Can China Be Hedged?

There is a difference between people and markets. While both have histories, they are portrayed differently. The experience of people is recorded with lots of emotions, thought processes and personalities. We record market movements whether they are for securities, commodities, real estate or objets d’art in two dimensions, up or down. I believe the study of both are essential for any successful investor. However, the study of people should serve as alerts to those who focus on the history of markets.

Calamities Travel

Once in a while the single tree falling in a forest or an insect flapping her wings could be the start of a world-wide calamity. There are two relatively recent examples that I saw early, but did not fully comprehend until much later, to my accounts’ disadvantage. The first was the collapse of a Greenwich, Connecticut based hedge fund firm called Long Term Capital Management (LTCM). Actually before the founding of LTCM, I was exposed to one of its widely proclaimed “geniuses.” This learned academic gentleman believed that market-based statistics could be used to predict future market prices. He was correct in many instances, but not in each and every instance. He and his associates applied their mathematical skills to foreign treasury instruments with considerable leverage. They were totally “blindsided” when the Russians defaulted on their treasury issues. My mistake was I did not fully understand the implications of this collapse, after all none of my accounts were exposed to Russian paper. Initially I missed two knock on relationships. The first was the contagion effect. LTCM and other leveraged players (more on this shortly) needed to quickly restore their capital base. They quickly sold their other emerging market positions. (I did not foresee how a Russian default would be the cause of Mexican market decline.)

The second relationship, or if you prefer the second order problem that I missed, was the nature of the trading community. LTCM was one of the largest customers of many fixed income trading desks on “The Street.” Initially these desks merely filled the order of their customer rapidly, perhaps in some cases they sold short the securities as part of filling the order. Soon they saw how successful LTCM was and they followed its trading patterns and in some cases put money into LTCM’s funds. The size of these actual or potential losses would have been very large for the trading community if all of The Street’s trading positions had to be liquidated quickly when LTCM problems became known. Unlike the more recent cases of Bear Stearns and Merrill Lynch, the government recognized the problem early, but the Fed did not ride to the rescue of LTCM with saddle bags full of money. The Federal Reserve Bank of New York convened a meeting of all the principal players including a very reluctant Bear Stearns and would not let the participants out of the meeting until they agreed to loan enough money to LTCM so it could be prudently liquidated. Thus Wall Street was saved from its own potential collapse. (In this instance the FRB of New York played the role of J.P. Morgan when he helped end the “Money Panic of 1907,” before the Federal Reserve was created.) Thus, the tree falling in Moscow almost took down the entire trading market in the US and probably elsewhere as well.

The Sub Prime Calamity

While I recognized that far too many people were speculating in real estate and that amateurs often lose to professionals in the market place, I did not appreciate who the real losers would be. (The providers of credit all the way along the line were the losers.) Initially, people began writing about the ballooning sub prime and the “Alt A” mortgages and that they would lead to bankruptcies and a slowdown on the building of new homes. While this was serious, at the time it was not of monumental importance, as new house construction is a small part of our expanding economy. Once again I was not sufficiently conscious of significant changes and how the market place was operating. I did not fully comprehend that the major investment banking houses had become the center of the mortgage origination casino to feed their securitization sales forces. This process was replicated in the UK, Australia, and elsewhere and the resulting production of mortgage slices were owned throughout the world, including places as distant as Norway and China. While in the case of LTCM the infusion of leverage was at the so-called professional level, at almost every stage of the housing chain leverage was induced so there were many more losers, including those living on fixed income from these mortgage tranches. When the various governments started to get inklings as to the size of the looming debt on the way to non-payment status, the governments rode to the rescue to save at least their financial communities, if not their economies. (We can debate whether the rescue attempt was ham-handed and whether the private sector should have been let to sort out the problem, as Mr. Morgan forced in 1907.)

Is China A Potential Calamity?

Recently I spent time thinking about conventional asset allocation strategies. In almost all cases, institutions are attempting to broadly diversify their assets. Often the categories they use are as follows:

• emerging market equity and debt
  
• developed market equity and debt
  
• domestic equity and debt
  
• commodities including timber
  
• domestic and foreign real estate
  

My unanswered concern is that these diversification attempts are making a common bet and therefore do not have the diversification against a major risk, which suggests there exists a potential for a major dislocation. All of these classes are exposed to China in one way or another. Most emerging markets are increasing their trade with China. General Motors sells more cars in China than the US. Proctor & Gamble, Coca Cola, Microsoft and soon Apple, have important sales and/or facilities in China. “The Middle Kingdom” is the swing buyer or seller of most non-agricultural commodities in the world. Almost all bonds are priced in relationship to US Treasury issues of similar maturities. The Chinese convert much of their trade surplus with the US into the purchase of US bonds, which helps to absorb our increasing deficits. A significant slowdown in China’s purchases, let alone its absence from the market, could send most bond prices down around the world.

I am not an expert on China. I have a great deal of respect for its economic leadership so far. Perhaps these “experts” will continue to manage the population’s needs and desires as they have done in the past, but each year it becomes more difficult. China has replaced the US as the locomotive for global growth. This is not a prediction but an observation that at some point it is conceivable that the engine will perceptively slow down or even temporarily go off its planned track. With so much of the world dependent on the continued growth of the Chinese economy, a slight flicker or a rumor of an unexpected result could cause all markets to react.

How Does One Hedge The Chinese Risk?

Granted we don’t know for sure that there is such a risk, but we should have learned from the LTCM and sub prime examples that calamities can happen. As a professional investor I would like to identify a satisfactory hedge against the possibility of a Chinese calamity. I would like to do this on two counts. First, I am in the market for some insurance. Second, if there was a recognized hedge, its price action could be a clue to a the current market’s perception of the risk.

I have reviewed all of the current asset allocation categories and have found to varying degrees each is dependent on developments within China. At the moment I can not find an independent hedge. Perhaps you will share your thoughts with me on such a hedge or at least your leading indicator of Chinese problems.


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LESSONS TO ALL INVESTORS FROM WARREN BUFFETT’S LETTER

Many investors, including me, spent Saturday and Sunday of this weekend reading Warren Buffett’s latest letter to the shareholders of Berkshire Hathaway. I was interested in his comments about the company and its quite poor 2008 investments. I have been a shareholder for many years and the stock is in the portfolio of the hedge fund that I help manage. However, my principal focus was on the implications I could draw from the 22 page letter to apply to our other investments and to share with you in this blog.

What follows are items that Mr. Buffett commented in the order of his comments and my reactions to the comments. As usual in most things that I write, my mission is to provoke tangential thinking on your part rather than the laying down dictum “according to Mike Lipper.”

Throughout the letter Buffett focuses on the financial and political abuses of our trust carried out on both the national and local levels. I agree with him that the after-inflation value in various governments’ paper is more questionable now than ever. In addition, Buffett also expects rising unemployment in 2009, and perhaps beyond. Despite those dour views, he intones that the best days for America lie ahead. Part of his optimism is probably based on his assumption that Americans are focused on saving money as never before. (With our oversized position in financial service securities that is good news in the long term.)

Turning to investing in securities, Buffett has a number of observations that may seem to be logically inconsistent, but actually recognize the complexities of investing. “When investing, pessimism is your friend, euphoria the enemy,” Buffett reminds us. Nevertheless, he points out that the S&P500 has gone up about 75% of the time in the last 44 years that he has been managing the company. The historic upward slant to the market has not prevented him from either buying securities or companies. However, his pricing decisions are different and insightful. He says, “We like buying underpriced securities, but we like buying fairly priced operating businesses even more.” I suspect this apparent dichotomy is based on the reality that good, privately-owned businesses managed by owner/operators instinctively know both their present and future values, and want their price.

It is my belief that in the public securities market, future prices are not primarily dictated by the operating results, but by the co-ventures in the security. When will they sell and what will prompt the sale? Thus, one needs to apply a discount from value for the irrational behavior of one’s co-ventures. Given the choice between the two; securities or operating businesses with management attached, Berkshire has a decided bias in favor of buying operating companies at fair prices over securities at a discount. A number of ultra high net worth investors have a similar bias.

Buffett issues some cautions regarding the future. He is suspicious of relying on past financial data, particularly price data in its many derivative forms. Two of his quotes are instructive. First, “Investors should be skeptical of history-based models. Beware of geeks bearing formulas.” Second: “If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.” Having really learned about security investing at the local race tracks, I have a more than skeptical view of those who have a “system” that can beat the odds repeatedly. Despite these cautions, I agree with Mr. Buffett in believing that after many years of under-pricing risk, we are now over-pricing risk. His major financial warning deals with derivatives, which he appropriately labels as dangerous, having spent $400 million to unwind the derivatives he bought at a very wrong price when he purchased General Re.

Despite these feelings, he has entered the market for credit default swaps (CDS). These securities are somewhat like the reinsurance policies that Berkshire manages brilliantly in most instances. On the other hand, in some cases these securities settle many years in the future, and it is the final price that matters, not any of the intervening prices. What makes this much more risky is that the counterparty can, and does change without the permission, or in some cases knowledge, of the other party to the trade. I believe Buffett is correct that until effective clearing houses and exchanges are established, the bulk of this business will rest with a concentrated group of dealers. In this case a handful or less of major banks will be dealers, which add to both risk and opportunity to those in and around the concentrated circle.

Finishing his securities insights, Buffett provides details of his sale of part of his positions in Johnson & Johnson, Procter & Gamble and Conoco, which I assume were largely at a profit. He did this to fund his high yield with equity kickers in Wrigley, Goldman Sachs and General Electric. I am much more confident in the return of all of his capital than I am of the value of the GE kicker. What is significant about these trades is that while Berkshire still had significant cash and debt-carrying capacity, Buffett felt that he should maintain these reserves and accepted the discipline of having to sell some favored positions to fund purchases of better bargains. I am particularly focused on the Conoco sale, made after adding to this position earlier this year. Yet in his letter he states he still believes oil will sell for higher prices in the future to which I concur.

As is appropriate, Mr. Buffett states his views on the current housing credit crisis. Though the letter doesn’t volunteer the information that he is betting on both sides, publicly he urges home buyers to look to their purchase for enjoyment and utility, not for profit and the opportunity to refinance. Less publicly stated, but in the innards of the letter, is the disclosure that the company owns the second largest real estate broker in the country, and that Berkshire will continue to buy local real estate agents at reasonable prices.

No summation of Warren Buffett, his letter, or his work would be complete without a recognition of how great a showman he is, and a genius at cleverly manipulating public opinion through skilled conversations with the press. His PR acumen will be demonstrated at this year’s annual meeting of Berkshire Hathaway, where he has invited three high profile journalists to pose questions to himself and vice chairman Charlie Munger. Included are Carol Loomis of Fortune (who has written more great insightful pieces than any author that I have read), Becky Quick of CNBC (which guarantees electronic media coverage), and Andrew Ross Sorkin of The New York Times (which fits Mr. Buffett’s political tendencies).

Bottom line: One can learn much from Mr. Buffett, but don’t try to copy him, you don’t have the same equipment. He and Berkshire Hathaway will survive. The economic outlook over the next couple years may be challenging, but as the structure of the new world departs from the old, the opportunities for investment bargains will be great.