machines controlling the most important stock market in the world was a good idea?

Now, here we are almost 23 years later and apparently we have learned nothing from our past mistakes. In fact, computer trading programs, or algorithms if you will, now dominate the day-to-day trading on the major exchanges. While it is difficult to quantify precisely, most estimates suggest that what is known as high frequency trading (HFT) makes up between 50% and 75% of all trades¹. Let us say that again: Robots trading shares in between one another now accounts for anywhere between half and three-quarters of market activity on a daily basis. So much for fundamental, bottom’s up investing.

What is HFT? (Moved to the top from the bottom)

We understand that we are attempting to tackle a difficult topic. In fact, we are in the process of trying to understand it better ourselves and are certainly not experts. However, if we did not think that the emergence of HFT was an incredibly important development or that we could not present our analysis in approachable manner, we would not be stressing the issue. The truth is that HFT potentially affects all investors, not just those who are involved in the daily trading of the markets.

Investopedia.com defines HFT in the following manner²:

“A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds.”

So far, not so complicated. Basically, companies engaged in high frequency trading use trading speed and sophisticated computer programs to create an advantage over other traders. The specific strategy of many of these programs it to use their superior technology to make pennies or fractions of pennies on every trade. This process, which is kind of like collecting pennies in front of a steamroller, may not seem particularly lucrative until you realize that there are billions of trades executed on US stock markets each day. A billion pennies sure adds up over time.

If it sounds like these firms profit from an unfair and uneven market structure, it is because that is precisely the case. But why is this inequity tolerated and often cited as a positive thing? Well, the common defense of HFT is that these firms who run these algorithms are providing liquidity, a measure of the degree to which a stock can be bought and sold without affecting the price. Generally, the more liquid a stock is the easier it can be traded without causing huge swings in the price. As long as the liquidity is real and those who provide it are committed to it, greater liquidity can be very beneficial to investors. Specifically, it can lead to lower bid-ask spreads (which can lead to lower costs of trading) and a greater ability to move into and out of cash when investors so desire.

However, we believe that the problems created by HFT are twofold:

Increased volatility and the risk of extreme moves in the markets
Increased trading costs through predatory activities

The market roller coaster

First off, all of the evidence we find suggests that HFT creates unusual volatility in the markets. Let’s go back to the so called “Flash Crash” on May 6^th, 2010. The Dow Jones dropped 600 points in a matter of minutes, shares of Accenture (ACN) dropped from over $40 to a penny, and shares of Apple (APPL) rose to over $100,000 each. Even though the exchanges eventually cancelled these outlier trades, how is it possible that share prices can fluctuate so dramatically? The initial reaction to this dramatic move in the price of market indexes was the “fat finger” theory. This is the idea that some incompetent trader who meant to sell one thousand shares inadvertently added three extra zeroes and sold one million shares. However, we believe that such explanations are created in an attempt to obscure the fact that the markets are broken. Actually, these are not our words but basically what Larry Leibowitz, the COO of NYSE Euronext (owner of the New York Stock Exchange), said during his testimony in front of a House Financial Services Subcommittee five days after the Flash Crash³. Specifically, this is what he said about the impact of technology on the functioning of our stock markets:

“The May 6 market drop certainly should inform the SEC’s [Security and Exchange Commission’s] current examination of the changes in the markets, and in particular how certain recent advances in technology may have fostered trading practices that negatively impact the entire market…As regulators seek to determine whether regulatory action is necessary to address the shifts in market structure resulting from technological change, the events of May 6 make it clear that the regulators also need to consider steps to avoid the types of extreme volatility our markets experienced that day.”

This indictment of the recent technological revolution in trading came from a man whose company thrives on market volatility since fees go up as volume increases. Additionally, NYSE Euronext jus opened a huge new $500 million data center in order to take advantage of co-location (where exchanges like NYSE allow traders to plug directly into their servers and increase their trading speed dramatically) revenue that is derived solely from firms who want quicker speeds for their electronic trading. So, despite his vested interest in the increased proliferation of HFT, Mr. Leibowitz is clearly concerned that the practice is a threat to the integrity of the U.S. stock markets.

Liquidity dries up

The problem arises when other market participants depend on liquidity that will only be present when the market is going up or trading sideways. Unfortunately, as we believe the Flash Crash proved, when the market declines rapidly the liquidity dries up as the algorithms shut down to avoid catching a falling knife. Essentially, our concern is that when the market plunges the HFT algorithms are programmed to stop trading so that the firms are not caught holding assets that are falling in value. But, this just exacerbates the drop in the market as there are subsequently fewer buyers remaining. A true liquidity provider would remain in the market in order to bid on assets even if they are declining in price and make an active market (one with both buyers and sellers) in stocks. But, if the HFTs flee the market at the first hint of weakness, the market can stop functioning. When this happens, stocks such as Accenture, which usually trade close to 4 million shares a day but saw volume spike to 10.3 million shares on the Flash Crash day⁴, can fall from over $40 to $.01. Unfortunately, this type of volatility can make stocks stray far away from their intrinsic values and cause retail investors to leave the market because they are unable to stomach the price swings.

The hidden HFT tax⁵

The following is the most technical portion of this analysis. However, we think that if you are willing to stay with us, you will understand why HFT likely costs you money. The best way to explain the HFT tax is through an example. Let’s say you are a mutual fund that wants to buy one million shares of Microsoft (MSFT). This is such a large order that you are worried that you may move the market up with your trade. Therefore, in order to make sure you don’t pay more than you want per share you put in a limit order. Let’s say the stock is trading at $24.95 but you put in a limit order (i.e. the most you are willing to pay) of $25. Many mutual funds use what are known as VWAP (Volume Weighted Average Pricing) trading algorithms to execute these large trades. The problem with these algorithms is that even if they break up the buy orders in smaller batches (i.e. not all one million shares in a single trade) they create patterns that the HFT algorithms can sniff out.

Think of a VWAP kind of like an 18-wheeler trying to switch lanes on the highway. It takes a long time to move and therefore a quicker vehicle has the opportunity to outmaneuver it. This is what the HFTs do when they sense a VWAP-based order. By exploiting the predictable patterns created by the VWAP, the HFT algorithm is fast enough to sense the limit order of $25 on the MSFT shares, buy the shares at $24.95 and then sell them to the mutual fund at $25. No harm, right? The mutual fund got its trade executed at $25 and no one ever thinks twice. Wrong! The problem is that the HFT basically engaged in what is known as front running by jumping in front of the VWAP and causing the mutual fund to pay $.05 too much for each share. If this only happened every once in a while it might not be a big deal. But imagine the costs to mutual fund shareholders if this dynamic played out each and every day with thousands of stocks. We are talking about billions of dollars in potential profits for the HFTs. If you are wondering why the NYSE pre-sold ALL of its co-location spots for its new data center within a short period of time, you now have the answer.

Want to know who the major players are? Well, according to NASDAQ’s website, the top five liquidity providers for the NYSE as of July 2010 were Wedbush Morgan Securities, GETCO, Citadel Securities, Merrill Lynch and UBS Securities⁶.

How does HFT affect the price of stocks?

West Coast Asset Management engages in bottom’s up value investing. Our belief is that if you buy shares of a company at a price less than their intrinsic value, the market will eventually appreciate the fundamentals of the company and bid the price up near the stock’s true value. But what does it mean if 50% to 75% of trading comes from predatory robots trading shares back and forth? It means that shares are not necessarily trading based on economic or company-specific factors in the short term. The irony is that this dynamic may actually create opportunities for value investors. We invest based on the notion that markets are often inefficient in the short run but that the market’s pricing mechanism functions properly in the long run and allows us to profit from our contrarian strategy. Accordingly, if the presence of the HFTs causes temporary dislocations in price of individual securities, we may be able to take advantage and generate excess returns for our clients. Additionally, if the HFT algorithms begin to focus on a stock that previously had not been particularly liquid, investors who own that stock could benefit from the increased tradability of the security.

What should be done about HFT?

Unlike many of the problems we face as investors, this one seems easily solvable. Specifically, it is our position that HFT should be banned. By disallowing co-location the regulators could level the playing field in terms of speed and thus limit the ability of the HFTs to outrun other investors. The SEC is currently looking at the issue and we hope they come to the conclusion that the increased clout of the HFTs is not good for our markets. As we have illustrated in the preceding discussion, HFT does not appear to serve any purpose from an overall public welfare perspective. In fact, it seems as though these algorithms extract rents directly from smaller investors who do not have the same technological advantages. We also can’t forget the violent swings in market prices that the HFT facilitates and the associated potential for a severe market crash. When all of these issues are combined it becomes unambiguous that high frequency trading presents a real threat to the vitality of our stock markets and to investor confidence. Therefore, we hope that the U.S. regulators do something proactive to protect the investing public as opposed to catering to the powerful financial “services” industry. Let’s stop this practice before we all are forced to look back at a debilitating market crash and say, “we knew this was going to happen all along.”

For more information on the subject of HFT we highly recommend reading the second quarter shareholder letter from Iridian Asset Management ($7.1 billion assets under management) available here: http://www.zerohedge.com/article/more-are-waking-hft-terrorism-iridian-asset-managements-latest-investor-letter-blasts-high-f. We would also like to thank the authors, Jeff Silver and Ben Hunt, as their explanations helped frame our analysis.

Sources:

Give Us Back Our Cash

2010-08-24T15:17:00.003-04:00

The following is my latest piece (in Scribd to preserve formatting) about the large amount of cash on the balance sheets of US corporations. Based on the number of proposed M&A deals announced recently, it appears that companies are starting to put their cash hoards to work. But, is this good news for shareholders? Given the dismal performance of many big mergers you will forgive me if I do not trust the majority of US CEOs to allocate capital in a way that is optimal for shareholders. For this reason and a number of others, it is our position at West Coast Asset Management that companies with huge net cash positions should begin returning cash to shareholders as opposed to letting it languish on their balance sheets.

A version of this article was posted on WCAM's website at: http://wcam.com/newsroom. If you are looking for a value-biased, long only manager for your assets, feel free to contact former TV star Andrew Firestone at afirestone@wcam.com to inquire about WCAM's investment philosophy.

Give Us Back Our Cash!

Summer Update and Double Dip Analysis

2010-07-28T13:13:00.002-04:00

Readers,
It has been a little while since I last had the opportunity to post and I thought I would provide a brief update on how my summer is progressing. But first, I want to thank everyone for the overwhelming outpouring of support after I created the post that asked for help in finding a summer internship. I literally received emails from people all over the world offering their assistance and guidance. I really appreciate all of the support and I hope that I can continue to create content and research that is both valuable and informative.

Thanks to my good friend Marcelo Lima, I was able to secure an internship position at West Coast Asset Management (WCAM) in Santa Barbara, CA. WCAM is a long only manager of separate accounts focused on high net worth individuals, institutions and charitable foundations. The firm was founded by Lance Helfert and Kinko’s founder Paul Orfalea. Anyone who attended the 2008 Value Investing Congress sessions in New York or California will probably remember the presentations made by Lance and CIO Atticus Lowe. Furthermore, Atticus was profiled in the April 2007 and May 2008 editions of Value Investor Insight and Lance makes regular appearances on Fox Business News and CNBC. Finally, Lance, Atticus and Paul are co-authors of the book, The Entrepreneurial Investor: The Art, Science and Business of Value Investing which has sold thousands of copies and has recently been translated in Korean.

If you would like to learn more about WCAM, I encourage you to check out the website at www.wcam.com. Additionally, if you are looking for a manager who is capable of handling both equity and fixed income separately managed accounts feel free to contact me or Andrew Firestone (of The Bachelor fame) at afirestone@wcam.com.

My role at WCAM is to find new investments for the equity separately managed accounts. So far this summer I have extensively researched a number of companies, including two exchanges, a power transmission company and a couple of data processing and outsourced services firms. We are specifically looking for companies with a market capitalization greater than $1 billion which possess robust moats, resilient business models, strong and recurring cash flow generation and preferably a consistent dividend. If this sounds like a relatively defensive stance, that is precisely because it is. As a team we continue to believe that the US is at risk of falling back into a recession and prefer to be invested in companies that will prosper even in stressed economic circumstances.

It was in this context that I was asked to contribute to the quarterly letter that recently went out to clients. Given our outlook, my goals were to shed some light on the risks that we see brewing in the US economy and explain to clients why we are positioned cautiously. There are clearly a number of people talking about the risks of a double dip recession. However, I decided to highlight those that I thought were most relevant to equity investors and our clients. I hope you enjoy my updated analysis (in Scribd format to maintain the formatting) and will stay tuned for additional posts in the near future.

5 Reasons to Fear a US Double Dip

The Investment Case for PMACA

2010-05-20T22:58:00.003-04:00

Finally, I get to post some research. The following piece is an updated and expanded version of the research that I have been pitching to anyone and everyone who will listen. The last time I liked a P&C insurance company this much the company was IPC Holdings and Buffett/Berkshire made a bid for it before it got taken out by another company. Very simply, this microcap stock is under-followed and unloved and the market has yet to fully notice that the company has removed the overhang that has clouded the stock since about 2005.

I know this stock is not for everyone, but I think the valuation is compelling and the risk-reward is very attractive at the current price. As usual, I have kept the document in Scribd format in order to preserve the formatting of the charts. If anyone would like a PDF of the research, please feel free to email me. Also, I welcome any comments or questions.

PMA Capital Corporation (PMACA) Research

Summer Internship

2010-05-16T20:14:00.007-04:00

Dear Readers,

I hate to do this, but given the wonderful state of affairs in the market for jobs in investment management, I am running out of options. For those of you who do not know me, I am currently a first year MBA at the Anderson School of Management at UCLA. I went to the Wharton School of Business at the University of Pennsylvania for undergrad. After that I spent about four years working for my family in commercial real estate before my inoculation into the value investing world. From there I was fortunate enough to work at two small, long/short hedge funds in the New York City area, focusing mainly on financials. I think I understand the banking and P&C insurance sectors the best, but I have had plenty of exposure to other sectors. Specifically, the time I spent focusing on financials was mostly based on the market environment that included very attractive short opportunities (October 2007 to early 2009) and then compelling long opportunities (March-April 2009).

Right now I happen to be looking for hidden value among financial companies that have been left behind by this improbable and seemingly bulletproof market rally. I have been pitching both Synovus (SNV) and PMA Capital Corp. (PMACA) to just about anyone who will listen. They have both had very nice runs since I started recommending them but I still believe that they both offer long term, patient investors significant upside potential. If anyone would like to see my research on either company feel free to check out this post on SNV but stay tuned for my updated research on both companies.

I am looking for an internship position this summer that will help me become a better analyst and a better investor. To be honest, I am not focused on working for a "big name" fund. What I care about is working for a smart manager who can help me improve my research skills and for whom I can add a lot of value. I now am going to say something that people are never supposed to say: I don't care about being paid this summer. I am much more interested in finding an opportunity to learn and to potentially secure a full time position for when I graduate in June 2011. Clearly, I would rather not work for free because I know my research has the potential to help boost returns, both on the long and short sides. But, in the grand scheme of things, 10 weeks of salary will be just about meaningless if I can get one step closer to living my dream of being a portfolio manager.

So, I am looking for help from readers and from those in the value investing space. Anyone who has seen my recent notes from the Berkshire meeting, the Wesco meeting or the Value Investing Congress can see that I have a passion for investing. I am dedicated to making securities analysis a part of my life for the long run. Accordingly, if you know of anyone who could use a diligent and disciplined value-biased analyst for the summer, I would appreciate your willingness to keep me in mind. I am happy to email out copies of my resume and even sample research to anyone who might be interested.

Thank you for your time and for anything you can do to help.

Sincerely,

Ben Claremon
The Inoculated Investor

Classic Value Investors

2010-05-15T15:44:00.002-04:00

Readers,

I thought that I would introduce you to another talented member of the value investing clan who I believe has a lot to offer both new and experienced investors. His name is Mariusz Skonieczny and he runs the site called Classic Value Investors. He has also written a very comprehensive book entitled Why Are We So Clueless about the Stock Market?. I have read the book and have told Mariusz that it should be required reading for all incoming MBA students. As many of you know, I am getting my MBA currently at the UCLA Anderson School of Management in sunny, southern California. It probably won't surprise you to hear that my knowledge and passion for financial markets and investing make me a little bit unique. In fact, many of my classmates do not have a formal business background and initially have trouble with relatively simple concepts and vocabulary as a result of not being exposed to finance previously. This is where I think Mariusz's short, but comprehensive book could really add value. If students were required to read it before they started taking classes, they would be much more familiar with the concepts and would not struggle to learn the terminology and the technical concepts at the same time.

Accordingly, for anyone who is new to investing or who is thinking about making a career switch, I highly recommend going to Amazon.com and picking up a copy of Mariusz's book. I know that learning about the financial markets, especially given their global nature and the seemingly never-ending complexity, can appear to be a daunting task. However, everyone must start somewhere and in my mind there is no better place to start than with this book. I also urge you to go through his website (linked above). There is a lot of information on it about his investing strategy and how to invest with him if you are looking for a value-biased asset manager. I met Mariusz in Omaha a few weeks ago and was very impressed with the way he approaches investing. Since then multiple people have mentioned to me that they thought he was very intelligent and seemed to have the proper temperament required to be a great investor.

Please help me welcome Mariusz to the club by checking out his website. If you would like to learn more about him, I'm sure he would not mind if you emailed him at

mskonieczny@classicvalueinvestors.com.

I hope that everyone enjoyed all of the notes from the various events from the past few weeks. Thanks to all of you who sent me emails. I promise I will email each and every one of you back. It just might take a little time.

Stay tuned for my updated research on PMA Capital Corp. (PMACA). The stock is up but I think it is still severely undervalued.

Thanks for following me and I look forward to trying to create valuable content that resonates with everyone.

Sincerely,

The Inoculated Investor

2010 Value Investing Congress Notes

2010-05-09T19:16:00.002-04:00

Readers,

The following are my detailed notes from the 2010 Value Investing Congress in Pasadena, CA on May 4th and 5th.. The great list of speakers included Bruce Berkowitz, Mohnish Pabrai, Eric Sprott, Tom Russo and Whitney Tilson, just to name a few. Topics ranged from the merits of owning gold to the attractiveness of small caps to investing in India and China.

After over 33 pages and about 18,000 words I hope have I captured all of the stocks discussed as well as the unique investment philosophies and themes highlighted by the speakers. I also included all of the responses from the Q&A sessions after each one of the presentations.

Again, these were hand-typed in real time so I apologize for any errors or omissions. I want to thank John Schwartz and Whitney Tilson for allowing me to attend this year's Congress and to post my notes. I hope you all enjoy them.

Sincerely,

A very tired of typing Inoculated Investor

2010 Value Investing Congress Notes

2010 Wesco Annual Meeting Notes

2010-05-07T16:13:00.003-04:00

If you thought Munger was on fire at the BRK Annual Meeting, wait until you see the notes from the Wesco meeting. As with the BRK meeting, the following are my hand-typed notes from the Munger love fest that occurred on Wednesday in Pasadena.

Every time I hear him speak, I gain new appreciation for Charles T. Munger. His pragmatism and practical nature resonate with me. He also has a sense of fairness and an appreciation for what is right and what is wrong that makes him very unique. For those of you who were not able to attend the meeting, I hope this 8500 word recap captures some of the wisdom he bestowed on us all.

I hope you enjoy the notes and look out for Value Investing Congress notes to be posted in the coming days.

2010 Wesco Annual Meeting Notes

2010 Markel Annual Meeting Notes

2010-05-06T01:52:00.002-04:00

The notes just keep on coming. Here are my notes from the 2010 Markel Annual Meeting in Omaha that was held the day after the Berkshire Hathaway Annual Meeting. Both Tom Gayner and Steve Markel shared a lot of wisdom with those who were in attendance. For those of you who could not make it, enjoy the notes.

Also, stay tuned for notes from:
Day 1 of the Value Investing Congress in Pasadena
Day 2 of the Value Investing Congress in Pasadena
Wesco Annual Meeting in Pasadena

I have 25 pages of notes from the VIC that will be posted (with permission from the organizers) and 10 pages of absolute gold from Charlie Munger. Check back by the end of the weekend. I hope to have them edited for your reading pleasure by then.

Your loyal scribe,

Ben

Markel Annual Meeting 2010

2010 Berkshire Hathaway Annual Meeting Notes

2010-05-04T00:27:00.003-04:00

Readers,

I just got back from Omaha. Just as last year I tried to get down just about every word that was said by The Oracle and Charlie. Last year's notes were in outline form. This year they are in sentence form and the document is close to 15,000 words. I like to think that this is almost as good as being there. Well, except for missing Munger being absolutely on fire this year. Feel free to pass them along. If you click on the link above the notes you can download a PDF file on Scribd. Enjoy!

Berkshire Hathaway 2010 Annual Meeting Notes

Return Fom the Abyss

2010-03-22T19:45:00.003-04:00

Readers,

I must apologize for my absence. This past quarter at school was uniquely intense and I was forced to give up many things that I enjoy. I am very hopeful that next quarter I will be able to keep up with the blog and will do my best to try to balance the many obligations I have in my life.

I return with updated research on Synovus (SNV). The stock has had an amazing run from $1.92 in December when I first wrote about it to around $3.56 today. I think the long-term earnings story is still intact but with a second wave of bank losses on the horizon, an investor who buys in now might suffer some initial losses before eventually realizing a substantial gain later.

As always, I appreciate your comments and questions. Here is the piece in Scribd format to preserve the formatting of charts:

Updated Research on Synovus (SNV)

The True Bank Bailout is Ongoing

2010-01-22T20:44:00.003-05:00

I had a light bulb go off over my head the other day. Well, maybe it was less of an “aha” realization than an “oh yeah” recognition of the relevant facts. When we think about the bank bailouts that have occurred over the last two years we think of a number of measures. First, there were the direct interventions like the one the Fed engaged in by facilitating JP Morgan’s purchase of Bear Stearns. Another one that is still under the radar to most non-professional investors was the bailout of Fannie and Freddie. While the preferred share of those companies that had found their way onto banks’ balance sheets did get hurt by the fact that F&F were forced into conservatorship, the fact that the agency paper was not made worthless prevented the banks from suffering further losses. Then of course we have TARP, a bank slush fund created after Hank Paulson put a gun to the head of Congress. As Elizabeth Warren continues to attest, we have no idea what happened within these banks to the money they received. I understand that money is fungible (making it irrelevant what the precise funds coming from TARP were used for) but the goal of the TARP-enabling legislation was not have banks use the extra funds to engage in risky activities or hoard the money by refusing to lend it out. Based on just about any data you look at, this is exactly what the TARP money was used for.

Then of course was the FDIC’s backing of bank debt, a subsidy that allowed banks to issue debt at fractions of what it would have cost without the FDIC guarantee. Furthermore, allowing Goldman and Morgan Stanley to become bank holdings companies basically overnight was a bailout that allowed them access to additional cheap funding from the Fed and FDIC. We also must not forget (how could we—this is the story that unfortunately never dies) the bailout of AIG’s counterparties on all of AIGFP’s terribly ill-conceived derivative bets. Each detail that emerges in this ongoing saga suggests that the banks were paid 100 cents on the dollar for assets that were worth quite a bit less, without any regard for the consequences for taxpayers.

Next, the how can we forget that the FASB grudgingly relaxed mark to market accounting rules, a decision that may more than anything else have allowed the banks to postpone the day of reckoning when it comes to the worst assets on their balance sheets. I don’t think it is a coincidence that along with the confidence built after the so-called successful stress tests that the banks stocks have rallied massively since then. This fortuitous reversal has allowed banks to raise additional equity at prices that were not unreasonably dilutive and the increase in stock prices has inexplicably calmed creditors’ nerves and led to narrower CDS spreads despite many risks not having been eliminated. Finally, it appears that all of the new Treasury issuance and Fed activity through primary dealers has provided a windfall of trading revenue for the big banks. I haven’t really dug into the data on the profitability of government desks but you know the banks are making basically risk free profits from all of the government’s interaction with the markets.

Wow. I had never really enumerated the number of different full scale and quasi-bailouts before. It really is unbelievable and from what have I read regarding US history, also unprecedented, at least in terms of scale. No doubt I have also forgotten some events and details but the message that the government sent to the banks was clear: not only are you too big to fail, but we are also going to do whatever we can to help you get back to profitability and stabilize your balance sheets. Unfortunately, the message of US taxpayers has been commensurately blunt: despite the fact that the banks had a hand in this crisis, their health is pivotal to US economic prosperity and it is your job(my dear taxpayer) to backstop them and suffer the associated economic hardship as we nurse the banks back to health. It was within this context that I realized which bailout/subsidy was the most unappreciated and maybe even most harmful to people on Main Street.

What I am referring to is the zero interest rate policy (ZIRP) of the Fed. While the taxpayer losses that will eventually come out of TARP, FDIC debt guarantees, and the explicit extend and pretend policy are tough to quantify, the impact of miniscule rates on US savers is pretty easy to determine. According to this data from ICI, at the end of December 2009 there was close to $3.3 trillion in US money market funds. I don’t even have to include checking and savings accounts that are paying virtually no interest to illustrate the impact of low rates on savers. Specifically, according to Bankrate.com, the current average high yield money market rate is 1.03%. So, if there were no outflows and the rate remained the same for the rest of the year (clearly this will not be the case but I want to illustrate a point here), that $3.3 trillion would earn total interest for a full year of about $33 billion or $110 for every one of the 300 million people in the US.

Unfortunately I had some trouble finding data on historical money market rates. But, on the Fed’s website there is data going back to 1964 on the average 6 month CD rates. Right now the average rate on standard six month CDs is about 1.03%, almost exactly what the money market rate is offering. Let’s just assume that rates on these short duration CDs are a reasonable proxy for money market rates. The 1964-2009 average is about 6.42%. If you exclude the high interest rate environment that was pervasive in the mid-1970’s and 1980s, the average rate from 1990 to 2009 was about 4.37%. So it is not hard to see the impact of the Fed’s low interest rate policy has had on people who depend on interest on their cash. Using the 1964-2009 average rate implies $211.89 billion or $706 of interest per year per person. Even the 1990-2009 average rate yields $480.70 of interest per year per person. I would say that when you have so many people struggling to meet end meat these differences are not trivial. In fact, I would even go as far to say that this is a form of stealing from the poor to give to the rich. Not exactly the kind of behavior that leads to a stable society.

I can already hear the Fed apologists and proponents of low interest rates as a cure for all our ills saying that higher interest rates would surely destroy an economic recovery and thus ZIRP is justified. This may be true to some degree. I do understand the need keep interest rates low to encourage borrowing in hopes that people will start to invest again and the economy will rebound. Unfortunately, the Fed’s position that interest rates should stay low for an extended period of time in order to help revive the economy is kind of like an arsonist leaving the fire hose on indefinitely after he puts out the fire he created. Yes, maybe it is necessary but what further damage is being done? My answer to that is the savers are being punished by the low interest rate environment while the banks use low short term rates, just about interest free funds from the Fed and a steep yield curve to literally print money. Yes, this helps banks earn their way through the cycle. Yes, we do want a functioning banking system in the US. But none of that takes away from the fact that in order to achieve those goals people on Main Street have taken another hit to their incomes. After the banks help precipitate a global financial crisis that caused many asset classes to plunge in value and severely damaged the retirement plans of millions of people, somehow that just doesn’t seem fair, does it?

I would be remiss not to mention that low interest rates cause people who are searching for yield to go further out onto the risk curve whether they can afford to or not. While there is little data out there that suggests that Main Street has jumped back into stocks, there is no question in my mind that banks, traders, and hedge funds have once again embraced risk. The problem is that the structural problems and risks inherent in our financial system have not disappeared. If anything, the risks are even more concentrated than before and with Congress locked in irrelevance we are unlikely to see meaningful reforms anytime soon that would address this problem. So when you have fewer players making bigger and more flammable bets with cheap money provided by the Fed, it creates a dangerous cocktail. What happens if it all blows up again? Well, even if Washington decided not to bail out the culprits (highly unlikely as that is) the impact on asset markets would surely only harm savers and retail investors even more.

So, as we employ all these means in an attempt to determine what went wrong and how to stop it from happening again, we can’t forget that not everything is solely visible through the rear view mirror. In fact, we can see the pain caused by ZIRP as we look out through the front windshield. Let’s just hope the people in charge of reforms and future policies remember that it is Main Street that loses the most when the Fed and the banks create huge booms and busts. For the US to create a sustainably prosperous economy and high quality of life society, I have no doubt this dynamic must change. And soon; before we have hit the point of no return.

(Picture courtesy of flickr.com)

Help Haiti & Recieve A Valuable Membership for Free

2010-01-18T10:20:00.002-05:00

Dear Readers,

My friend at ValueHuntr.com contacted me about a promotion he is running in an attempt to raise money for the people affected by the recent earthquake in Haiti. Here is the information he provided me regarding the generous offer:

"In solidarity with those affected by the earthquake in Haiti, ValueHuntr.com will be providing a free premium membership, including a subscription to our monthly ValueFocus Newsletter, to readers who donate more than $30 to the ValueHuntr Haiti Relief Fund below. This offer expires Friday, January 22nd.

It is our hope that this will provide an extra incentive for our readers to donate. We guarantee you that all funds collected will be donated to the Haiti Relief and Development Fund of the Red Cross (we will send receipt to donors as proof)."

The link is: http://valuehuntr.com/2010/01/15/haiti/

I ask people to contribute whatever they can and urge them to take advantage of the opportunity to receive a great newsletter as well. I understand that a lot of people are currently struggling in their own right. I'm not sure the dislocation between the boom on Wall Street and the near depression on Main Street has ever been more dramatic. But we have to remember that most of us have won what Warren Buffett calls the Ovarian Lottery. Those of us who were born in developed countries with ubiquitous infrastructure and endless opportunities for future prosperity are incredibly lucky. No matter how stellar our intellect or amazing our talents, if we had been born in different circumstances our chances of achieving professional and personal success would have been much more limited. Accordingly, it is our obligation to help those who are suffering and it is clear from the disturbing images currently being shown on the news that the Haitian people are suffering beyond what just about any Americans can fathom.

So, times are tough. The US deficit continues to increase by the millisecond. Underemployment continues to levitate at distressing levels. We somehow are still fighting two wars. But none of that should feed a tendency to lean towards ethnocentrism. One of the lessons of the Great Depression was that protectionism and turning inward only prolonged the slump. So let's take this opportunity to show our solidarity with the rest of the world and do whatever we can to help the people of Haiti.

Sincerely,

The Inoculated Investor

The Best Links of the Week That Was

2010-01-08T16:04:00.005-05:00

Looks like the government piling up all that debt is a problem after all: Who would have thought that endlessly accumulating debt to finance current spending obligations could be a bad thing? Come to think of it, the reminders of the risks associated with excessive leverage are probably the central lessons that have emerged from the credit crisis. Even households are starting to understand that you can’t borrow and spend your way to sustainable prosperity and subsequently have been tightening their purse strings. Unfortunately, this intuition has clearly been lost on the US government. Specifically, the backdrop of the need to stimulate a depressed economy has given the powers that be in the US a remarkably convenient excuse to ignore these lessons and continue to borrow with reckless abandon. Aside from the usual risks like default, debt service as a percentage of total revenue increasing as rates rise and the destruction of the US dollar, authors Carmen Reinhart and Ken Rogoff now find that future growth may also be impacted by unsustainable debt levels:

In a new paper presented Monday at the annual meeting of the American Economic Association, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard study the link between different levels of debt and countries’ economic growth over the last two centuries. One finding: Countries with a gross public debt exceeding about 90% of annual economic output tended to grow a lot more slowly. For advanced countries above the 90% threshold, average annual growth was about two percentage points lower than for countries with public debt of less than 30% of GDP.

The results are particularly relevant at a time when debt levels in the U.S. and other countries at the center of the financial crisis are rapidly approaching the 90% threshold. Gross government debt in the U.S., for example, stood at 85% of GDP in 2009 and will reach 108% of GDP by 2014, according to IMF projections. The U.K.’s gross government debt stood at 69% of GDP in 2009 and is expected to reach 98% of GDP by 2013.

“If history is any guide,” the rising government debt “is very troubling for the U.S. and other advanced economies,” says Ms. Reinhart.

Left unaddressed, it appears that the US’s debt to GDP ratio will cross the 90% point of no return threshold in the next few years and that event could dampen an already meager growth rate. I don’t think I have to point out that a lot of the budget projections that have come out over the last year have included some particularly rosy estimates of future GDP growth. If the debt and deficit collaborate to stunt that growth then suddenly the US has to borrow more than anticipated even though tax revenues are unlikely to increase without meaningful GDP growth. I don’t know what the technical definition of a debt spiral is, but this situation sure sounds like one.

Would a bonus deferral scheme help solve the compensation problem on Wall Street? James Kwak of The Baseline Scenario recently created an interesting post on the potential way to remedy the misaligned incentives issue that is the plague of the taxpayer and a windfall for Wall Street traders. At just about every firm bonuses are paid on a yearly basis even though it could take years for the success of certain trades to be ascertained. Recent trading “profits” stemming from RMBS and CMBS assets come to mind as those that have looked great for a while but then turned into crippling losses when the housing and commercial real estate markets started to implode. A trader who loaded his company’s balance sheet with MBS probably looked like, and was compensated like, a star when the prices of these securities were going up. But then when some of these securities could not be unloaded without taking gigantic losses a few years later, most firms reluctance to claw back past bonuses meant this trader got to keep his bonus even though his trades endangered the going concern status of the institution. Recently, this dynamic has meant heads the trader wins and tails the taxpayer loses as the government has been forced to bail out the firm in question when its balance sheet caught fire.

There has to be another way right? Let’s review what Kwak’s idea is:

Instead, what about making your 2009 year-end bonus based on your performance in 2006, 2007, and 2008? That is, by the end of 2009 you would have better information about whether the trades placed in those years had turned out well or badly. There are all sorts of variations possible: you could weight the years differently; you could include 2009 (with a low weight because it’s too early to tell); you could do it on a quarterly basis to smooth out the lumps; you could pay out on a quarterly basis; and so on. But the basic principle is that you don’t calculate the bonus until enough time has elapsed to ensure that the employee deserves it. If you wait long enough, you could even just pay it out in cash instead of restricted stock.

The first objection will be that new employees get screwed, since they will get lower bonuses until they have been with the company for a few years. There are a couple possible solutions to that. The one I like less is that for someone who joins on 1/1/2009, his 2009 bonus could have a full-size target and be based on 2009 performance; but his 2010 bonus would be based on two years of results, his 2011 bonus on three years of results, and his 2012 and later bonuses on four years of results.

My preferred solution, though, is that people simply get smaller bonuses (and maybe somewhat higher salaries to compensate) when they switch companies, and only get the big bonuses after they’ve been around a few years. (You can imagine a new equilibrium where bonuses for employees in their first years are lower than today, but bonuses for long-term employees are higher. I’m not saying in this post that total compensation has to go down; that’s a separate issue.) In the technology startup industry, employees get stock options that vest over four years (with a one-year cliff). If you leave after two years, you give up your last two years of options (and unless the company is already public, you have a difficult choice about whether or not to exercise your options). This increases the cost to the employee of switching companies, which is good on two levels. First, as far as the division of the pie is concerned, it benefits employers (shareholders) relative to employees, which would be a good thing for the banking industry (as opposed to, say, the fast food industry). Second, it makes the pie bigger, since companies are more productive if they have more stable workforces. For these reasons, banks should actually want to move to this type of bonus calculation.

Although the exact calculations of yearly weights or how many years to include when determining a bonus need to be worked out, this seems like an infinitely better scenario (for taxpayers) than what we have now. Currently, traders have the incentive to make as much money now as possible with little regard for the future consequences. But, if a big bonus after a particularly profitable year were deferred, a trader’s time horizon would be elongated in a way that reduced the possibility of a future blow up. This would actually be great for the bank and would protect taxpayers a lot better without capping or reducing compensation. I’m sure if such a scheme were ever forced upon members of Wall Street I would be able hear their cries from Los Angeles. But, if the goal is to create a more stable financial system in which individual participants are reluctant to take excessive short-term risks because their own compensation is one the line, then maybe Obama and Congress should ignore those ubiquitous financial lobbyists on this topic.

You don’t always have to use a bazooka: In 2008 former Treasury Secretary Paulson likened the threat to take over Fannie and Freddie to having a bazooka that he hoped not to use. In the end, he eventually did have to use the bazooka but the sentiment of his comment was interesting. He thought that the threat of nationalization or conservatorship would be enough to force Fannie and Freddie to reform their money losing ways. In retrospect, by the time he made that threat it was way too late as it had become abundantly clear that F&F had filled their balance sheets with such toxic waste that the HAZMAT team needed to be summoned.

The truth is that in the past sometimes all government officials or the Fed had to do was hint at taking action in order to change market sentiment or practice. Unfortunately, the financial crisis has diminished the credibility of such threats. When Tim Geithner talks about the US’s commitment to a strong dollar people laugh at him and the markets ignore him. However, the Fed does this type of thing all the time and it appears to still be working. Without any actual action, all the Fed has to do is say that rates will be held low for an “extended” period and the market gets the signal that interest rate hikes are not forthcoming immediately. We will see how long this continues but for now the Fed has the ability to pull out the bazooka but not actually fire.

In his most recent piece, Martin Hutchinson of The Prudent Bear goes through a list of potential actions the government could take to incrementally help solve our myriad problems without actually pulling out the big guns. Think of it as pulling out a pistol as opposed to a rocket launcher. It is now painfully obvious that Congress cannot pass single bills that address all of the issues that need attention and if they do, the bills are 20,000 pages long and contain so much pork that they would make pig farmers blush. That’s why I think it makes sense to take little steps like the ones suggested by Hutchinson. Unfortunately, as he details below, the government could also use its pistols in ways that do not tackle the long term conundrums facing the US and only kick the can down the road at the expensive of future taxpayers:

The Christmas Eve decision by the U.S. Treasury to extend unlimited support to Fannie Mae and Freddie Mac was such a policy, albeit one pointed in a pernicious direction. In reality, it makes very little difference; Fannie and Freddie have such massive political support that no kind of devastation in their home mortgage operations would cause the Obama administration to abandon them. However, the unlimited support line from the Treasury allows them to extend their pernicious operations aggressively, thus diverting yet more U.S. capital into the wasteful housing sector, and increasing the contingent liability on taxpayers still further.

Come the November midterm elections, the Democrats will be able to claim that house prices have recovered substantially on their watch. However, a market that is propped up artificially in this way has a tendency to extract its revenge by requiring still larger and larger subsidies in order to avoid collapsing to its true equilibrium level, perhaps still 15% below current levels. Thus the cost to taxpayers, homeowners who buy houses in 2010 and the U.S. economy in general from this particular "miracle" of Treasury sleight of hand will be substantial.

Turning in the opposite direction, to an action of no direct economic consequence that could cause a genuinely useful miracle, we can consider the effect of a modest increase in the federal funds target rate, perhaps to a trading range of 0.25% to 0.50% from its current 0% to 0.25%.

This would have no immediate economic effect. With inflation already running at 2% to 3% and heading higher, short-term rates would remain heavily negative, so monetary policy would remain hugely "stimulative" as Ben Bernanke and the political class wants it.

However, such a move would have a considerable effect on commodity and energy markets. Currently, the main near-term threat to continuing economic recovery arises from these markets, in which prices are continuing to rise and may at some point get to levels that threaten recovery, by draining purchasing power out of commodity-using Western economies and/or produce a confidence-sapping acceleration of inflation…

The United States could have a similar benign effect by agreeing to raise the eligibility age for Social Security and Medicare entitlement by one month each year from 2026, the year in which the Social Security retirement age reaches 67. Such a change would have no direct economic effect at all for the next 16 years but it would at a stroke eliminate the long-term deficit in the Social Security system and greatly reduce that in the Medicare system.

Further reductions in the Medicare system's deficit certainly require a year or two to allow the whole health-care question to be depoliticized after 2009's battles. Then, some cost-saving measures such as limiting damage awards for medical malpractice are themselves highly political.

However, there is one counterintuitive measure that could be taken which would hugely reduce costs in the system overall even though at first sight it would increase federal funding for health care. That would be for the federal government to fund properly the mandate it imposed on hospitals in 1986 to treat indigent patients in emergency rooms, without regard to their ability to pay. If the federal government reimbursed the costs of this mandate, hospitals would no longer have to load the losses onto the charges for insurance-covered patients or the even higher charges on individuals, nor would they have to employ a large staff chasing deadbeats. Since the unfunded cost of emergency room treatment is estimated at $80 billion annually, transferring that burden to government would save two or three times that amount from the costs to insurance companies and individuals of medical treatment, probably saving 1% of GDP from health-care costs by that reform alone.

Does the US have more criminals on a per person basis than the rest of the world or just laws that are too restrictive? It is hard for me to believe that the average person in the US is more likely to engage in criminal activities than someone in a third world country. But that’s what the data regarding the number of incarcerated Americans relative to the US’s percentage of total world population would seem to imply. In reality, without doing a lot of research on the subject I surmise that the reason for this is that the US just has much more developed policing practices, court systems and jail infrastructure. If another country does not have to resources to catch, prosecute and then incarcerate its criminals then of course it would have fewer people in jail on a relative basis.

The problem now is that our ability to house the criminals that we are so good at catching is diminishing fast. The cost of holding all of these people in jail has begun to cripple state budgets. So, we really need to figure out what to do before states literally are forced to raise taxes on the rest of us just to keep so many people locked up. Either we need to change the laws that define what a criminal is or shorten the time that certain types of lawbreakers are forced to stay in jail. In retrospect it may have been a poor decision to put people in jail for having a minimal amount of pot or when their third strike was jaywalking, for example. Thus, we need to assess the actual threat that nonviolent offenders pose on broader society. I have no problem keeping murders, rapists, child molesters, and drug traffickers in prison. There is no question that isolating those people from the rest of us is necessary to maintain some sort of civilized and functioning society.

I just think it makes sense to try to rehabilitate some people outside of jail by helping them gain skills that allow them to re-enter the workforce. My guess is that in just about any scenario the cost of job training or classes about how to properly function within the mainstream society would be a fraction of what we now spend feeding and monitoring these individuals in jail. Not surprisingly, as this NY Times editorial points out, there is some data that supports at least trying some of these alternative measures:

The United States, which has less than 5 percent of the world’s population, has about one-quarter of its prisoners. But the relentless rise in the nation’s prison population has suddenly slowed as many states discover that it is simply too expensive to overincarcerate.

Between 1987 and 2007 the prison population nearly tripled, from 585,000 to almost 1.6 million. Much of that increase occurred in states — many with falling crime rates — that had adopted overly harsh punishment policies, such as the “three strikes and you’re out” rule and drug laws requiring that nonviolent drug offenders be locked away.

These policies have been hugely costly. According to the Pew Center on the States, state spending from general funds on corrections increased from $10.6 billion in 1987 to more than $44 billion in 2007, a 127 percent increase in inflation-adjusted dollars. In the same period, adjusted spending on higher education increased only 21 percent…

One factor seems to be tight budgets as states decide to release nonviolent offenders early. This can not only save money. If done correctly, it can also be very sound social policy. Many nonviolent offenders can be dealt with more effectively and more cheaply through treatment and jobs programs.

Michigan, which has been hard hit by the recession, has done a particularly good job of releasing people who do not need to be in prison. As the American Civil Liberties Union’s National Prison Project details in a new report, Michigan reduced its prison population by about 8 percent between March 2007 and November 2009 by taking smart steps, notably doing more to get nonviolent drug offenders out, while helping in their transition to a productive, and crime-free, life.

What we don’t know is whether crime also increased in Michigan after the prisoners were let go. A skeptic might argue, “once a criminal, always a criminal.” But it doesn’t appear that states have enough money to incarcerate all the people who they decided were criminals so at some point tough choices must be made. I don’t see the harm in implementing prison reduction programs on a trial basis in states that have the resources to monitor the released individuals and properly assess the ongoing risks they pose to society. You never know. We might be pleasantly surprised by the outcome.

(Picture courtesy of usoge.gov)