Tag: davidson

NY Times 2002 Piece on Lampert

Post author By ToddSullivan
Post date April 2, 2009
1 Comment on NY Times 2002 Piece on Lampert

This is interesting. Thanks to “Davidson” for emailing the article. Sorry but do not have original link to the article on Sears Holdings (SHLD) Chairman Eddie Lampert.

Personal Business; Big Returns, Minus the Pleasantries

By GERALDINE FABRIKANT

Published: February 17, 2002

HE is known as secretive, controlling and so impatient for success and obsessed with work that some who know him say he takes little note of people unless he needs them.

Warm and fuzzy Edward S. Lampert is not. But that has not seemed to matter. Mr. Lampert, a 39-year-old money manager, has scored an extraordinary 14-year record of value investing, with an average annual return of 24.5 percent. The 2001 performance of the ESL Partnerships, a group of hedge funds he controls, was particularly stunning: it soared 66 percent as the Standard & Poor’s 500-stock index sank 13 percent. Even after the typically high hedge fund fees, his investors had a 53 percent return.

He has attracted a host of superwealthy clients over the last decade, including David Geffen, the media mogul; Thomas J. Tisch, a son of Laurence Tisch, the co-chairman of the Loews Corporation; Michael S. Dell of Dell Computer; and Ziff Brothers Investments, the principals of which are the sons of the publisher William B. Ziff Jr.

”Eddie is probably the best single money manager of his generation, but he has never thought that a great bedside manner in investing was the No. 1 thing,” said Richard Rainwater, the Texas financier. In fact, Mr. Rainwater, one of his first big backers, had his own run-in with Mr. Lampert years ago.

Mr. Lampert is dismissive of the criticism. ”Our focus has been first and foremost on earning returns for our partners,” he said.

His dazzling returns have come from a high-wire act of intensely heavy concentration in a handful of companies and of betting for the longer term. Currently, 85 percent of the $5 billion that ESL invests is in just eight companies. He has avoided Internet stocks and other fads over the years and has instead sought holdings in more mundane companies like AutoZone, a car parts retailer, and the Deluxe Corporation, a check-printing and electronic payment services concern. During the 1990’s, his fund made killings in American Express and I.B.M.

Because of such heavy concentration, poor performance of a single stock can drag down total returns, and selling out of such illiquid positions can be tough. But, he said, ”If you have just 10 names and one blows up, you have less risk than if you are highly leveraged and you don’t really understand the other companies well.”

Clearly, he has made it work. Since he started his fund business in 1988, he has had returns there that are nearly double the 13 percent of the S.& P. 500, according to company documents obtained by The New York Times.

”There are very few investors who have done that over time,” said Jeffrey Tarrant, the founder and an advisory board member of Altvest, which tracks hedge funds.

Even last year, when short-selling funds did well in a falling market, his returns came from plain-vanilla, long-term investing, though his hedge fund can go short, or bet on market declines. In 2001, ESL trounced the CSFB Tremont hedge fund long/short equity index, which fell 3.65 percent.

IN the tightknit world of money managers to the superrich, Mr. Lampert is watched closely but is hard to follow. Until he has to file public documents after acquiring more than 5 percent of a company, he is reluctant to share information with even some of his highest-profile investors, like Mr. Tisch and Mr. Geffen.

That is noteworthy, given that both are longtime investors, that Mr. Tisch is a friend as well, and that Mr. Geffen’s $200 million investment in 1992 helped put Mr. Lampert on the money management map.

In an interview in his low-key suite of offices in Greenwich, Conn., where he works with a staff of 15, Mr. Lampert said: ”I tell people in advance what our practices are. If they don’t like those practices, they have a choice not to invest.” He is extremely proud of — some say arrogant about — his track record, which he likens to that of the basketball superstar Michael Jordan. ”People keep criticizing him,” Mr. Lampert said, ”but he keeps winning.”

For the privilege of riding along, ESL investors are asked to put up at least $10 million. They must pay a 1 percent management fee and 20 percent of profits — standard requirements for hedge funds, those investment vehicles for institutions and the superwealthy. They must also agree to lock up their money for at least five years — a highly unusual requirement. Most hedge funds allow annual withdrawals.

The lockup provision has discouraged several foundations from putting money into ESL, according to one hedge fund manager who serves on some foundation boards. But it has not deterred a host of sophisticated investors. ”You know your money is tucked in safe every night,” Mr. Tisch said. ”You know it isn’t chasing some silliness. He’s investing with solid, proven principles.”

The five-year lockup ”gives us time to build and to exit a position without having to worry about investors forcing liquidations,” Mr. Lampert said. ESL has kept its most profitable holdings an average of four years, qualifying them as long-term gains for tax purposes.

Mr. Lampert began requiring the lockup after his only down year: in 1990, investors lost 16 percent. Mr. Lampert had bought stock in the middle of the year, though by December the market had plunged. ”It was terrible,” he recalled. But for investors who stayed, the fund soared 56 percent in 1991. That underscored for him the value of having capital locked up through weak periods.

AutoZone was the big payoff last year. It also reflects another of his tactics — an increasingly active role in companies in which he invests. Attracted by AutoZone’s cash flows, brand name and low profile on Wall Street, he began acquiring shares in 1997. For two years, the stock barely budged, but Mr. Lampert kept buying. In mid-1999, James Hedges IV, a hedge fund consultant and a mutual friend of Mr. Lampert and AutoZone’s founder, Joseph Hyde III, arranged for them to meet.

Mr. Hyde recalls vividly the lunch at his 600-acre ranch, WildCat, in Aspen, Colo. ”He had visited our stores, talked to management up and down the line and knew everything — far more than most money managers,” Mr. Hyde recalled. ”Most investors talk to management and that’s it. But he had a fanatical awareness of the company.”

(The scrutiny continues: A report sent to shareholders in 2001 states that ESL employees had visited or spoken with people at 690 of the more than 3,000 AutoZone stores.)

In 1999, Mr. Lampert, who then owned about 15 percent of AutoZone stock, also gained a seat on the board. He believes that board membership allows him to participate in discussions of important decisions.

A year later, the board put in a poison-pill provision that would have been set off had he increased his stake. He fought it, and the board backed down. The poison pill was rescinded and the chief executive, John C. Adams, resigned. Mr. Lampert led the committee that in early 2001 brought in Steve Odland, an executive at Ahold USA, the subsidiary of the Dutch company. Under Mr. Odland, AutoZone increased its gross margins by two percentage points in the most recent quarter, ended Nov. 30.

For most of last year, ESL had 30 million shares of AutoZone, or 27.8 percent of the company. In that time, the stock more than doubled in value.

THERE have been disappointments, too. For example, Mr. Lampert holds 12 percent of Payless ShoeSource, the shoe retailer. Its stock fell from $70.75 a share at the end of 2000 to $56.15 at the end of 2001, dragging down Mr. Lampert’s investment by 20.6 percent, to $153 million. The shares closed at $56.94 on Friday.

A small investment in the ANC Rental Corporation, the parent of Alamo Rent-a-Car and National Car Rental, ended badly when the company filed for Chapter 11 bankruptcy protection in November.
The son of a lawyer and a homemaker, Mr. Lampert grew up in Roslyn, N.Y., on Long Island. The family lived in middle-class comfort until he was 14, when his father died of a heart attack. Mr. Lampert says the death put financial pressure on the family and is partly responsible for his relentless drive for financial security.

He became interested in investing during visits to his grandmother’s home in Miami, where they would study the stock market together. ”She owned a handful of stocks,” he recalled. ”I.B.M. and AT&T. She always wanted a good dividend. In her simplicity, she was profound.”

Mr. Lampert said his grandmother, who did not have much money, invested as a hobby. ”I thought she was good,” he said, ”but I never calculated her returns.”

At Yale, he majored in economics, and, contrary to his mother’s wishes, he decided to skip law school.

Early on, he showed great skill at cultivating powerful people who could help him move ahead in the elite world of finance. One story, in particular, has long made the rounds. While at Yale, he managed to snare a summer job at Goldman Sachs, and pursued an acquaintance with Robert E. Rubin, then head of risk arbitrage there. One day, Mr. Lampert offered to help carry his heavy briefcases to a rental car, gaining the ear of his quarry. He ultimately landed a job in the risk arbitrage department.

In a recent phone interview, Mr. Rubin, who later became Treasury secretary in the Clinton administration and is now chairman of the executive committee of Citigroup, said he did not remember the incident but did not dispute it. He said he did recall thinking: ”Eddie will go out on his own one day. He won’t stay at Goldman Sachs.”

Though some associates regarded such efforts by Mr. Lampert to parlay connections into cash as distasteful, Mr. Lampert counters: ”I want to be with people who can challenge me to be better.”

It was while he was at Goldman that Mr. Lampert met Mr. Rainwater, famous in the investment world for managing the Bass brothers’ fortune through the early 1980’s. He and Mr. Rainwater were introduced by mutual friends on Nantucket in 1987, and Mr. Lampert made sure to stay in touch.

In 1988, he left Goldman to work with Mr. Rainwater. His drive was evident. Over the summer, again on Nantucket, Mr. Lampert almost never left Mr. Rainwater’s house, Mr. Rainwater recalled. ”He slept in the room, ate in the room, never went to the beach, never saw the beach,” Mr. Rainwater said. ”I don’t think he ever went out to dinner with us.”

Mr. Rainwater backed his protégé by putting up the bulk of the $28 million in Mr. Lampert’s first fund, which the young investor ran from Mr. Rainwater’s Fort Worth office. Mr. Lampert was focusing on risk arbitrage and value investing. But after just a year, the strong-willed men clashed when Mr. Lampert wanted more control over what types of investments he could make. At the time, associates say, the parting was extremely acrimonious, and Mr. Rainwater withdrew his money.

In 1992, after a few more years of working in Texas, Mr. Lampert moved to Greenwich, at the urging of Mr. Geffen, whom he had met through Mr. Rainwater. ”David told me I needed to get a life,” he recalled.

But Mr. Lampert’s obsessions went with him. According to several people who have worked with him, he still works nonstop and makes all the decisions himself. One former employee said, ”Even if you presented a research report and he could not punch holes in it, he would not buy it.”

Mr. Lampert concedes the point. ”Most of the ideas come from me,” he said. ”I am the only person who has the ability to allocate capital.”

He also exercises very tight control over compensation, a former employee said. ”You were expected to work hard to make him rich,” he said. ”Bonuses were discretionary and Eddie was pretty moody, so you never knew how you would come out.”

Mr. Lampert seems to have come out fine. Though he declined to discuss his personal finances, several people who know him say he is worth $700 million or more. He has a home in Aspen and a sprawling estate in Greenwich, where he and his wife, Kinga Lampert, were married last summer.

Several hedge fund managers say the compensation arrangements for members of his staff are a bit controlling, but Mr. Lampert says they are more than fair. While employees are not pressured to invest in the fund, ”they were just prohibited from investing anywhere else,” he said. That, he said, could work to their interest.

Employees are not the only ones who can be put off by his style. One veteran money manager described a social lunch several years ago: ”He picked my brain on stocks, but offered nothing. The next time, I decided to talk about fishing until he offered something. So we never got past fishing.”

EVEN had Mr. Lampert been forthcoming, his investment strategy might have sounded deceptively simple: sticking to the basics. Because he tends to take large positions, each stock decision is crucial.

He studied the Internet but avoided the sector despite its wild run-up: ”Most businesses, as they grow, have a model where they make more money as they get more customers. Internet companies seemed to lose more money as that happened.”

He also does not like what he calls ”the vision thing.” ”Average investors like themes,” he said. ”A lot of times you pay a high price for the vision, and you can lose 80 percent of your money.”

Mr. Lampert also shies away from capital-intensive businesses. He says he believes that Intel, the computer chip maker, ”is a terrific business, but for it to exist, it has to keep feeding more and more money in, and it needs to be right when it does it.”

”If it is wrong,” he added, ”that will be a huge problem.”

He doesn’t like convoluted financial statements. Even when Enron was soaring, Mr. Lampert said, he was not interested. ”Complex financials don’t necessarily mean there is something wrong,” he said. ”But if you don’t have a clue, why invest?”

Grandma would have been proud.

Disclosure (“none” means no position):Long SHLD

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Wicksell Rate Says Buy..

“Davidson” submits……

It is useful for value investors to see how this may be applied when investing in common stock as it reveals that the markets do indeed arbitrage with the principle of Relative Returns. For the many who have attempted the use of simple relationships, i.e. P/BV, Market Cap/GDP, P/E this will appear overly complicated, but I do not apologize. I only observe that the world of capital requires adjustments to valuation so that a competitive return can be had.

The basic formula is the long term Real GDP + adjustment for inflation = Wicksell Rate(proposed by Knut Wicksell in 1898).

In reality this comes down to using the Dallas Fed 12mo trimmed mean PCE as the measure of core inflation and for US investors the Real US GDP long term trend which today sits at 3.16% and over the next 10yrs will fall to 3.15% based on 80yrs of history. Based on the Feb 2009 Dallas Fed PCE release of 2.2%, the Wicksell Rate at the moment is ~5.4%. This is the moving Wicksell Rate(Capital Return Benchmark) that essentially rises and falls with core inflation while Real US GDP does not vary very much for 5yr forecasting purposes. This approach is not for next quarter’s GDP or even next year’s GDP as we all know that no one has ever forecasted these levels with precision. However, IF WE KNOW WHEN THE MARKET IS OVER VALUED OR UNDERVALUED VS. THE WICKSELL RATE, WE CAN KNOW WHEN TO COMMIT FUNDS AND WHEN TO REMOVE FUNDS BASED ON RELATIVE RATE OF RETURN.

In using this approach one needs to be cognizant that psychology plays a significant role in market valuations for periods as long as several years. I call attention to the sell signal given when the SP500 return fell below that of the Wicksell Rate in 1997 and did not provide a buy signal till August of 2002. In general this valuation approach would have sold during periods of excess valuation and bought only after corrections had mostly run their course. The fact that it resulted in a buy signal just prior to the Fall 2008 collapse demonstrates that when market valuation rules change so does the ability of the market players to know where the values are in the market place. They just sell out and wait for the dust to settle. This was the stark effect of imposing an artificial price-based Mark-to-Market valuation methodology to securities known to be of much higher quality than those prices reflected.

The other half of the process, i.e. developing a reliable forward return for the SP500, requires the knowledge that 1) SP500 ROE has been surprisingly steady at ~14%, 2) SP500 BV has had surprisingly growth of ~6% since 1978 and the SP500 represents ~90%+ of US market capitalization. Together, these facts let us assume that the next few years will run along the same trend. This method is to divide the 2yr forward SP500 Book Value into the current SP500 Index Price and multiply this by the ROE to get a measure of how much of this ROE the investor receives at the current SP500 Price level. The 2yr number is based on the rational that Value investors look at least 2yrs into the future.(Value investors are not traders) The calculation looks like this:

(SP500 Price)*(SP500 ROE Trend of 14.2%)/(2yr Forward SP500 Book Value) = 2yr Forward Return at the Current SP500 Price Level

This proves that the market does have a rational Relative Return process at work. It also proves just as simply that regulations and psychology can tamper with the relationship over shorter periods such as the one we find ourselves in today.

The current market is an extraordinary buying opportunity!!

Disclosure (“none” means no position):

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Is Case-Shiller Flawed??

“Davidson” makes the case that it is indeed flawed analysis….

Robert Shiller has made quite an impact with his various appearances in the media and his active financial consulting business heavily promoting his negative market views. I downloaded his spreadsheets with the goal of understanding his views better, but was surprised to discover serious errors in his approach. I start with his analysis of the housing data and then follow with his view of the SP500.

This is an analysis of Robert Shiller’s data downloaded from his site with out modification. His chart is inflation adjusted Housing Prices in arithmetic format. My chart below is of his Nominal Housing Price Index in semi-log format.

Price/time series of this type require semi-log analysis and clearly reveal that conditions over the series are non-uniform. The point to make with this comparison is that Prof. Shiller draws conclusions regarding housing trends from 1890-Present (Chart 1) treating the period as if the conditions affecting housing prices had been uniform. My chart below Chart 2) provides a clear indication that this is an erroneous supposition as the pre-1933 environment greatly differed from the post-1933 environment. Namely, the Banking Act of 1933 and the Glass-Steagall Act provided improved financial stability which led to a ~300% growth rate in the housing index post-1933 vs. pre-1933. No analytical method can make a valid combination of pre-1933 data and post-1933 data and hope to come to conclusions with any validity.

Prof. Shiller’s housing forecasts are simply meaningless based on the data he presents.

Chart 1: Shiller’s Inflation Adjusted Housing Index Chart arithmetic scale

Chart 2: “Davidson’s Chart of Shiller’s Nominal Housing Index in semi-log format.

Next I turned to Prof. Shiller’s analysis of the Inflation Adjusted SP500 Index and again compared his chart (Chart 3)analysis vs. the proper semi-log format unadjusted SP500 Index(Chart 4). Prof. Shiller draws conclusions and makes forecasts based on the SP500 Inflation Adjusted chart below. He assumes that uniform conditions applied throughout the period. This is shown to be a very simplistic and incorrect assumption by observation of my semi-log non-inflation adjusted plot of the SP500 below. Pre-1933 and post-1933 environments are readily observed. Again one cannot combine the pre-1933 period with the post-1933 period as he has and make any intelligible analysis much less a valid forecast.

Note that the SP500 grew ~400% faster post-1933 when compared to the pre-1933 pace.

The greatest difference in both instances of Shiller’s analyses is that the laws enacted in 1933 to protect the US financial system, greatly reduced the rate of bank failure post-1933 and the subsequent capital destruction. Prof. Shiller has failed to recognize this in his assumptions that conditions remained uniform throughout the period of his analyses. He needs to reassess his approach.

Chart 3: Shiller’s Inflation Adjusted SP500 Index

Chart 4: “Davidson’s SP500 Index unadj. From Shiller’s Data in semi-log format.

I believe Prof. Shiller’s work by this simple analysis is revealed to be considerably flawed.

Humbly submitted,

“Davidson”

Disclosure (“none” means no position):

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Historical Look at S&P Book Value

Post author By ToddSullivan
Post date March 13, 2009

According to everything I am finding, we are way oversold long term. Now, that does not mean run out and blindly get yourself fully invested. We can also stay this was for a very long time. It does mean for the patient investor the are bargains out there..big ones…

Take a look at this chart (click chart for larger version):

“Davidson” submits:
The value to using this is to know that the average ROE for the SP500 is ~14% with about 57% of earnings paid out in Dividends and ~43% being reinvested. This provides for a Book Value growth rate of ~6% which has been remarkably consistent and in line with the SP500 earning’s chart showing the remarkable consistency of our economy. Knowledge of this consistency becomes a tool for the value player.

What you do is to convert the P/BV into a ROE to the investor. On 3/6/2009 the P/BV was 1.2 which converts to 14%/1.2 = ~11.7% return for investors who buy the SP500. Then, what must be done is compare this to the Wicksell Rate which is 5.4% today and falling.

“Wicksell Rate” explained here

You can look at this discrepancy as Buffett would and simply say that you are buying an 11.7% yield in a long term 5%-7% SP500 return range. The current SP500 provides sizable upside if inflation remains low. The lower the inflation the higher the SP500 valuation will be in the future during normal times.

For example:

If inflation is 1.8% the Wicksell Rate will be ~5% and the SP500 will reach about 20 P/E. If inflation drops to 1% then the Wicksell Rate becomes ~4.2% and the SP500 could reach ~25 P/E. You can also have inflation move in the opposite direction and should it move to 3% the Wicksell Rate will be ~ 6.2% and SP500 would price near ~16 P/E.

What permits an investor to enter the market during times of distress such as these is the knowledge of economic history and the trust that the growth of our economy is inherent within the free nature of our society and will continue in the future.

This is one instance in which knowledgeable investors expect history to repeat itself.

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Sentiment and Investing in The Depression & Today

Post author By ToddSullivan
Post date March 11, 2009

An interesting point on how investor sentiment has always overshot to the downside.

“Davidson” comments on the following chart”

Here is the SP500 from Dec ’27 to Dec ’49. The P/E and EPS are included. The change in psychology from Sept 1929 to June 1931 was much greater than the $1.60 per share to ~$0.50 per share earnings drop. Psychology has always had an enormous effect on market prices and true Value Investors utilize this knowledge to their advantage. Most available data bases do not go back beyond the 1960’s as the data reliability is not guaranteed.

(This chart is constructed from data extracted from older SP500 sources and likely does not conform to modern accounting standards. The relative perspective is useful just the same.)

From 1929 to 1931, the S&P Earnings dropped 37% yet the value of the S&P dropped 85%. Simply said this means investors were over twice as pessimistic about US business then what the reality of them actually was.

Another interesting point is the 1931-36 recovery. Note the PE skyrocket up ahead of the market. It is clear investor sentiment turned positive BEFORE the actual earnings of the S&P did. Notice from the chart earnings stays flat until essentially 1934 while the market has a massive rally. So, great you say, what does it all mean?

It means the market bottoms before earnings do and then rallies before they rebound due to sentiment. So, then, where are we now with sentiment? I am using modern numbers because to the best of my knowledge there are no “sentiment” readings from the 1930’s other than market results (if anyone knows that there are, please let educate me).

Link to chart data

We are now more negative than the last two recessions (with reason). Those low readings eventually gave way to the 1990’s and 2002-2008 bull markets.

We can go back to a post I did last week regarding cash vs. the S&P. It shows just how pessimistic people are. Money sitting in the bank right now in Treasuries in earning essentially nothing. This, for the majority of people is preferable to the “expected” losses they assume in the market. It also is tremendous fuel for the fire once that sentiment changes and, yes it will. The current situation is not even as bad as 1980-81 much less 1929-31. The US economy and the market both came back from those periods and will again.

Now, the trillion dollar question is “when?” Again, I do not make “bottom” calls but I feel there is a large swath of the market trading at “eventual destruction” valuations. I also know people are of the mindset the world, while not quite ending is racing towards depression. With the ammunition sitting there to buy equities present, when the depression does not occur people will tired rather rapidly of earning nothing on cash in the bank or in US Treasuries and will want a higher return in the market from equities again.

When they do, the floodgates will open..

Disclosure (“none” means no position):

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Watching Mr. Copper

Post author By ToddSullivan
Post date March 10, 2009

This goes to recent statement from other industrial producers…

“Davidson submits”

Keep an eye on “Dr.Copper”.

Dennis Gartman, Doug Kass and other traders focus on this for fundamental changes in the direction of the markets. The cost of production is variously pegged between $1.50-$2.00lb with $1.75lb often mentioned. Copper being fundamental to the transfer of electricity for buildings, machinery, transportation and construction is often used to signal changes in economic activity and has the moniker “Dr. Copper”.

Copper’s trend as reflected in Freeport McMoran (FCX) and the commodity appears to have begun a new uptrend. This bears watching.

My Thoughts (not Davidson’s):

“Inventory destocking” has been a theme lately. The trend (running inventories to very low levels) has destroyed earnings for chemical producers like Dow Chemical (DOW), BASF (BASF) and caused commodity prices to plummet (people who are not producing things aren’t buying the ingredients).

Data like this also suggests when the global economy turns (there is evidence the free fall is abating) with inventory levels next to zero, we could see an explosion of orders and manufacturing activity. China has a stimulus package it enacted that is building everything under the sun and the US one, while diminutive in statue (and eventual effectiveness) will increase activity here somewhat.

Disclosure (“none” means no position):Long Dow, none

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The "Wicksell Rate" Explained

Post author By ToddSullivan
Post date March 8, 2009

I had several folks wonder what this was when it was first discussed here

“Davidson” submits:

One of the most difficult tasks one can have is to find a proper method of valuing the marketplace as so many competing methods are offered. I have looked to basics and once I learned of Knut Wicksell, much became clear.

My view which has developed over the years is that capital returns follow the Wicksell Rate which was first authored in 1898 by Knut Wicksell. This rate is the US Real GDP Trend + the trimmed core PCE (core inflation rate as run by the Dallas Fed). Written as the formula:

Real US GDP(long term trend) + 12mo trimmed mean PCE(Personal Consumption Expenditure per Dallas Fed) = Wicksell Rate

All long term returns arbitrage about this rate but with considerable deviation due to market psychology (Chart Below) and earnings swings. Long term this should be about 5% if inflation is kept between 1.5%-2% and equates to a 20 P/E on the SP500. The emergence of inflation can substantially depress P/E’s regardless of the strength or breadth of earnings and represents the greatest risk to undiversified portfolios. The Dallas Fed has information on Wicksell.

Coming to terms with periods of economic distress and the associated market declines can in my view be greatly fortified by looking at some of our economic and market history.

US Real GDP (Chart Below) shows just how resilient the US economic system has been over nearly 80yrs. There have been seemingly catastrophic events, i.e. Herbert Hoover followed by FDR, WWII, Kennedy’s assassination, rampant inflation, Richard Nixon followed by Jimmy Carter, “Death of Equities”-1982, Crash of 1987, Crash of Long Term Capital, Crash of the Russian and Asian currencies, Crash of the Internet Bubble and more yet we have ALWAYS snapped back. Note that in the early 30’s with 4 weak years we had 4 quite strong years so that the avg. US Real GDP trend has been in fact a fairly smooth procession from a smallish economy of ~3.9% to the one we have now of ~3.2%. I think you can rely on the fact that our society’s productivity has had resiliency that is basic to our system of government. I do not think that we have destroyed US productivity in our current situation. In fact the evidence suggests that productivity has improved. I for one trust that we will return to the normal trend in a couple of years including a few years better than 3.2% to reestablish the long term trend.

Turning to the SP500 chart(Below) note the earnings trend of ~6.1%. I observe that Greenspan’s tenure has resulted in higher than normal earnings volatility vs. Paul Volcker. Although I did not draw it on this chart, my previous trend had been slightly below 6% before I recently added on the last 5yrs of earnings. It would appear that as technology has entered our economy’s various nooks and crannies we have been more productive and our earnings from our existing capital has risen some what.

I view the earnings in 1974, 1982, 1987, 1990 and 2002 as low points. We are close to comparable low earnings levels today. The market psychology today is comparable with similar media headlines of crisis and fear of Depression. However, we have avoided Depressions since the 1940’s due to the Federal Reserve acting as a financial shock absorber thus giving our society and economy financial breathing space to adjust to new conditions. This is why the US Real GDP has had decidedly much less volatility over the years as the Fed has exercised its financial cushioning actions. I estimate the current Standard Deviation at +/- 2.4%. This is well below what we had experienced in the ‘30’s of +/- 14%.

Yes, we may see lower earnings than we have seen, but historically most of the damage is done in my opinion. The Fed has loosened the purse strings forcibly and in multiple modes. So that, even though the media argues in the same fashion as in the past that the Fed either has not done enough or not done it the “Right” way, the end result is that the Fed has acted forcibly and our economy remains free to sort out the process of recovery. I have sent you several studies that indicate the early stages of recovery are with us.

The advice I provide is also based on that proffered by some of the greatest investment minds of the last 50yrs, i.e. Warren Buffett, Bruce Berkowitz and many more too numerous to list. A continuous process is in use in my office to assess the current insight of the most astute investors which I believe to be extraordinarily helpful

The advice to add REITs( see 5th Chart), Nat. Res and EmgMkts as part of a balanced portfolio is based upon the longer term observations of US economic strength and history as well as other observations as noted above. The use of the Wicksell Rate and the 5yr MovAvg Return/Risk analysis( 4th Chart) is helpful to determine when asset classes evolve to carrying higher levels of risk than is appropriate. Today this means to avoid Treasuries. Berkshire’s (BRK.A) Warren Buffett just called Treasuries a “Bubble” in his latest Chairman’s Letter. A comparison of Treasuries with the current 5.4% Wicksell Rate confirms this view.

The reason for being in most available asset classes(but for Treasuries) today is simple. They all appear relatively cheap. To try to focus on one or another using an expected return is difficult. You can be right on the earnings trend, but if the market cares more about another area you will not be rewarded with expected gains. Psychology plays a huge role in all markets as most market players are trend followers. In my opinion they are “Players” not “Investors”.

Disclosure (“none” means no position):none

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Lack of Clarity Into Selling Causing Fear

Post author By ToddSullivan
Post date March 6, 2009
2 Comments on Lack of Clarity Into Selling Causing Fear

“Davidson” makes a great point here. Things are getting a bit overdone here and the “who is selling and why” questions are the cause.

Todd,

The current selling is pushing the SP500 down to 1xBV (~550). This occurred in 1974 and 1982 when the Wicksell Rate was ~14%(3.2% Real US GDP + 11% core inflation) and represented realistic pricing of the earnings yield for the SP500. Today, we are priced at ~10% on reduced ttm SP500 earnings in an environment of a 5.4% Wicksell Rate. This is equivalent to a Real Rate of Return for SP500 of 7.5%(10%-2.4%). This figure is at a historically high level for an inflation adjusted return back through the 1940’s.

To throw out basic financial reasoning and pricing that has been in place for ~70 years as we have done today, means that some one with little discipline is selling portfolios wholesale. I suspect foreign sellers who have used too much leverage are now delevering. Our markets have no transparency to this and are trying to make sense of something for which we lack adequate information. We are trying to garner information from price movements and making many, many wrong assumptions about risk that is not likely present. GE (GE) is a prime example.

GE’s Sherin noted that $35mil of trades over 2 days caused the fear that forced GE to lose $21bil market cap this week. GE has taken an extraordinary step to open up the books later this month to show all that they do not have the issues rumored in the market. But, note that there is great leverage in the CDS market when $35 mil can be levered into a $21bil move. That is a 600 multiplier.

I believe that GE’s Immelt is an extraordinary astute and honest manager. The insider buying in this company is so high at this time that the term “of historical proportions” does not express the true meaning. I was once a GE insider and I know the culture. It is much, much better now than when under Welch and in sound hands in my opinion.

I think we are seeing much selling from sources not transparent to us and attributing this to some one knowing more than is widely available. This is the “Boogy Man in the dark room” syndrome. If we had a benchmark which is not susceptible to emotional pricing, then we could fairly compare returns on all assets and then discount for financial risk rather than be in this overblown panic. I propose the Wicksell Rate which is based on longer trending economic fundamentals and not subject to emotional volatility.

At the current level the SP500 provides extraordinary returns. I think we are seeing liquidation by foreign companies that took cash on the books and traded it in our markets to boost earnings. This occurred during the “Japanese Bubble” and was known to have been going on with the recent boom. It is my belief that these corporate treasurers are panicking and selling to recover much needed cash.

I would be buying with cash in both fists if I were not already in. Perhaps the world should step back from the precipice and see the current activity as crazy and go in the opposite direction.

I have sent you a chart via another email of the Percentage of MM Funds vs. MM Funds and Corp Equities. The panic is clear.

“Davidson”

Here is the chart:

Disclosure (“none” means no position):Long GE

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Articles

Should We Apply Wicksell Rate to Monetary Policy?

Post author By ToddSullivan
Post date March 2, 2009

“Davidson” took a stab at having an influence with the Dallas Fed using their own published data and their statement that Wicksell is the “Father of Modern Monetary Policy”. The following letter was sent..

To whom this may concern:

Below you will find a comparison of what I call the Wicksell Rate based on Knut Wicksell’s observation that the cost of capital is arbitraged on the Return of GDP vs. comparable fixed alternatives, namely the 10yr Treasury Note. I took the Dallas Fed trimmed mean12mo PCE values and added these to the long term trend line of the Real US GDP(2nd Chart) to produce the Wicksell Rate(1st Chart). The reason for using longer term trends is that business investors typically make capital commitments with 10yr time horizons and ignore year to year fluctuations.

I think this comparison helps to differentiate the enormous short term effect of market psychology which can be observed in the multiple deviations reflecting both periods of enthusiasm and gloom. Net/net the proper relative return relationship holds over long periods. Perhaps, one will find a better fit with changes in tax treatment of capital gains, but I am a lone practitioner and have neither the resources nor the time for extensive analysis.

I note that a better alternative for making the same point which would strip out the economic swings of earnings (because the market does look ahead on the expected returns on assets) is to use a 5yr MovAvg ROE for the SP500 and its P/BV multiple thus producing a ROE/(P/BV) = hypothetical Asset Based Return Yield.

Not all returns come from earnings. For instance, oil companies and real estate companies have asset gains due to inflation which are eventually converted to earnings at some point in the future in the form of higher rents or asset sales. This is less true of companies like GE and PG which have finished products with rising cost inputs but do not have the ability to convert the rising cost of production (rising value of factory equipment) into higher margins during inflation periods as do oil and real estate based businesses. The problem with this approach is that SP500 has to my knowledge stopped issuing BV information as it is deemed unreliable as a financial indicator. However, I think that as a gross measure of the asset base of the economy, I have seen from Ned Davis Research an avg 14% ROE and ~6.1% BV growth rate which is much smoother than the ~6.1% earnings trend you see below for the SP500(3rd Chart).

The point to be made is that Knut Wicksell had the correct observation in 1898 even though the tools for proving it were not available till much later. By using his observation a less volatile monetary policy should produce a less volatile economy, less volatile inflation, fewer economic headaches and Federal Reserve decisions with substantial genius.

It is clear to me that the activities of the Federal Reserve have proven to have been since the US Real GDP trend from 1930 very beneficial as a shock absorber. However, under the Greenspan years the availability of cheap money followed by comparable contractions has resulted in higher corporate earnings volatility(see 3rd Chart Earnings Trend Line)

I ask that you consider using the Wicksell Rate. I ask that you publish this for all to see so that corporate and investment decisions can be made with greater long term clarity. My suggestion is that in the current environment an immediate implementation would be disruptive, BUT, if you were to announce that you were going to work towards implementing Wicksell Rate as a policy over the next 5yrs-10yrs, I believe you would bring great clarity to many financial decisions as well as give all a period in which to make adjustments that would not be unduly disruptive. Importantly this would result in far less speculation as returns would have to breach the Wicksell Rate and all would realize that the cost to doing this would be considerably higher than with funds much lower. Perhaps it would also be helpful to dampen rampant speculation that the Federal Reserve promote the concept of “matching maturities” when investment commitments occur and recourse as opposed to non-recourse financing.

I think some of these suggestions would result in higher levels of individual discipline and common sense.

Humbly submitted,

“Davidson”

Disclosure (“none” means no position):

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Articles

"Davidson": Traders Rule the Moment

Post author By ToddSullivan
Post date February 24, 2009

He has a very valid point, there is no talk of valuation out there currently. That both creates tremendous markets swings and for the patient of us, tremendous opportunity.,

I thought that these charts (below) told the story of the credit freeze. I think the Traders rule at the moment. Valuation for the moment does not carry much weight. The forecasted earnings yield of ~8.6% 12mo forward for SP500 seems to stimulate some to forecast worse earnings than this in order to get their 20 secs on CNBC. I interpret these charts to indicate that it appears that earnings are forecasted to be well below the long term trend. I do have a chart that takes the earnings trend back to the late ‘40’s with what appears to be the same variance within the same channel at ~6% compounded for the entire period. Today forecasts are well out side the historical range.

To get a similar collapse of valuations in the past required a high rate of inflation, 1974 and 1982 both had 7 P/E’s and 12%-14% earnings yield range. This was required. I have observed that since 1978 when we have reasonably good data that the market requires a return that provides just over 3% Real Rate of Return. In 1982 with core inflation (see Dallas Fed trimmed mean PCE data 1982 inflation at ~9%-11% + ~3% Real Rate of Return = 12%-14%) in the 11%-12% range the SP500 earnings yield was in the 12%-14% range.

Over the past few months 12mos forward earnings yields have ranged over 11% to the current ~8.6%. The market appears to be pricing inflation in the next few years at the 5.5%-8% range or a period of earnings well below that which has been in place since the 1940’s.

I cannot forecast the future any better than the many professionals who are paid handsomely to do this. But, I do not think our national productivity, our willingness to work our desire put our kids through school and our general improvement of our condition has not changed from last year to this. My view is that the SP500 which represents some 90%+ of US public companies mirrors the results of these efforts. We can measure this with some certainty since the ‘40’s. We have certainly had many issues along the way. We have always recovered.

Disclosure (“none” means no position):

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"Davidson": Thoughts on "Fair" vs "Free" Markets

Post author By ToddSullivan
Post date February 22, 2009

Davidson has a very thoughtful pieces on markets, the government’s roles, investors and traders vs value investors.

Under the Bush Administration it would appear that “Fair Markets” which was the theme of Securities Act of 1934 and other responses to the events that produced the Great Depression became “Free Markets”. Free Markets which have little restraint become dominated by the avarice of the marginal investors who are bright enough to skirt all the laws then enforced to take undo advantage of all other investors who being responsible and in the view of these few operate within the doctrine of “Fairness”. The “Free Market” syndrome simply missed the fact that there are always individuals who will “game” the system and because they have greater resources manipulate markets for their own advantage knowing that most will follow a sense of “Fairness”. These few are not stupid people. They are very bright. Bright enough to understand the system, see its flaws and acquire the means by which to enrich themselves at the expense of others who believe in the concept of “Fairness” as originally conceived.

It would appear the April 28, 2004 SEC regulatory meeting much discussed today at which investment banks were freed to lever up to 40-50X was simply part of a general belief that “Free Markets” self-correct and self-monitor. Unfortunately what was missed is that this is only possible in a medium of complete and utter transparency. In fact, while we gradually forced Warren Buffett to expose his holdings thus taking away some of his freedom to move about the market place, we gave HF’s invisibility. We also gave these folks invisibility as to the new securities contracts they created with the incredibly wrong belief that they would self-monitor. Many including Alan Greenspan supported this construct.

“Free Markets” will never be completely transparent as individuals will always find a means to game the system dishonestly. This is why rules are necessary to make markets “Fair Markets” to all with the individual investors who are the fundamental base of all investing through their daily effort, their labor and creativity, to produce GDP. We lose sight that our economy and the stock and bond markets rest on the efforts of people earning a living. We lose sight of the fact that the investment markets are not a world unto themselves that can be mathematically analyzed and thrown in to formulas by which to create wealth. The investment markets are simply a representation of the productivity of our society. I like to think of the markets as a console full of dials. It simply measures the results of all the inputs to society as it pertains to our productivity. The markets reflect our hopes, our generosity, our legal system and our political system. The markets reflect our entire value system and how we organize our efforts to self improve.

Markets need to be “Fair” not “Free”. Transparency of every contract, every levered position, every trade and every association of one contract holder with another should be paramount. If there is an ability of one investor to gain advantage over another with secrecy, then there should be rules that forces this into the light of day so that we can determine if it is “Fair to Individual Investors”.

There should also be a “Recourse Rule”. If you buy a house today it is non-recourse to the buyer. It is up to the bank to have performed the underwriting to the level that assures safety of principle and interest. This lets single buyers own multiple homes to speculate without personal risk. We are all suffering today from the fallout of housing speculators who have walked away from recent transactions leaving our financial institutions with the losses. All obligations should carry some form of recourse to the parties involved. It would add personal risk to speculation and reduce the risk to us all. How this can be done regarding investment contracts and investment firms can be left up to them to develop a fair solution. The concept is that there should be some recourse to the individual who created the contract till the contract has terminated.

“Fairness” should be the rule-personal responsibility of behavior should be the goal. “Free Markets” leads to avoidance of responsibility. I liked Pres. Bush, but he simply got it wrong. This mess will be his legacy.

We have Traders and Value Investors. The former believes that price accounts for all information, Efficient Mkt Hypothesis. The latter believe in understanding a business and buy with cash flow, Owner’s Earnings and etc.

First, the Traders support Mark-to-Market while the Value Investors scream that it is a bogus benchmark. The Traders sell stock and if it goes down they say, “See!! If it goes down, it was meant to go down to find its real “value”!!” It is an amazing set of mental gymnastics that Traders use to convince themselves that “emotional pricing” of securities represents a valid method of “fair value accounting” for which Mark-to-Market was designed to effect.

Second, there are many, many more Traders with their simplistic approach and strong self belief/confidence than there are true Value Investors. It is easy to see that Value Investors do not by their selling create tops nor by their buying create bottoms. It appears to be more a factor that Traders simply exhausted their fire power. Where this level is I do not know. Unfortunately, “Mark-to-Market” is a destructive feed-back device. It supports erroneous contention reinforcing it’s own effect. It goes in the wrong direction till you reach such a silly level that eventually some percentage of Traders see the folly and an apparent “Value” becomes obvious. The snap back becomes very sharp.

I don’t know where that level is. Obviously this past week was not that level.

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Articles

Do We Get A "V"??

There is a growing chorus that feels the current situation will be resolved with a “V” recovery in which upside is a violent as the downside has been. To wit:

Here is the theory:

“Davidson” submits:

Wesbury has had this stance for some time. One way I would explain this is that this was not a consumer lead economic slow down. Consumers were actually still in good shape re: credit scores and could have continued to buy cars and houses if the lending institutions were lending. BUT, the lending institutions stopped lending and consumer sales hit a wall. Consumers do not stop dead this way, especially after nearly 3yrs of slow down that began at the beginning of 2006 in housing and autos. This whole slow down is an institutional/governmental heart attack on top of a normal slow down that began with the effect of Mark-to-Market on Lehman, AIG, Bear Stearns and then was kicked over the cliff with SEC Cox’ ban on short selling.

This has been such a misunderstood economic panic that was caused by first cheap money, then encouraged by political avarice, fostered by poor regulation and the incredibly stupid belief in the “Free Markets Self Correct” syndrome and then topped off by incredibly inane elimination of the “Up-Tick Rule”, the passive approach to naked short selling, the political decision to let Lehman fail so that Republicans could display some “Character?” during the Presidential election and the rest is history. The consumer was in fact OK till the credit markets and importantly the Money Markets seized with now bankrupt Lehman commercial paper.

Politicians and regulators just do not see that it is they who are the problem, it is they who have failed to act in accordance with the regulations that they passed. Politicians and regulators are looking for some one else to blame because they are so thick in the middle of causing this mess that I really don’t think they even have a clue as to what they have done. And they think that they are the solution to the problem??

The market is healing on its own. That this is occurring you can see from the rise in Treasury rates as funds flow into various market channels looking for opportunity. I watch with fascination the activities of Warren Buffett and numerous savvy investors buying up discounted assets especially real estate. The signs are there for all to see.

I am all in and have been since January ’09.

Could it be? Consider the following chart from Howard Lindzon

It shows, far from being an abnormality, “V” recoveries in equity markets are the norm. Now, the question we need to answer is “Are we at the bottom of the “V” or are we going down to a point between where we are now and the bottom of the 1931 “V”?”

The optimists will say we are at the bottom while the pessimist will say we will pass 1931. I lay not in either camp. My take is that we fall further then shoot up. How much further, who knows, and anyone who tells you they do is lying, they are guessing. My take is that based on the news flow and economics trends, which are still negative in the aggregate, more downside is in store. I know recent numbers have been encouraging but a month does not a trend make (nor does two).

In that vein, Henry Blodget writes:

Prof Shiller’s work (above chart) shows clearly that stock values are mean-reverting. The only trouble is the time they take to mean-revert. If things go badly over the next few years, stocks could bounce along the bottom for another decade or more.

For example, Jeremy Grantham, whose shop (GMO) produced the forecasts above, reminds us what happened in the 1970s:

“Today all equities are moderately – one might say, boringly – cheap. The forecast for the S&P has been jumping around +6% to +7% real, with other global equities slightly higher.

To put that in perspective, a 1-year forecast done on the same basis we use today that started in December 1974 would have predicted a 14% return (which, by the way, it did not deliver since the market stayed so cheap). For August 1982, the forecast would have been shockingly high – over 20% real! So do not think for a second that this is as low as markets can get. “

(It’s worth noting, though, that 1982 was the start of the great bull market. Jeremy also warns of the possibility of another sucker’s rally, so don’t get too comfortable waiting for the bottom:

“Now, I admit that Greenspan and 9/11 tax cuts caused the “greatest sucker rally in history” from 2002-07. We therefore cannot rule out another aberrant phase in which extreme stimulus causes the market to rally once again to an overpriced level for a few more years, thus postponing the opportunity to make excellent long-term investments yet again. But I think it’s unlikely. “

One thing seems certain: Stocks are cheaper now than they have been at any time in the past two decades. That’s encouraging for those with another couple of decades to invest and–increasingly rare these days–cash to put to work.

We’ll see….I think we have a bit deeper on the “V” to go..

Disclosure (“none” means no position):

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Articles

The Mark-To-Market Debate Continued

Post author By ToddSullivan
Post date February 15, 2009
2 Comments on The Mark-To-Market Debate Continued

A follow-up to last weeks conversation…

“Davidson” chimes in about the following piece:
“Wesbury had a follow-up to his prediction that last Monday would see some Mark-to-Market modification. He stated that Sen. Dodd had told him that this would happen and my guess that Wesbury was so miffed at being used as a trial balloon that he decided to reveal his source in this video. Keep up the pressure on this issue as the tide is turning I think.”

Disclosure (“none” means no position):

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Articles

"Davidson" Says: PG Is A Buy!!

Post author By ToddSullivan
Post date February 12, 2009

“Davidson” is back with a breakdown of Proctor & Gamble (PG)

He writes:
I calculated the ROE/Multiple of BV for PG from 2000 till the lastest Morningstar report. Gillette was bought in 2006 and it was a transition year which did not have simple year end values.

For the time period the Current Market Rate of Return has been between 5-6%. Currently the value is 5.4% and for a return that makes a LgCap equity attractive the average is 150% x CMRR = 8.1%

With PG about $52shr this makes it buyable for the 1st time in the last 10yrs. I have looked at the margins and have been very impressed with the debt pay down from 80% Debt/Equity in 2005 to 32% today, this company has very a conservative financial position and appear to have seen our current environment coming. Their business has been steady even during the last slow down 2001-2003. Business is international with a manageable commodity input cost.

He provides the following information:

Disclosure (“none” means no position):None

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Articles

Berkshire Now Just Might Be A Buy??

Post author By ToddSullivan
Post date February 12, 2009
8 Comments on Berkshire Now Just Might Be A Buy??

After a a year of saying Berkshire Hathaway (BRK.A) was no value, I’m thinking it just may be getting there.

In July 2008 I said:

Wholly-owned subs such as Shaw Industries, Clayton Homes, Jordan’s Furniture (the are 4 furniture companies), Benjamin Moore, Home Services and Acme Brick and directly tied to housing and will suffer in the downturn.

For all its holdings, Berkshire is essentially an insurance company. It has operated under “perfect” conditions for the last two years according to Buffett and eventually to run must end. Premiums are already falling and as houses are re-poed and fewer new cars are purchase, insurance premiums derived from those products will fall accordingly. I know people who are looking at homeowners and auto policies for way to decrease coverage and save money. Whether or not this is a good idea is irrelevant (I do not think it is), it is happening. Throw in a hurricane or two (we are due) and insurance could suffer quite a poor year.

For more on Berkshire’s insurance read this former post:

Back in March when shares sat at $133,000 I argued they were not a “value”. Today they sit at $111,000. Are they a value now? Perhaps but one also has to expect that the near term, if Tilson is correct is fraught with potholes for Berkshire and earnings ought to take a hit.

Based on that, share price ought to suffer also meaning you will probably be able to pick them up cheaper down the road. If I owned shares would I sell? If I needed the money in the next year, yes. If I had a multi-year time frame would I sell? No. If that was the case I would be watching down the road for a cheaper entry price, I think you’ll get it.

What has happened since then?

From Barrons:

Berkshire agreed to purchase $150 million of 10 1/8% notes due in 2015 and $250 million of 10 3/8% notes due in 2018 from Birmingham, Ala.-based Vulcan. The note sale was reported in late January, but Vulcan didn’t identify the buyer of the notes until Tuesday’s earnings conference call.

Other recent Berkshire bond purchases include $300 million of Harley Davidson Inc. (HOG) 15% notes due in 2014 and $150 million of Sealed Air 12% notes due in 2014.

These purchases follow big transactions in the fourth quarter, when Berkshire purchased $5 billion of 10% preferred stock from Goldman Sachs (GS) and $3 billion of 10% preferred from General Electric (GE). Both those deals came with a sizable amount of equity warrants. During October, Berkshire also bought $4.4 billion of 11.45% subordinated notes and $2.1 billion of 5% preferred stock issued by Wrigley, which was purchased by Mars in a leveraged buyout.

One deal that Buffett probably regrets is his agreement to purchase $3 billion of convertible preferred stock in Dow Chemical Co. (DOW) if it goes forward with its deal to buy chemical maker Rohm & Haas Co. (ROH) for $15 billion. Berkshire’s purchase is contingent on the consummation of the deal.

Buffett may be hoping that the deal dies, or that Dow comes back to Berkshire with more generous terms to get a larger investment from Berkshire if Dow goes forward with the deal. Dow is resisting completion of the transaction, arguing that the debt that it would have to take on would be ruinous financially. As it stands, the Dow convertible preferred that Berkshire agreed to purchase will carry an 8.5% interest rate and a conversion price around $40, way above Dow’s current share price of $10.

If we do some simple math, Bekshire has put roughly $17.9 billion to work at 10%. That will provide Berkshire $1.7 billion a year for the next three years (some of it may convert to equity at that point). When one considers Berkshire has earned $7.8 billion of the last 12 months (Q4 2008 numbers not released yet), Buffett’s recent moved will add 21% to those earnings.

Now, insurance. Yes as stated above, the party is over but, rates are scheduled for increases. As insurance companies look to cover losses in investment portfolio’s, the aggressive pricing that has taken place in the past few years will abate, causing industry rates to rise. Also, one should expect those insurance companies feeling the pinch to take fewer larger risks. Since this is an area Berkshire loves to play in, fewer players will mean stronger pricing power on the part of Berkshire.

We will not a resurgence to the “glory years” in insurance, but conditions for the first time in a few years will improve. Remember, Berkshire is essentially an insurance company, since that business seems to have stabilized, being the best of that lot, we must assume Berkhsire has.

Berkshire’s investment portfolio has been hurt this year by the weak showing of some of its major equity investments, Wells Fargo (WFC), U.S. Bancorp (USB), Kraft (KFT), Coca-Cola (K) and Procter & Gamble (PG). While prices here are depressed, there is no permanent impairment to earnings and that is a point being missed by folks. To believe these companies will be at depressed prices 3 years from now means the global economy will not recover. If you believe that, buying any equity is a waste of time.

Berkshire is big holder of those three companies’ shares and it also is short $37 billion of long-dated put options on the S&P 500 and other equity indexes. As the market has dropped, Berkshire has taken a charge to earnings (no cash) in the write-down of the value of these options. When the market rises, the opposite will happen (write-up). Again, to assume no improvement here implies US business is stagnant for the next decade.

Now, Berkshire is down roughly 33% since my fist post on it. The difference now is that several of its businesses are showing signs of life and Buffett has put billions to work at 10% vs the pittance is was getting previously in Treasuries.

The next piece of the puzzle is the Berkshire manufacturing businesses listed above. They will turn when the economy does. If you believe that is the 2nd half of this year, the time to buy is now. If you believe that is 2010, you have time to wait.

Will Berkshire go lower? I do not know but I do know that there isn’t a good reason for it to go much lower barring further dramatic worldwide economic collapse.

Time will tell but I think Berkhsire at its current levels do not have much more downside….

Disclosure (“none” means no position):Long WFC, none

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