Sunday, February 28, 2010

When Warren Buffett Speaks
About Investing,
the Wealthy Should Listen

Is this you?

The really wealthy are those that have liquid investment capital in excess of their perceived needs. All the rest are enslaved to their circumstances and lack the flexibility to be the masters of their investment future. This blog is directed to the wealthy; whether they are ultra high net worth counting their portfolios in the tens of millions or those that are merely wealthy, who have a spare few dollars to invest.

My Saturday Chore

Approximately 60 days before the annual meeting of Berkshire Hathaway (BRK.A), Warren Buffett publishes his letter to shareholders. He times the release for a Saturday morning. I have two reasons for reading this year’s nineteen page letter. First, thankfully I have been a shareholder personally for many years and the stock is also in the hedge fund I manage. The second reason I read the letter intently is that it is an excellent investment primer, particularly for those who can think of themselves as wealthy as described above. This year, with one of my sons, I plan to attend the annual meeting, known to some as “the Woodstock of Capitalism.”


Liquidity is a good defense

The first lesson is to lose less on the inevitable downturns. Buffett’s direct quote is, “Our defense has been better than our offense.” When you examine the Berkshire portfolio, you can see that in many years there is an excess of short term cash instruments (wealthy people have cash). Part of Buffett’s business strategy is to use a large amount of cash generation owned by others (float). He uses this float to replenish the cash he uses for investment. Wealthy people also have a positive cash flow which allows them to have spare ammunition to be able to shoot at attractive targets during down turns. Perhaps more importantly, with a pile of cash on the sideline, the wealthy don’t panic and sell at depressed prices. Liquidity is a good thing to own or control at all times, but particularly in rough periods. The low return on liquidity in ebullient periods is a tolerable insurance premium.

Invest in what you know

Warren Buffett at age 79 and Charlie Munger at 86 only invest in those companies that they think they understand and whose future they can predict with some degree of certainty. They are not comfortable investing on the basis of new products, no matter how exciting they may be. (Remember that Bill Gates of Microsoft is not only a director of the company, but he and his wife will direct the vast bulk of Buffett’s charitable estate.) Berkshire’s caution on new products did not prevent them from investing $3 billion in wind generation for a controlled utility in a monopoly position.

Investors bring their own needs to an investment

With its long term need to find productive places to invest its continuous cash flow, Berkshire has found that Burlington Northern Santa Fe (BNSF), a railroad serving many of its customers, will continually need cash for capital investments. Berkshire views positively the railroad’s need for additional capital every year. Berkshire’s willingness to supply long-term capital trumped a price that an ordinary buyer would pay for this stock. The lesson here is that a particular need of an investor leads to an investment decision that others do not perceive when one is buying the whole company. This is similar to a property owner buying adjacent land to prevent any construction on the site.

We can all make investment mistakes

Over the last forty years, one of the attributes of all the great investment managers that I have known is that they admit their mistakes. Privately, they are like fishermen: they talk about the one that got away. With Berkshire Hathaway, Mr. Buffett dwells on mistakes of commission. Buffett publicly admits it was his personal mistake that drove GEICO, one of their owned companies, into the sub prime credit card business.

In their publicly traded portfolio, Berkshire Hathaway has thirteen positions each with a market value of $1 billion or more. Many of these have been great long term successes: American Express (AXP), Coca Cola (KO) and Procter & Gamble (PG). One of the thirteen is ConocoPhilips (COP), which they have been selling, but still have a book loss remaining of some $ 800 million. The reason that I find this holding so interesting is that I have noted a similar position in a number of value-oriented funds with great long term records. This stock has been a great value trap. As good as Warren Buffet is, it shows even he can make a mistake, particularly when a position in the larger Exxon (XOM) would have produced better results.

Think Global, even in US Investments

An additional insight from looking at the baker’s dozen billion dollar holdings is that there are two foreign stocks; BYD,the Chinese battery manufacturer and Tesco, a British retailer. But when you look further into the other companies one can speculate that at least half of their underlying earnings power comes from overseas. Thus, in truth Berkshire is increasingly becoming a global investment vehicle despite the high profile railroad investment (which also has some foreign trade elements).

Berkshire’s Liquidity Advantage

The final lesson that I choose to highlight relates back to the first, but in this case pertains to good companies when they have a need for liquidity. Taking advantage of those needs, Berkshire purchased the non-traded securities of Dow Chemical, GE, Goldman Sachs, Swiss Re and Wrigley. All these holdings produce dividends and interest which pay Berkshire roughly 10% on its investment plus an additional equity kicker. From time to time good companies have poor liquidity and are willing to pay a big price for it. Thus, one can use one’s own liquidity to help others for an outsized return. But like a good US Marine Corps Division, as soon as one commits a reserve, one needs to reestablish a new reserve so that one can fight another day.

What are your lessons that you would like to pass on?
To Members of Mike Lipper's Blog Community:

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Sunday, February 21, 2010

Connecting the Dots and Fears
Are they Already in The Price?

China Markets' Dots

The following are the latest “dots” from China:

  • China accounts for about one quarter of the new demand for oil.

  • China demand for gold in 2009 was up 22%.

  • China apparently sold US Treasuries and is diversifying its reserves.

  • China’s power consumption is up 40% over the last year.

  • China has the world’s second largest power capacity and rapidly adding more.

  • China’s increase in imports from Australia and Brazil are each up over 40%.

Fears of Stagflation

The yield gap between short term US Treasuries and longer term Treasuries has reached a record level. To some in Bondland this is an indicator of “stagflation.” Stagflation is not an erotic party for a soon-to-be groom, but a condition of high inflation and stagnant economic growth. During stagflation, the price equilibrium between materials prices increases, (think oil, already about $80 a barrel), and includes the inability of end goods and service producers to raise prices.

The Interconnection Between China and World Economies

In order to head off massive social unrest in China, its latest dynasty in power is driving a significant increase in consumption. New buildings are going up next to empty or near-empty buildings. The history of the fall of Chinese dynasties is always the same. Social unrest eventually leads to the fall of authority. The present leaders in China are very conscious of their history and are acting accordingly. The difference this time is that China has, in many respects, become the economic growth locomotive for the world. Even the rumor of any disruption within China can affect the prices of US Treasuries. Almost all other publicly-traded securities in institutions’ portfolios are priced off of US Treasuries. In addition, for almost all commodity-exporting nations, China represents their single largest growth market. To paraphrase an old saying about the US, if China catches a cold, most of the rest of the world will get pneumonia. Remember the fear is that a rumor can cause the disruption within China as well as a rumor external to China. We saw the speed and impact of largely untrue rumors on the owners, clients, counter-parties and employees of Bear Stearns and Lehman. Notice the concerns about the “PIIGS” (Portugal, Ireland, Italy, Greece. and Spain) had on the Euro as well in part on Sterling.

Implications for Equity and Fixed-Income Markets

Nothing that I have said here is a new revelation to those involved with the investment community. Have these denizens of the deep already appreciated the chances of such disruptions? Have they added an additional discount into their valuation constructs? I don’t know. My current guess, (which may change with an overseas conference call tomorrow morning), is that the fixed income market, normally the most sophisticated market, has not materially discounted the risks of either a Chinese-oriented disruption rumor and/or a concern as to stagflation if things just mellow out.

Equity Market Recovery

The recovering equity market is like to an addict swearing that he will never again succumb to induced happy feelings. Currently, many stock prices have adjusted to earnings improvements from tighter expense controls and pedestrian revenue growth. Relying on statistical history, which could be a mistake, major parts of the stock markets appear to be fairly priced. Fair in the sense of representing a price that discounts both a return to normal growth and periodic recessions, but not depressions. If we have begun a new “bull” market, as some believe, there is comfort that prices are not fully priced on what good news could occur.

Our Approach at Lipper Advisory Services

Our management of discretionary accounts is to maintain very high quality and quite short-term fixed income holdings, including money market instruments. In terms of equity positions, we are mainly invested, but have some dry powder to add a couple of new positions and a willingness to switch existing holdings into, using Sir John Templeton’s term, “better bargains.”

What are you doing?

To Members of Mike Lipper's Blog Community:

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Sunday, February 14, 2010

Valentine’s Day Challenges
for Ultra High Net Worth Investors

What are the Valentine’s Day challenges for Ultra High Net Worth Investors? For your humble scribe, the challenges have to do with producing this particular blog. When I think about the 14th of February, three different themes come to mind. First, a day to proclaim love. Second, the commercialization of emotions. Third is the St. Valentine’s Day massacre in Chicago, where one band of criminals was killed by another group to settle a dispute. I won’t dwell on the third at this time, or make comparisons with various global political leaders and their relations with financial community contributors. Nor will I deride anyone’s desire to make a buck on other people’s “Whoopi.” Come to think of it, maybe these first two themes are more related than I thought. Instead I will focus on the nicest of the four letter words,” Love,” and how it intersects with your portfolio.

At the suggestion of my son Don, the writer, I began to think about how we fall in love, how we show our love and how we protect our love as found in our portfolios. At one level, as an investment manager I must deal with stocks or funds in which my clients or I fall in love. Even very sophisticated investment committees of experts believe that a particular investment will show them love by bestowing substantial capital appreciation. While this feeling could well have started in courtship based on past performance or other statistical garb, love (or at least marriage) is consummated early and verified when the rough times come, as they do in all relationships. We do not desert our loves in periods of stress. Speak to any investor who is sitting with a large loss, he or she will tell you of past dreams whose fulfillment has been delayed. Heavy is the job of the adviser to convince the investor that this was a false love and not meant to be. Woe unto the adviser if his or her client does sell a once-beloved security and the dreams of the now-sold position then come into fruition. Recognizing these emotions, many advisors back away and leave the deteriorating positions in place, but maintain the client. Despite this comment I believe every portfolio can use periodic pruning.

At a much deeper level, a portfolio for a spouse or family or a favored charity can be read as a document of love. As the ultimate beneficiary of its results, one’s personal portfolio could be said to show love for one’s self. All life and all portfolios should deal with balance. We need to balance the production of optimum total return and the protection against life-changing losses. We can do this either through controlling spending and/or the growth and swings in the value of the portfolio. Deciding on the best mix of total return production pivots on the desire to have the beneficiaries participate in the cyclical nature of investing or have their spending controlled each year. Underlying these thoughts is the possibility that all the wealth will be consumed by spending or unfortunate markets at some point in the future. The approach of a variable spending policy based on performance is a good compromise, but does not guarantee that the assets will outlive the primary beneficiaries. Where does love come into this? One might say love could be measured by the rate the generator of the wealth saves or invests for the benefit and protection of others. In the phrase, “the benefit and protection of others,” is the concept of avoiding life-changes, (in this case on the upside), for the heirs. Spoiling children or charities is never a good idea. As money grows, often does its complexities. For those Ultra High Net Worth individuals, and/or their granting foundations, complexities grow at a much faster rate than the accumulation of wealth. Given enough time, the requests (or if you will, demands) will be larger than the pile of wealth. Often, the love of the generator of the wealth is expressed by how he or she disperses while alive and what provisions they make when they are no longer with us.

Particularly in times like these, your portfolio can use some tender loving care, not just with planning responsibilities, but also including and you and your adviser. Many of us have been bruised by the markets, disappointed by various investments, found strategies to be wanting and the list goes on and on. First one should recognize there are no perfect records in any long lasting game. The best players eventually lose. From my days at the racetrack I have always been interested in winning percentages, both in terms of number of races, but more importantly, in dollars won. (I wish I had the data on the expenses behind each winning race and dollar earned, but my guess is that racing in general is a losing proposition, but breeding can be quite profitable on an after-tax basis.) Using the same type of analysis on securities investing, particularly through funds, one can sense what winners produce. Benefiting from the long term secular growth in many equity markets, the individual investor makes money at least half the time, particularly those that stay in the game. Professional investors who survive, produce winners at least 60% of the time. Generally, good professionals are right two-thirds or more of the time and great ones three-quarters of the time. Just as at the race track, the relative size of one’s bets determine the size of the winnings when right. I believe the key to sizeable investment winnings is appropriate concentration with winning managers and funds.

Two lessons from the above: First don’t beat yourself up. The last couple of years have been rough, the vast majority of investors have not recovered to their former peak levels. Second, extreme concentration can put the preservation of capital and spending at risk for your loved ones. You need to achieve some balance in your portfolios and show to your important others some love and concern for them.

Happy Valentine’s Day.

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Sunday, February 7, 2010

“Stop the World,
I Want to Get Off,”

I Don’t Want to be Global

Some may remember the Broadway musical, “Stop the World, I Want to Get Off.” The title’s message, also found in the Bible, is that the world is too much for us. Today almost every activity we do is the result of product, services, influences or fears of the same from beyond our borders. The very act of watching the Super Bowl is being done on television sets that are made totally or in part from overseas. The commercials that bring us the game are largely from global companies selling globally. If the commercials are animated, the odds are that the animations, at least in part, were not done in this country. A few of the players were born outside of the fifty states. Much of the clothing worn at the game and a good bit of the clothing worn by the larger electronic audience was produced overseas. One quickly recognizes that if America’s most iconic event, the Super Bowl, has gone global, so has most of the rest of our lives. Shouldn’t our investments recognize that we live in One World? (One World is the name of the book written by Wendell Willkie summarizing his thinking after his defeated presidential campaign against FDR. My mother was one of his assistants.)

The next-to-last financial crisis that faced this country was when Russia defaulted on its own treasury paper. This sent Long Term Capital Management, a very large, professional hedge fund managed by Nobel Prize winning economists and formerly brilliant traders, into a tail spin that threatened other Wall Street participants with similar holdings. The real damage was not done by the Russian default, but by the frantic urge to sell other emerging market debt to raise capital to avoid bankruptcy driven by margin calls. The rapid selling of other government debt and some equity was contagion, as particularly Latin American and Southeastern Asian markets collapsed. While there was no economic connection between Russia and Argentina and Thailand, there was a market connection in that some of the same owners panicked.

This weekend, while watching the football battle in south Florida, there is another financial battle occurring. The question at the moment is whether the government workers in Greece and Portugal will strike over wage cuts and lay offs that were designed to prevent sovereign defaults. Why should we care if Greece goes down? After all, it has been reported that Greece has been in default 105 years of its 200 year history as a modern nation. Throw Greece, Portugal, Spain, Ireland and Latvia together, they are smaller than one of our states, California. (For the sake of brevity I will ignore the dangerous combination that high government debt and large government work force has on the long term health of an economy.) If these are relatively small national economies, why are the various stock and bond markets around the world nervous and pausing during the slow recovery that is underway?

Is the pause just a reaction to the financial and business press? I don’t think so. I do not see recognition on the part of regulators or legislators as to the critical connection of potential foreign losses and the domestic economy. The connection that eludes most of these non-business politicians is the type of loans that are currently in use. With the exception of mortgage loans, most loans in the United States for individuals and businesses, particularly small businesses, are “call loans.” Like margin debt, these loans can be called for immediate repayment, without cause. Simply, the bank or broker wants its money back. (Only the large and /or public entities can borrow on a fixed term basis.) If the banks or brokers believe that they will sustain large losses in their foreign loan books, they will search for capital from all of their sources. Thus, I believe there is a fear that problems on the streets of Athens or Lisbon could cause problems for the Main Street borrowers in Baltimore, Cleveland and Denver as well as smaller towns.

As much as we would like to be isolated from problems, particularly from those generated beyond our borders, we can not. The Super Bowl can not be a purely domestic game; in reality neither can our own financial posture be without foreign perspective. As with many nervous, I would say prudent, investors, we keep our reserves in US Treasuries directly or through money market funds. We have been trained that these are the most secure of all investments. However, it would be naïve on my part not to recognize that foreigners, particularly their central banks, are very important participants in the markets for US Government paper of all sorts. Thus, to some extent, this most domestic of all securities investments is, in reality, globally influenced paper.

The segmentation of investments into international (ex-US) and domestic is the favored technique of consultants and brokers. At one point in time the differences between these two general classes were real and there was major difference in their performance. Today it is less true and will probably be an artifact in the future. While we will continue to report to our investment management clients the way they are used to seeing reports (bifurcating US and non-US investments), my thinking is evolving beyond those distinctions. First, I tend to look at who are the major buyers of various securities, e.g. international institutions, domestic institutions, wealthy domestic families, or the general public served by brokerage firms. Second, where is the source of expected earnings growth? Third, what is the nature of law and regulation governing the securities and their issuers?

I would be pleased to discuss this different way of looking at your portfolio.