Sunday, May 4, 2014

Pretend & Extend vs. Prediction - Other Lessons from Berkshire-Hathaway


A surviving investor is always learning beyond what is the obvious from platform presentations as well as gaining additional insights from past experiences. These are my inputs to today's post as I return from the annual investor conference for Berkshire Hathaway.

Clashes of past with different futures

As almost all the investing world knows there is a five hour question and answer session at the annual Berkshire Hathaway meeting which this year probably had an additional 10,000 attendees participating, including many well known value focused investors. If one was paying attention one could hear the clash of the quantitative/accounting approach written about by Warren Buffett's patron saint Ben Graham and a more real world focus on the nature of businesses and focus on people as advocated by Charlie Munger, a proud graduate of Caltech. The clash can be summed up in prior bank mortgage policies of "Pretend & Extend" vs. prediction of meaningful change.

The investment quants believe the future is captured by extended past published earnings reports projected into the future based on today's prices. The genius of the Berkshire Hathaway approach, particularly to acquisitions, is to focus on likely significant future changes. At this year's meeting there was focus on its two regulated activities, the railroad and the utility group. Part of the attraction of these two large and growing investments is that they are major cash users rather than cash generators. 

What Buffett and Munger, the 83 and 90 year young leaders are betting on is that the concerns about climate change will not dampen the world's thirst for liquid energy. The evolutions in the production of oil and natural gas have led to dramatic changes in quantity and processes. The railroad now has nine long tanker trains that can deliver petroleum twice as fast as the pipeline and it has ordered 5,000 new tanker cars and are looking at the possibility of using liquid natural gas to fuel its locomotives.

On the utility side this week Berkshire Hathaway purchased oil transmission pipelines in Alberta, Canada. In addition, it has recently purchased a chemical process that would speed the transmission rate within pipelines. The company is hedging its bets by being one of the largest tax benefitted suppliers of solar and wind power.

Clearly, the favorite mathematical measure that the quants use (extrapolation to determine future valuations) is likely to significantly understate the future value of these operations and for Berkshire Hathaway. In this particular case the predictive method is much more growth oriented than the mathematical models. It is this very specific focus on growth which is the key to likely future general stock market performance.

"Just not yet”

One of the leading theorists that study the market is Jeremy Grantham, who has a generally good but spotty record as a portfolio manager. Grantham believes that the current bull market will have to rise to an S&P 500 level of 2250 from the current level of approximately 1880. Jeremy believes this will happen within the current presidential cycle. He is generally viewed in the investment community as a bear. I find it a bit ironic that while possibly correct at a future peak, his timing may be too long-term.

Regular readers of these posts know that I am obsessed with spotting the next major peak and for our managed accounts, largely avoiding a substantial decline. My studies of past peaks have uncovered many similarities with the current structure of the bond and stock markets except the final parabolic advance. I believe we may be near the launching point of the final spike. We need wide scale public participation to get breakthrough acceleration. 

Typically before a major peak there is a period of almost exhausting enthusiasm which translates into parabolic price rises. Whether a potential 19% rise from the current level qualifies as a parabolic rise is questionable after 30%+ gains in 2013 and more than a double in the five year recovery. However if we look at the potential rate of ascent, a net 1% per day over a trading month might just qualify for the kind of blow-off that characterizes many peaks. If we don't get such a move, I would agree with Jeremy for now, with his belief that we are not yet at peak. However the increase of volume being generated by the more publicly oriented discount brokerage firms that we own in our financial services private fund is something to watch as an enthusiasm indicator.

Further declines in the quality of bank services

All sectors don't peak at the same time. The weekend in Omaha perhaps should be called the “Reunion of Value Investors.” Many of the well known value focused investors were there.  We met with and examined portfolios that like Berkshire and me have substantial positions in financial securities. In most cases (except me) they are in bank shares. We also see this high commitment to banks in the portfolios of many international stock portfolios, particularly if the portfolio managers were trained in Europe.

My concern is that on a longer term basis many banks increasingly rely on administrative services and investing for others as a source of earnings power. In a somewhat misguided rule change, regulators have reduced the potential for capturing yield spreads and at the same time required more isolated capital. Thus, the historic ways banks have to make money have been materially curtailed. As a natural outcome of these pressures on bank profitability, banks have been cutting their personnel rosters, particular trust banks that have less highly profitable loan opportunities.

Until I started to refocus on secondary sources of bank earnings power, I forgot one of my reactions as a young bank trainee at a trust bank. One of my tasks was to remove checks and letters from envelopes addressed to an insurance company's drop box. It was at that time that I recognized that among other things banks were giant paper processors. They remain paper/data mills as they process clearing and settlements, making transactions in securities, currencies, and structured loans. Years ago the banks had armies of clerks and support people to carry out these activities efficiently and safely. In the intervening years much, but not all of the work was automated. However, I fear that because of the combination of the elimination of some competition as well as the probable narrowing of the profitability of foreign exchange and structured loans utilizing LIBOR and related indices, some major banks have been forced to cut administrative and investment staffs. While some of these people may have been excess, I am predicting future bank services clients will be disappointed and their reliance on past experience will be similar to an analyst using extrapolation as a principal decision tool. We predict there is a good chance that the quality of bank services is likely to decline.  Don’t say that you weren't warned.

Questions of the week:

What predictions are you making that are contra to extrapolation?

Have you noticed a decline in the quality service you have been receiving from banks?

Please privately share your thoughts with me.

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