1776 Can Make Us Independent Again

Historical Introduction

Most Americans believe the single most significant act of 1776 was the signing of the Declaration of Independence. I suggest that when facing today’s economic problems we consider a still more important event that occurred  in 1776, the publication of Adam Smith’s The Wealth of Nations.  (Not to be confused with the very insightful contemporary author and television personality who uses Adam Smith as a pseudonym.)

The two events are very much related. Our Declaration of Independence was driven by the colonists’ abhorrence to the Navigation Acts and other laws of Great Britain that raised the costs of imports into America and restricted the transportation of our exports. Remember the famous Boston Tea Party was caused by the tax on imported tea.

These laws were an outgrowth of the mercantilist philosophy of European governments to promote their own exports and restrict imports into their lands. This governing philosophy reigned between about 1500 and 1800, and was based on the need to get trading partners to ship gold to those countries where they had an unfavorable balance of trade. The importance of gold was not primarily economic, but rather to pay for their constant wars. In the minds of the European leaders, particularly the British and French, this was a matter of survival.

What Adam Smith advocated was that nations should specialize in their production of items to be exported and import those items where they did not have a cost advantage. Over the succeeding generations his ideas were finally accepted.

Today and for some time American Presidents have announced policies that would make the US independent of foreign oil. In response to questions and comments from a number of regular blog readers, I will attempt, in a small way, to play an Adam Smith role.

My biases

I have never seen a totally unbiased report. Most of the authors are not fully conscious of their own biases, particularly those that were inculcated into them at their universities. As we are all captives of our experience, biases cannot be completely avoided. The best we should do is to identify either the biases or the sources of our biases. Mine starts with a college course in Middle-Eastern history, geology and geo-politics. I learned that in Saudi Arabia, the direct lifting cost of a barrel of oil was approximately four dollars and did not change much over the years. From time to time I have invested directly into domestic gas producers to make money or energy-focused mutual funds as an inflation defensive move. When I was lucky enough to become a trustee of Caltech I was exposed to numerous professors who were focusing advanced scientific approaches to find energy and use it more efficiently. These inputs allow me to think about a problem from different viewpoints, and therefore biases. 

Parsing the search for energy solutions

The three main fuel sources of energy are oil, gas, and coal. (For the purposes of this search I am ignoring nuclear, solar, wind, hydro, and geothermal with the belief they will play an expanding role, but won’t provide sufficient power in the short to intermediate future.) I believe that each of the age-old big three should be addressed individually.

Oil

This is where I put my hat on as a modern Adam Smith. The popular view of Americans from the White House to Main Street is that it is dangerous for us to rely on the importation of oil from those nations that  “don’t like us.”  The fear is that in time of military conflict those that supply us with oil will cut off flow, or at least hold it up for ransom. There are many counter arguments to this fear. First, our military has developed lots of means to defeat an enemy without the need for the quantities of petroleum products required in World War II and subsequent engagements. Second, we have built a strategic oil reserve which is intended for military emergencies. (Not to be used as a politically-inspired price mechanism.) Third, if needed, government agencies believe that there is more oil underlying US government-owned land than has been discovered in the rest of the world.

There is another set of economic arguments which update Smith, the canny Scotsman. If oil is a scarce resource and cannot be easily replaced, we should deplete other countries’ reserves and political power by buying all that they will sell to us. Further, a rise in the international price of oil, while somewhat painful to the US in the short-term, dramatically changes our competitive position in the world. The US is less dependent on foreign oil than Western Europe, Japan and China. If petroleum manufacturing costs for the rest of the globe goes up and we have competitive products at a lower price, the US share of market will go up which can aid our job growth. Based on what we have already seen, the threat of higher priced oil will trigger greater conservation efforts and the development of more efficient uses of energy.

Gas

There are reasons to believe that the US and certainly Canada can be net exporters of natural gas. Other countries are also developing their gas properties. From a strategic viewpoint, I might be reluctant to become too reliant on imported gas except from Canada. Over time I would expect the bulk of our heating requirements will be filled by natural gas. We are likely to see both the military and large trucking fleets switching to hybrid or fully dependent upon “nat. gas.” The environmentalists will need to prove that fracking is dangerous to the neighborhoods of gas extraction and then our technologists will probably find solutions.

Coal

Some politicians have proclaimed that there is no such thing as clean coal. Considering the US has a reported 250 year supply of coal, I hope they are wrong.

If the price of energy goes up, I believe that there will be enough room in the final price of coal for both steel-making and heating to cover the costs of technological fixes that are underway.

Conclusions

Just as 1776 brought forth thoughts and actions that changed the world, I think we are at the point of achieving meaningful economic energy independence in the near-term future as we modernize our thinking.

As is my wont turning to investments, I would suggest investments in stocks of companies that are devoting some of their efforts to new ways to make our search and use of energy more efficient. These areas could be mining and extracting efforts, transportation efficiencies, and battery producers among many other beneficiaries of the application of new and improved technologies. These could include some, but not all, of the major oil, gas and coal companies.

Are you ready to be independent in the new world?  Let me know.

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Unknown Impacts from JP Morgan

Since Thursday night, no single financial topic has gotten more print and airtime than the announcement of the unexpected net loss of an estimated $800 million, out of a $2 billion gross loss sustained in the Chief Investment Office (CIO) at JP Morgan Chase (JPM) London. With market participants and the media searching for more information and in some cases insight, one can perhaps benefit from former US Defense Secretary Donald Rumsfeld’s method of dealing with the press. He divided the questions he was asked between known knowns, known unknowns, and unknown unknowns. According to Rumsfeld:

• There are known knowns; these are things we know we know.
  
• We also know there are known unknowns; i.e., we know there are some things we do not know.
• There are also unknown unknowns; these are things we do not know we do not know.

I will array my thinking using this pattern.

One should understand the biases of the sources one is using. Regular readers of this blog already know that I have investments in many financial services companies. These investments were largely obtained through stock-based mergers in my personal account as well as a selection, I think of the better ones, in a private financial services fund that I manage. While I have been a long-term investor in the JPM stock in my personal account, I do not own the company in my managed fund. This is the same distinction that Warren Buffett revealed at the recent annual meeting of Berkshire Hathaway (BRK-A), (BRK-B); he personally owns JPM, but invested heavily in Wells Fargo (WFC) and US Bank (USB) for Berkshire Hathaway. Up to this point my reluctance to add JPM to the fund is based on what I perceive to be a requirement to a higher standard of selection for the fund than my personal account. To the best of my knowledge, JPM has by far the largest single gross investment in derivatives of any publicly disclosed financial institution. My focus on the gross commitment, adding the long and short positions rather than netting them, is based on closely examining trading desks that have experienced simultaneous problems in both their long and short books. Further, I will admit I am not comfortable with my lack of full understanding of these instruments. Thus despite the fact my family has dealt with the JP Morgan organization for three generations and has great respect for some of its present leadership, my lack of sufficient understanding of the use of derivatives has prevented me from owning the stock of JPM in my managed fund.

Known knowns

On Friday after the Thursday evening announcement, the price of JPM shares crashed -9.28%, with a record 217 million shares traded. Shares of Citigroup (C) declined -4.24%, Goldman Sachs (GS) -4.19%, Morgan Stanley -4.17% and Bank of America (BAC) -1.95%. (Both Goldman Sachs and Morgan Stanley are in the fund and the others are owned personally.) At least as of this weekend, the combined wisdom of the marketplace is that JPM has a very specific problem on its hands. The two investment banks that have become bank holding companies may have somewhat similar problems. There is a view that Citi is similarly hobbled and Bank of America’s price already recognized lots of its problems.

Before this announcement, I was trying to better understand JP Morgan. Thus, I was reading its massive reports to the SEC. In a section entitled Treasury and CIO Selected Income Statements and Balance Sheet Data, a couple of items struck me as significant. The first was securities gains in the first quarter, which were up 344% from the prior year, to a total of $453 million. This item was footnoted to reflect repositioning of the corporate investment securities portfolio. Clearly this was a highly volatile component to JPM’s earnings and something of significance was going on. The post-quarter disclosure of an estimated $800 million loss in what may have been fifteen days (as reported by some) compared with the first quarter’s securities gains, is a further indication of the type of volatility that one could expect. The second figure that caught my eye in this table was that at quarter-end, the aggregate investment securities portfolio totaled $375 billion ($362 billion averaged for the quarter). While the size is staggering, the return for the quarter was only 1.3%, hardly a worthwhile return considering what we now know to be the early second quarter risk.

Known use of derivatives

Based on what we have already learned or suspected, the London CIO office was not primarily focused on making money, but on hedging the bank’s credit exposure. As of March 31, 2012, JPM had a total credit exposure of $798 billion, up from $776 billion at the end of the year (again relying on the report to the SEC). At the end of the quarter the bank had credit derivative hedges just shy of $30 billion to hedge their perceived credit risks. Perhaps one clue to the mid-April to early-May large losses is that JPM had net credit derivative hedges of almost $11 billion against $22 billion of credit exposure to central governments. During this period, the news flow and foreign exchange rates were negative to many central governments.

Known unknowns

The media has reported that very senior officers of the bank, including its much respected CEO, were involved with twice daily conferences about this unfolding situation. Some were dispatched to London to personally get a hand on the situation. Various government agencies were alerted to the growing problem. One of the issues to be determined is why JPM’s vaunted risk control measures did not alert or stop the mounting losses. One report has as a contributing factor the switch to a different index as a benchmark. This change proved to be faulty, and there was a switch back to the previous indicator. The Financial Times reports the index used is the Markit CDX.NA.IG.9 which is comprised of 125 North American credits that were investment grade at the time of their inclusion in the index. The net notional value for the index has surged from about $90 billion to $150 billion at the end of April, according to the FT.

Conjecture analysis

Note that the notional value of the reputed index at the end of April was about $150 billion. The size of JPM’s credit exposure (excluding its exposure to central banks) is approximately $776 billion. If, as is believed, JPM was trying through the CIO to reduce its overall credit exposure, the near-term market was too small to accommodate a safe withdrawal. If a swarm of hedge funds saw one big insistent player on one side of the market (as was reported in the news media) they could profit by being on the other side, and make the exiting more expensive. I believe this is the reason why JPM will take its time exiting its position and possibly exposing itself to greater losses.

Unknown unknowns

Various politicians and media pundits are calling for increased capital rules and size restrictions. If they are successful, they may cause more rapid and for some, disastrous change. I believe that we are in an early stage of radically changing the financial structure of our world. I believe we have insufficient equity capital to create sound long term jobs, and this has been true globally for many years. Whatever progress that has been made is largely due to individual, corporate and governmental borrowing. The money has been borrowed from different elements of retirement capital at each level. The net result in the current periods of interest rate suppression is that current retirement capital is insufficient to pay for our longer-lived lives. Anything that raises the costs of banks will raise the cost of borrowing at all levels, impeding meaningful long-term job growth. Higher interest rates will drive inflation higher, particularly hurting the non-working retired population. Over the last several years we have paid this group low interest rates, and now when rates recover to something like a normal level, the inflation-induced, devalued currency will hurt their real spending power. We are creating two new economic class sub-sets: first, those that no longer are earning their keep and second, their grandchildren with large education loans. Thus, the issues surrounding the losses at JPM have wider impacts.

Investment Implications

1. As many of our readers are aware, I have a certain allergy to what I call crowded trades, where too many are trying to do the same thing at the same time. JPM is very much involved with a series of crowded trades. To some degree this fear, excluding the IPO dances, makes me more interested in smaller companies.
   
   
2. Our political leaders are trying to repeal history. Throughout recent times, certain banks have failed. Their failure hurts their equity owners, some of their debt holders and possibly some uninsured depositors. These are momentary disruptions in people’s lives and practices. But in almost every case that I am familiar with, new or expanded banks replace the failed bank. Society, perhaps wounded, progresses.

I will be completing my 200th blog post in early June. Are there are any particular topics you would like me to readdress in my weekend musings? If so, please email me early in the week with your thoughts.

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

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

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Lessons from Omaha and Louisville

Introduction

On Saturday there were two iconic events occurring in the heartland of America. In Louisville there was the 138th running of the Kentucky Derby, America's most famous horse race for three year olds. As regular readers of these blogs may remember, despite graduating from Columbia University, I count my two most important learning experiences the analysis of thoroughbred horses and my experience in the U.S. Marine Corps. One of the things that I learned from handicapping races was to select races that I could assess the critical elements of picking winning bets with some confidence. In terms of this year's Derby, the appropriate statement is, “I did not have a horse in that race.” There were 19 horses running. That the first two horses to finish had the smallest odds of 5 to 1 and 2 to 1, indicates that the betting crowds lacked confidence in their choices. (Often winning favorites have odds of 1 to 1 or lower.) The inability to pick winners and the lack of confidence shown by the crowd (or if you prefer, the market) are similar to the lessons learned at Berkshire Hathaway's (BRK-A),(BRK-B)annual meeting celebration.

The warm up

My wife Ruth and I were privileged to attend the Friday night dinner hosted by Charlie Munger for his large family and his friends, (mostly from his days of living in Omaha) and other well wishers. For those who don't know Munger, he has been Warren Buffett's business partner for at least 47 years. His training as a leading attorney combined with a wonderful laconic delivery of encapsulated logic has been something of a control rod to Warren Buffett's natural enthusiasm. Keeping with his tradition of few words, his remarks were brief and to the point and can be summarized as follows:

1. The decision as to the successor to Buffett is probably the most important decision of Warren’s life and probably will be one of his best.
   
   
2. For Berkshire-Hathaway, making the second $200 billion will be easier than making the first $200 billion.
   
   
3. The managers of BRK’s subsidiaries are an unusual circle of trusted associates unlikely to be found at any other company.

The main event

What one takes out of the six hours of questions and answers is very much dependent on what one expected. The media used the estimate that 35,000 attended the meeting, which is possible including the exhibition space with its closed circuit television. However, I am told that the main arena has only 18,300 seats. Early in the day almost every seat was filled. As the day wore on, particularly after the lunch break, there were many empty seats. Either the lack of significant news or the distraction of buying, at a discount, merchandise from Berkshire’s subsidiaries, partially emptied the main arena. Nevertheless, my son Steve and I found some of the afternoon answers to the questions of interest. In summarizing the lessons of the day, it may be useful to respond to particular types of attendees. For example:

• Those primarily interested in valuing the stock
  
  
• Analysts trying to model near-term results
  
  
• People who are interested in business principles
  
  
• Those who have political considerations

Valuing Berkshire Hathaway's stock price

There is a belief that the stock should sell at a price equal to an unidentified intrinsic value. A poor substitute for this would be book value. Currently the company has announced a policy of buying back the stock at 110% of book value, (it believes the stock is undervalued by book value). For instance, BRK’s auto insurance company, GEICO, is being valued at $1 billion over its historic cost. The intrinsic value for that company is the firm's current book value plus the size of its float. Management stated that it would not accept a bid with a $15 billion premium over GEICO’s carrying value .

Analysts trying to model near-term results

With the exception of the housing-related operations, operating earnings are up at Berkshire-Hathaway. The current level of float is approximately $70 billion. Buffett and Munger are warning that the float is unlikely to rise further. Over the next ten years, it is possible that Berkshire’s utility operations and probably the railroad (Burlington Northern) will need additional capital of $100 billion combined. Creation and management of float has been one of the keys to the firm's success. These concerns led to a decision not to go forward with a possible $22 billion acquisition. If they did do this particular deal, the transaction would have forced Berkshire to sell some securities, either owned or to be issued, which management did not want to do. There is a desire to maintain a reserve of at least $20 billion for all possible opportunities and contingencies.

Todd Combs and Ted Weschler, the two internal investment managers had $2.75 billion each to manage as of the end of March. Each has a base salary of $1 million and an incentive on the excess return in which he would get 10%; 80% based on his own performance and 20% based on the other manager's results. This is similar to the arrangement BRK had with the former CIO of GEICO. (The company does not use compensation consultants or have a standard compensation plan for their operating executives.)

Business principles

There is a recognized risk of getting too big to manage effectively. Buffett and Munger believe they are pioneering with an uncoordinated holding company approach. Even with their various insurance companies, they do not attempt to coordinate their risks. The use of mathematical measures of market price risks is not believed to be prudent or realistic. Barriers to entry are critical for them in their acquisition and business planning. They do not believe in erecting barriers, but buying them. In their mind, a brand is a promise.

National (political) policies

Judging by the sound of applause, a large number of the audience were opposed to the popular understanding of the so-called "Buffet Rule." Some believed that his pronouncements have hurt the stock and are causing the stock's price to be below where it would normally trade.

Because of the current US interest rate repression that is likely to lead to inflation and higher interest rates, it was suggested that investing in medium and long-term bonds should be avoided. Instead of investing in developing more US-based oil and gas, the United States should import as much as possible, just the opposite of energy independence.

More reactions are available to members of this blog community by emailing me specific questions.
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When will Long-Term Prices for Gold and Natural Gas Go Up?

Introduction

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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I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

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Value Trap by the Book

Introduction

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

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

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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:

Taxes

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.

Technology

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.

Coal

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.

Nuclear

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?


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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?



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

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of MikeLipper'sBlog.Blogspot.com