Sunday, April 29, 2012

When will Long-Term Prices for Gold and Natural Gas Go Up?


One of the ways analysts attempt to get ahead of the market is by “connecting the dots.” The dots are stray pieces of seemingly unconnected bits of information which can lead to a useful insight. During World War II the US Marines were trying to estimate the size of various Pacific islands’ defense forces. As these islands had dense jungles, airborne photo reconnaissance didn’t work. As luck would have it, they were able to recover a bill of lading floating after an enemy ship was sunk. In this document there was the size of the shipment of volley balls that were being sent to the island. Knowing the normal table of equipment enabled them to estimate the size of the enemy forces that would oppose a landing by the Marines. With this new information, the decision was made to bypass the heavily defended island and land on less defended real estate.

The dots that I am trying to connect include a very insightful talk by Jim Grant to the Federal Reserve Bank of New York, actions of three different central banks, a comment by the CEO of Goldman Sachs in an interview, the financial leveraging by a CEO for his own account, and an almost recommendation by the highly respected Wall Street Journal columnist Jason Zweig.

Jim Grant

While I have known and admired Jim Grant for a long time, in a period of just two weeks I have encountered his thinking twice. First was at a small dinner party where he was the host. He spoke persuasively about the government’s attack on market-based pricing. While he was mostly focused on what is being called financial repression (of interest rates), it could also be applied on other areas of administered pricing. Second, John Mauldin, in his weekly letter, reprinted Jim Grant’s talk to the New York Federal Reserve Bank. He dwelt on how far the Fed has moved away from its founders and their philosophy. He points out that while the current Chair of the Federal Reserve System is a renowned scholar of the 1929-1933 depression, he and others would be wise to review the depression of 1920-1921 which was as deep as the “Great Depression,” and by 1922 the US had a vigorous recovery led by the government balancing its revenues and expenditures and not relying on any form of “quantitative easing.” However, his main thrust was that the founders of the Fed in 1913 believed in the gold standard and were horrified at the thought of a fiat currency.

A lot of credit should go to the NY Fed for inviting a well-known critic of its actions into the bank’s hallowed halls and perhaps listening to him. While I do not expect an immediate change of heart by our government manipulators, I am hopeful that this talk can have a ripple affect even if Ron Paul is not sitting in the White House. (Think about the various espoused policies the socialist Eugene Debs advocated in his numerous presidential runs and how over the succeeding years they were adopted by the two main political parties.)

Three central banks

As reported by US Global Investors, in March Mexico added 16.81 tons of gold to its reserves of 122.58 tons, Russia added 16.55 tons to its total reserves of 895.75 tons and Turkey added 11.48 tons to its hoard of 209.6 tons. (These purchases are after 2011, when in aggregate, central banks bought 439.7 tons, the largest increase in five decades.) What is significant to me is that all three of the buyers in the month would benefit if the price of oil went up and thus their economies would benefit. Perhaps they are addressing a more fundamental concern about fiat currencies in the US and Europe. Just possibly someone is listening to Jim.

Natural gas prices

Jason Zweig’s Saturday column in the Wall Street Journal is normally very balanced, describing the pluses and minuses of a topic often relying on some academic paper of interest. This week, I was shocked that the column called attention to the very low prices for natural gas and if an investor has a long-term orientation, like the accounts that I serve, there is significant potential in owning a number of the stocks. He included one where the CEO has borrowed substantial amounts to take up the provisions available to him to participate in various drilling opportunities. These are extraordinary times to see these kinds of situations.

Two weeks ago my blog speculated about the possibility of $1/gallon gasoline. This was a “think piece” not to be taken as a prediction, but recognition that the price of oil could go the other way and not climb to ever-higher prices. One of the foundations of this out-of-the-mainstream thinking was a belief that over a ten year period the US could become energy independent and possibly an exporter due to the potential of natural gas to fill its needs.

The bulls of Wall Street

For more than a decade in the past we have learned that when the large firm known as “the herd” was bullish on the US market, then look out. This time I am hearing a somewhat similar belief from a respected leader. Lloyd Blankfein was doing a number of cable television interviews on Thursday. On the one that I saw, he spoke about Goldman Sachs hedges, he thought that the risk was being on the sidelines rather than participating on the upside. Considering how well Goldman Sachs has positioned itself, I find this encouraging.

Conclusion: Putting the dots together

One of the lessons from both basic security analysis and Marine Corps intelligence is that one never gets all the dots to compile a complete actionable picture. While I would like to see more money placed on positive convictions than what I see now, I would use any significant declines to reposition various portfolios to be more aggressive. I don’t believe that we will get much positive momentum until we believe we see some clarity as to what 2013 will bring. Nevertheless, at some point we could see many investors decide all at once that the water is safe and jump in.

Next week’s blog

We are continuing our practice of attending the Berkshire Hathaway Annual Meeting. As usual the questions may be more enlightening than the answers (except when Charlie speaks). I plan to devote next week’s blog to my impressions and will write it on the return flights. Due to air schedules and my iPad, the timing of your receipt may be delayed.

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Sunday, April 15, 2012

Value Trap by the Book


One of my functions for clients is developing the menus of 401k and 403b rosters of funds. Quite properly the sponsors of these programs wish to offer a relatively low-risk equity alternative along with presumably higher performing funds. Many institutional as well as individual investors also seek lowered perceived risk investments. Each of these potential investors gets attracted to funds that have ‘value’ in their name. As has been said often, “One should not judge a book by its cover.” The perception of value may be quite different from the reality.

Value definitions

There is no universally accepted definition of value. Most investors believe that within the rubric of ‘value’ there is some attention being paid to the risk of permanent loss of capital. The marketing and distribution forces within the money management industry often attempt to demonstrate that advisors focus on value by quoting the price/book value statistic. According to this logic, the lower price/book ratio is better. A ratio below 1 is meant to be a sign of a real bargain. I believe this may well be a trap.

What is book value?

This is not the place or the time to produce a treatise on double entry accounting principles. The term ‘book value’ has a specific accounting definition. An investor searching for value needs to understand that there are a number of links between the income statement and the balance sheet. One of the key concepts is that the income statement is required show all of the costs that should be charged against the current period’s revenues. This is fairly simple to do for the cost of labor and supplies consumed during the period. There is a problem however on how to allocate some of the capital that has been invested in longer-lived assets like buildings, acquired customer lists and patents. Accounting rules dictate how much should be charged to the current period. The remaining portions of these costs are capitalized and are found in various entries on the balance sheets. They are included in the so-called book value. (In its simplest terms, book value is calculated by deducting from the assets all liabilities divided by the number of shares currently outstanding to arrive at a book value per share number.) Currently, auditing requirements demand an annual review as to whether these assets are at least worth what they are stated on the balance sheets. If they are worth less, they are to be written down on the balance sheet and an impairment charge is to be made to the income statement. Under conventional accounting procedures there is no provision to writing assets up.

Sound security analysis and effective loan officer research techniques should include reviewing these assets on internal spreadsheets. These augmented financials could lead to a justifiably higher price for the stock, the company, and/or an increase in collateral value for loans. These upward adjustments to book value cannot be published by the company issuing the financial statements.

“The Market” knows

While appropriate adjustments to stated book value are not published, market prices often reflect these changes. Years ago a successful, wise trader told me that a stock is only worth what it is selling for at the moment, not some theoretical accounting value. On Friday two of America’s strongest banks reported their first quarter results. Some in the media called attention to the fact that Wells Fargo* was selling at 1.29 times its book value and JP Morgan* was selling at 0.91 times its book value. Remembering what my old trader said, the market was suggesting that it was deducting an impairment charge for the “fortress balance sheet bank” (JP Morgan), and not for the bank with the largest home mortgage business (Wells Fargo). Considering that a portion of the former’s good earnings came from reversals in its bad loan reserves, the market could be right.

* Please note in terms of disclosure that I personally owned shares along with many other financial service stocks in my personal portfolio. Neither stock is included currently in the private financial services fund that I manage. The comments in this blog should not be interpreted as a recommendation to buy or sell these securities.

The corporate finance view on ‘value’

Both Warren Buffett and I studied at the feet of Graham and Dodd at Columbia. He studied under Benjamin Graham and I was with Professor David Dodd. Both instructed us to reconstitute financial statements in order to determine at least liquidating value. Part of the exercise was to eliminate most, if not all inventory value; also to re-price the outstanding debt at its current market value among other adjustments. The genius of Mr. Buffett was to recognize the economic value of the “moat” around the company that protected the firm’s market share. In many of Berkshire Hathaway’s** acquisitions, I believe the size of the “moat” relative to the price was an important element in the final decision. In some cases, key personnel were very much part of Berkshire’s valuation of the “moat.” (I know in the purchase and sale of financial data products and companies, the customer relations experience was a critical factor that I used in valuing the various opportunities before me.) These and similar approaches are used by corporate finance groups to determine acquisition value.

** As noted in earlier blogs, I personally own shares in Berkshire Hathaway, as does the private financial services fund that I manage. The mention of this stock should not be construed as a recommendation to purchase.

My concept of ‘value’

I try to divide potential investments into two large buckets. The first is one that future events will cause the stock to raise. Often this may have to with new products, processes, sales strategies and competitors’ problems. In the other bucket are stocks that are selling substantially below their current liquidating value, or at a price that a reasonably smart strategic buyer would pay for the company.

How to apply in fund/manager selection?

Avoid those managers that emphasize the value of published price/book ratios. Work with managers that know enough and have enough good contacts within an industry to come up with an independent valuation. Due to the time to research available companies, the preferred managers typically have relatively low portfolio turnover rates. However, these managers must have a history of reacting to their own misjudgments and exiting from what looked like great values.

All long-term successful investors use trial and error techniques. Thus the success of any particular investment is far from guaranteed. The truly great investors recognize their errors and quickly move on, so some portfolio turnover is a good thing to see. The essence of value-focused investing is to reduce the chances of large avoidable losses.

How do you find and invest in good values?

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Sunday, April 8, 2012

Exploring for $1/Gallon Gasoline

This is the season that the great religions of the world celebrate the past and look forward to a rewarding future. Analysts should also study the past and look to the future by thinking the “unthinkable thoughts.” Today’s blog seeks to do exactly that. I am exploring the possibility of $1 per gallon gasoline. Like most prospectors and researchers, our work is a series of explorations, not of successful predictions. Whether we will ever see $1 gas is dependent on many of the variables to be discussed. As with successful prognosticators to the public, I should not predict both a direction and timing; but I suggest that if you choose to save these thoughts, it should be for your children or probably your grandchildren.

An incomplete list of the variables:


No government that I am aware of will let a major stream of energy move from its source to its consumption without layering on taxes. (The main differences between our close to $4 price and Europe’s about $9 price for the same amount of auto fuel are the taxes imposed. There are some governments that subsidize the retail price, but find other ways to collect tax revenues.) Thus, the final price that we pay is dependent on tax distribution policies of host countries.


Due to my biases as a US Marine Corps communication officer, a securities analyst of tech companies, and most of all as a trustee in close contact with Caltech, I admit to being in awe of technology. Fundamentally, most forms of physical energy are found in nature and converted to power through various mechanical steps. Just as wars have spurred on the development of much of what is considered to be modern medicine and organizational management practices, I suspect that our exploration of space will lead to material changes in finding sources of energy, the extraction of energy as well as the processing, distribution and safe use of energy. Already, major oil deposits have been found through the use of manned and unmanned satellites. In order to accomplish our mission of exploring the planets, various remote techniques have been developed that deal with dangerous gasses and techniques for probing and “mining” from land surfaces. Some of the technological developments from space such as efficient payload management and global positioning systems (GPS) found use here on earth.

Technology is at work uncovering more efficient and safer ways of developing our natural resources; bringing into economic production energy sources that today look to be too expensive and too dangerous. Clearly we will utilize more fuel efficient vehicles on land, sea, and air in the future. Homes, offices, and manufacturing/processing plants will manage their usage of energy better. There are many other ways in which technology will both help give us more bang for our energy buck, and will also make us even more dependent on the increasingly efficient use of energy. Thus technology will affect both sides of the supply/demand equation.

Oil, natural gas, coal and nuclear

Ever since I first started looking at the economics and politics of energy in the 1950s, I have heard about reaching “peak oil production,” as we are not finding oil as fast as we are using it. I recall that some believed that we would have found all the oil the Earth had to give us by the 1960s. In each decade since, the peaking date has been reestablished, and in each decade more “juice” has been found. For both commercial and regulatory reasons, the size of these discoveries has been downplayed. Further, I suspect secondary drilling through the use of advanced technology will be more productive than is currently believed. In this season of heightened religious belief, I believe that there is more productive oil out there than most others believe, and a good bit of it in or near the US.

Natural gas was a waste product in the days of early oil production; it was just burned away at the wellhead. Through the use of technology and higher prices for oil, the governments and the people of the world have begun to appreciate the economic advantages of natural gas. We are addressing the concerns about fracking in terms of environmental dangers. Actually, at the moment we have too much natural gas, and this week we hit the lowest recorded price for this commodity in ten years. To me, it is only a matter of time and some technology until we have a significant expansion in the use of “NG” (No longer standing for Not Good, but for Natural Gas.) Thus, I see that the available supply of energy will rise and at some point impact the price of oil.


We are all aware of how dirty coal is. We are conscious of the dangers of manned mining and the effects of coal burning on our once pristine environment. Because of these issues and to some extent unwise government regulation, coal in all its forms has lost share of market. However, as a firm believer both in technology and the eventual power of economics, I do not think we have experienced the last of the beneficial use of coal on a global basis. In South Africa, I have seen the conversion of coal to oil to meet a politically-driven need, which demonstrates the creativity of some of the coal business leaders.


If you don’t want coal burning in your backyard do you want to have an atomic reactor quietly producing energy? The tragedies both in Japan and Russia were caused by faulty locations and poorly constructed facilities. Little publicity is seen on the safe use of atomic power in Europe, US, and elsewhere. After a period of twenty years, the US government has authorized the first new non-military use of a reactor. (The US Navy and others have been successful users of atomic power for a couple of generations.) Will procedures be developed to reduce the odds of fatal accidents? Yes.

Thus, I believe that with technology’s help, we have sufficient potential supply of energy.

The demand side

The Saudi Arabian government and others are vitally aware that the price of energy is, in the end, driven by demand. One of the best ways to measure the level of economic development in a country is to track its use of energy. (Some of the political leaders in China are more sensitive to the level of electricity use than they are to the softer calculation of GDP.) While the price for oil will have an impact as to the costs of a society to produce a particular standard of living, Saudi Arabia’s fear is that too high a price will drive substitution efforts even faster. On a long-term basis they should be worried. (As mentioned above, there are energy alternatives and technology is making them safer and cheaper.)

Habit changes

Slowly we are becoming more efficient consumers of energy. However, this is being offset by our growing demand to use more energy by our various appliances, including computer and entertainment devices. Some governments recognize that gradualism won’t work to bring energy demand into better balance. As an Easterner I hate to admit it, but the government of California has a useful idea. A recent Wall Street Journal article, entitled “California Declares War on Suburbia” suggests that a more efficient use of resources would be to gently move people into the cities, which is what is happening in China. Not only could this improve our use of energy, but could significantly improve the overall level of education and safety available within the cities. If it were to happen, then the number of energy consuming cars is likely to drop.

Two other considerations

Our current world is, as always, a balance of power. The current fulcrum of power is in the amount of energy that is produced both for internal and external use. If we had a world with a more balanced use of energy, various forces would likely cause changes of political leadership, and perhaps even the composition and identity of various countries. Many political leaders are not blind to these possibilities.

The second consideration is the monetary value of energy. At the wholesale level, energy today (particularly oil) is priced in dollars. This is a historic accident of past wars, economic development and relative stability of the value of the US dollar. At the moment, I believe the US society is committed to inflation, therefore at some point the rest of the world will wish to price things in dual, if not multiple currencies to protect from politically-inspired deficit spending by the US government. Thus, perhaps I should amend my search for $1/gallon gasoline to a level commensurate with about a $1700 per ounce price of gold.

Investment afterthoughts

Consider the following on how to put these thoughts into practice:

  1. You should not bet that the price of oil will always be a good inflation protection.

  2. Inflation is a product of global excessive spending relative to saving, and is likely to continue

  3. View some of the large international oil companies as akin to investment banks. If they choose investment wisely within their circle of competence, they can have good results. (Interestingly, both international oil stocks and those of investment banks are low price/earnings ratio groups. The difference is that the oil companies have higher dividends and yields.)

  4. Find technology producers that have a pattern of producing labor and energy saving devices, particularly those that can be applied to finding, extracting, transporting, processing, and using energy.

  5. Watch for useful lessons from space activities in terms of uses of energy on earth.

  6. Bet on increased urbanization, some of which will be cajoled by the government, which will lead to better primary and secondary education and safer streets.

  7. While $1/ gallon gasoline is not an “odds on favorite,” it could happen and that may not be a good thing

Does any of this make sense to either discuss with your children/grandchildren or to pass it on to them at some future point?

Did you miss Mike Lipper’s Blog last week? Click here to read.

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Sunday, April 1, 2012

Macro vs. Micro

The talking heads on financial television networks and writers in general circulation news media spend most of their time on minute changes in what they perceive to be the principal macro trends affecting today’s markets, with the underlying presumption that what influences today will affect long-term future investment results. Relatively little attention is paid to the stories behind individual company press releases. This focus is understandable, but not particularly useful to investors. Less dramatic changes in work procedures, the make-up of sales, supply-chain evolutions, shifts of key personnel below the board level, etc., are somewhat difficult to ferret out and appear to be dull to journalists.

I like listening to smart investors and that is why I try to attend a monthly meeting of an investment group where the participants have at least 40 years of investment experience. While one of the purposes of the group is to develop actionable ideas, most of the time is spent on top-down or macro thoughts. That way almost all feel that they have something to contribute. When the discussion finally turns to individual securities, the number of speakers drops considerably. As many of the members of this group are no longer working or managing money intensely, they are not doing detailed fundamental research on individual securities/commodities. An expressed view is that good security selection will come out from the correct macro decisions.

I disagree with both the pundits/media and some of the members of the investment group who share this view. Many of the members of various investment committees that I serve on want to discuss the macro trends. Most of the time I believe that it is very difficult to spot a changing macro trend in advance. However, there is one way that I have found useful in the past. When I have talked with various companies’ CEOs, heads of product research, heads of marketing research, and heads of sales among others, I can occasionally find out what is keeping them awake at night. Often I can determine how far out the time horizon that they are thinking about is, and how this has changed. Thus from the bottom up, I can sense changes before they are full grown macro trends. There are times when several well-managed companies foresee changes that can be an important macro change. I wonder whether they still say about tournament golf, that you drive for show, but putt for dough. Which suggests it is the smallest detail, getting the ball in the hole with the fewest number of strokes which wins.

Top-Down Macro Thoughts

In this blog I am going to constrain myself to top-down thoughts due to space considerations and to provide the widest utility to this community. In future blogs I will outline some micro analysis I use in selecting funds, fund managers, and individual financial services securities.

The following is a list of items that could lead to serious macro trends:

  1. In December, US money supply measured by M2 grew by 10% year over year (somewhat less currently), while the US economy grew, depending what source one reads, at 2.8-3.0%. Historically if these trends continue, the fear of rising inflation can drive markets. (We have recently increased commitments in TIPS.)

  2. Because a limited number of corporate defined benefit plans have gone broke, a couple of state legislators are proposing that the states manage money for the private sector. While I doubt, for good reasons, that this will happen, the desire on some parts to have government take more responsibility for the private sector is raising a flag of concern as to the long-term financial health of those states and perhaps the society in general. A trend to be watched.

  3. Courtesy of Protégé Partners and Welling@Weeden, I have seen some evidence of behavioral concerns facing the ability to retire. (I don’t intend to retire, as I hope to go out as they say, with my [combat] boots on.) Considering that many people voluntarily or involuntarily retire at age sixty, the number of younger people in the society to some degree assures the retirement funding in various government plans. In the US, this so-called dependency ratio has gone from 17.2 % in 2007 to an expected rate of 25.4% in 2040, or about two less people to support us. The US is in relatively good shape, for at the same time the dependency ratio in Japan is estimated to be 43.3%, Canada 31.5% and China 27.9%. (These statistics suggest to me that most of the global world must shift more of its resources into some form of savings, which will drive the investment markets higher. This, in turn, will reduce the amount that has to be shifted. But whatever is shifted will come out of consumption, which means that market valuations will rise even at the same time secular growth slows.) While the various austerity measures being introduced will also reduce consumption, they eventually will lead to lower personal debt, in part because of the write-offs of bad debt. After the calamity of the 1930s, personal debt in the US had returned to its lowest level since the Civil War; while in the 8 years from 1933 to 1941 the US economy doubled in real terms. So austerity measures can work in the long run if the political conditions are reasonably stable.

  4. Globalization may help the world manage risks better as well as transmit them faster. The stock exchanges in the BRIC countries (Brazil, Russia, India and China) are cross listing the other countries’ derivatives. In a “risk off” world there will be fewer places to hide. One of my concerns in our changing market structure is speeding up the transmission belt of global problems. In February the number of ETFs (Exchange Traded Funds) was relatively stable with the January roster with the exception Global/International Equity ETFs, which gained 22 new funds in the month for a total of 439. Many of these funds are getting narrower and narrower based, e.g., the new Markets Vectors Indonesia Small Cap ETF. Open End Mutual Funds are also responding with the newest post card I received announcing the Wasatch Frontier Emerging Small Countries Fund. (As many of the readers of my blog know, I have been an advocate of investing in Asia both in large and smaller countries. At this point, except for truly long-term oriented clients, I will not add to these positions. I get nervous in crowded market places.)

  5. Commodities and commodity producing/transporting stocks play an increasing role in many sophisticated portfolios. Commodities, a lot like bonds, move to a different drummer than equities. Often they are more sensitive to changes than equities. There is at least one manager who believes that commodities are over-priced based on historical standards. (Currently, there may be too much weight being placed on China and its thus-far managed slowdown.) Higher commodity prices bring on to the market new production which we have seen in metals and grains. For example, US farmers are planting the most corn in 75 years. Only time will tell whether this is an example of speculative excess.

  6. In Saturday’s Wall Street Journal, the very perceptive Jason Zweig devoted his column to a recent study of how well Lord John Maynard Keynes managed a portfolio for Cambridge University. The article and a subsequent exchange of emails is an appropriate summation of the skills of what started out to be a macro-driven fund and became a micro selection device. After Lord Keynes with his insight as an adviser to the Bank of England missed getting out of the 1929 decline, he shifted from a macro focus to using alternately cash, selected commodities and small/mid cap stocks. In effect he went very wide of the benchmark index that other fiduciaries used. By doing so he was able to add 8% per year in excess return. What we do not know is how well each component of his portfolio fared against a relevant index. While that would matter to me as an analyst/portfolio manager, I am sure it did not matter the Cambridge dons (professors).

Tentative Investment Conclusion

One needs to be alert to the macro concerns now more than in the wonderful first quarter.

What do you think?

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