Coming Out of Crisis

One of the better books on stocks is called “Triumph of the Optimists,” which tracks global markets throughout the past century. In fact, the title itself aptly describes the investment experience.

While the current crisis has thrust the Gloom & Doomers into the spotlight, their fame will be fleeting, as it always is. Bets against increased growth or productivity – the essence of economics – never turn out well.

The shamans of the current crisis will be forgotten, just as few people today can remember promoters of the 1990s tech bubble, or the 1970s technical analysis traders, the “Nifty Fifty” stocks of the 1960s, or the South Sea Bubble of the 1720s.

As Harvard economist John Kenneth Galbraith wrote, “the financial memory should be assumed to last, at a maximum, no more than twenty years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to come on the scene, impressed, as had been its predecessors, with its own innovative genius.”

From here, investors must assess where they are on the curve – ahead of it, with the pack, or bringing up the rear. I discuss this issue in a previous article that I wrote for the Expert Voices archive of the National Science Digital Library, at a cyclical peak in the agricultural commodities market.

As you can see, the bulk of profits from the commodities boom has already been made, by savvy investors like Warren Buffett and Jim Rogers, who were involved before anyone even knew that a secular shift in commodity prices was underway.

Furthermore, investors who've read a wide range of energy industry 10-Ks over the past few years know that substantial profits have been reinvested to expand capacity, in response to skyrocketing prices. The energy industry has had almost a full decade to adjust to the constrained world oil balance; and prices in excess of $100 per barrel gave an tremendous incentive to supply the market, while destroying global demand.

This is not to say that the bull market in crude oil is over, because I do not believe that it is. But the large number of new investors in the energy sector are by definition “with the pack,” not ahead of the curve.

In most cases, these investors are operating on outdated information that was generated many years ago, before the huge run-up in prices altered the capacity and oil balance picture. This will probably create greater volatility going forward, not the relatively steady double-digit annualized returns that accrued from oil over the past decade.

With 98% of stocks in the United States and Europe having delivered negative returns in 2008, there is no doubt that tremendous bargains currently prevail. But just as generals tend to fight the last war, the mass of investors will always look to reap the gains of the last bull market.

However, for those investors who are ahead of the curve, vast fortunes will emerge from the financial wreckage.

A Black Eye for Bill

Bill Ackman's overture into bookselling turned out to be nothing but a flop. He built positions in both Barnes & Noble (ticker: BKS) and Borders Group (ticker: BGP) during fall of 2006, essentially at the peak of the stock market.

Ackman's motivation was relatively clear: very thin spreads between price and value prevailed during this time, and he was overly aggressive in seeking excess returns, with the idea of forcing a merger to create a dominant player in a struggling industry. Here's how it turned out:


Last Friday, Ackman disclosed that he liquidated all of his 11.3% stake in Barnes & Noble, which had made him the second-largest shareholder. Borders, which now trades for only a few dimes, isn't even worth selling. Granted, Bill Ackman's Barnes & Noble sale might be motivated by a "sell cheap, buy cheaper" reasoning.

But with the benefit of hindsight, it is clear that he would have been better served by remaining patient with cash, as opposed to rushing into the retail sector, only to be dealt huge blows in these booksellers, as well as Sears and Target, with the latter position down 68% according to Bloomberg News.

How do you lose 68% of your money with a staid investment like Target? When the stock itself is down only about 40%? This highlights the danger of using call options (and, in Ackman's case, total return swaps) to structure one's investments.

Would Warren Buffett recommend or pursue a similar investment strategy? Or would he remain patient, build up a cash pile, and simply hold Treasuries? Only to deploy capital as stocks plunge?

While this illustrates the short-term orientation that is inherent in the hedge fund business, leading to an intense pressure for lots of action and yearly results, I also believe it tarnishes Ackman's reputation.

The fact is that Bill Ackman's plan for Target was nothing more than a sophisticated attempt to lift the stock price. And his ultra-aggressive attacks on MBIA, while right-on about the company's weaknesses, were motivated by an attempt to beat down the stock within an expedited time frame (thus making his short-dated put options and credit default swaps worth a fortune). Would Warren Buffett make these moves?

In sum, it is difficult to classify Bill Ackman as a Buffett-style investor, which many people have over the past few years. There is no doubt that Ackman is a very smart and shrewd moneymaker. But his aggressive style is closer to a Nelson Peltz or Carl Icahn than an investor with a gold-standard reputation like Warren Buffett.

While this may be rewarding for investors in Pershing Square, individual investors who follow Ackman's moves should remain cognizant of the distinction. Returns might not accrue equally; Bill Ackman's actions may favor Bill Ackman over the common shareholder.

A Leaky TARP?

While plans for the financial bailout were inherently imperfect, criticism tends to ring hollow if one thinks back to the months of September and October. Many of the most seasoned financiers were gripped by raw fear as global markets imploded following the Lehman Brothers bankruptcy. Put yourself in Hank Paulson's shoes: it's September 16th, 9:45 AM, the market is open and the New York Fed is on the phone. Point blank: AIG stock is down 60%; they're facing a liquidity crisis and preparing to file for Chapter 11. This is uncharted territory for the financial markets and economy. Make a decision. What do you do?

With the benefit of hindsight, here is how it turned out, from Bloomberg News:

The Treasury secretary has made 174 purchases of banks’ preferred shares that include certificates to buy stock at a later date. He invested $10 billion in Goldman Sachs in October, twice as much as Buffett did the month before, yet gained warrants worth one-fourth as much as the billionaire, according to data compiled by Bloomberg. The Goldman Sachs terms were repeated in most of the other bank bailouts.

Paulson’s warrant deals may give U.S. taxpayers, who are funding the bailouts, less profit from any recovery in financial stocks than shareholders such as Goldman Sachs Chief Executive Officer Lloyd Blankfein and Saudi Arabian Prince Alwaleed bin Talal, owner of 4 percent of Citigroup Inc., said Simon Johnson, former chief economist for the International Monetary Fund.

Paulson said “he had to make it attractive to banks, which is code for ‘I’m going to give money away,’” said Joseph Stiglitz, who won a Nobel Prize in 2001 for his work on the economic value of information.

“The worst aspect of this is that they were designed not to do what they were supposed to do,” he said in a telephone interview from Paris Jan. 7. “In many ways, it’s not only a giveaway, but a giveaway that was designed not to work.”

The Treasury would have held warrants for 116 million shares of Goldman Sachs under Buffett’s terms, which would be equivalent to a 21 percent stake when added to those currently outstanding. Instead, the dilution is 2.7 percent under the Treasury plan. Blankfein is the company’s biggest individual investor, with 2.08 million shares worth about $178 million today, according to Bloomberg data. His 0.47 percent interest would have declined to 0.36 percent under Buffett’s terms and would be 0.44 percent if the Treasury’s warrants were exercised.

The government has received warrants valued at $13.8 billion in the 25 biggest capital injections from TARP, according to Bloomberg data. Under the terms Buffett negotiated for his $5 billion stake in Goldman Sachs, the TARP certificates would have been worth $130.8 billion.

[Ten times as much!]

If Goldman Sachs rises to its five-year average price of $147, Buffett will be able to profit by $1.4 billion from exercising his warrants. The government warrants will be in the money for $294 million, or about a fifth as much for twice the investment.

Stiglitz said finance professionals at the Treasury possessed expertise on warrant pricing that members of Congress didn’t. As a result, Paulson gave lip service to the lawmakers’ intent on TARP without gaining much value for taxpayers, said Stiglitz, a Columbia University professor who described the pricing mechanism as “a gimmick to make sure that they were giving away something worth nothing.”

“If Paulson was still an employee of Goldman Sachs and he’d done this deal, he would have been fired,” he said.

Buffett on Taxes and Trading

One point Buffett fails to mention is that it is much easier to achieve such doubling through buying and selling – the foundation of his early career – than it is to find an investment that internally compounds at the same rate.

Through my favorite comic strip, Li'l Abner, I got a chance during my youth to see the benefits of delayed taxes, though I missed the lesson at the time. Making his readers feel superior, Li'l Abner bungled happily, but moronically, through life in Dogpatch. At one point he became infatuated with a New York temptress, Appassionatta Van Climax, but despaired of marrying her because he had only a single silver dollar and she was interested solely in millionaires. Dejected, Abner took his problem to Old Man Mose, the font of all knowledge in Dogpatch. Said the sage: Double your money 20 times and Appassionatta will be yours (1, 2, 4, 8 . . . . 1,048,576).

My last memory of the strip is Abner entering a roadhouse, dropping his dollar into a slot machine, and hitting a jackpot that spilled money all over the floor. Meticulously following Mose's advice, Abner picked up two dollars and went off to find his next double. Whereupon I dumped Abner and began reading Ben Graham.

Mose clearly was overrated as a guru: Besides failing to anticipate Abner's slavish obedience to instructions, he also forgot about taxes. Had Abner been subject, say, to the 35% federal tax rate that Berkshire pays, and had he managed one double annually, he would after 20 years only have accumulated $22,370. Indeed, had he kept on both getting his annual doubles and paying a 35% tax on each, he would have needed 7 1/2 years more to reach the $1 million required to win Appassionatta.

But what if Abner had instead put his dollar in a single investment and held it until it doubled the same 27 1/2 times? In that case, he would have realized about $200 million pre-tax or, after paying a $70 million tax in the final year, about $130 million after-tax. For that, Appassionatta would have crawled to Dogpatch. Of course, with 27 1/2 years having passed, how Appassionatta would have looked to a fellow sitting on $130 million is another question.

What this little tale tells us is that tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate. But I suspect many Berkshire shareholders figured that out long ago.

Warren E. Buffett, 1994

The Agricultural Commodities Boom

For global-macro investors, the agricultural commodities market has been of keen interest lately, and even more so now that prices have declined. The general outline of macroeconomic factors that are at play can be found in this Bloomberg News article:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aybeiozrUnuw&refer=home

As the article states, there is a strong probability that we might see the biggest rally ever in agricultural commodities in the near future, due to a fragile supply-demand situation.

But, as always, it is important to have a healthy degree of skepticism in approaching the situation. For example, similar to their call on $200 per barrel oil, Goldman Sachs made lofty predictions on agriculture in the above article at the apex of the market.

Here is another interesting take on the issue, from today's New York Times:

http://www.nytimes.com/2009/01/05/opinion/05berry.html

This is a particularly chilling passage:

"For 50 or 60 years, we have let ourselves believe that as long as we have money we will have food. That is a mistake. If we continue our offenses against the land and the labor by which we are fed, the food supply will decline, and we will have a problem far more complex than the failure of our paper economy. The government will bring forth no food by providing hundreds of billons of dollars to the agribusiness corporations."

For those who want to read more about agricultural commodities, here is a great overview with links to more extensive USDA reports:

http://www.ers.usda.gov/AmberWaves/November08/Features/FoodPrices.htm

When paired with the most pressing global issues such as water shortage, global warming, the energy crisis, population growth, low global food stocks, governments printing money and so on, investing in agricultural commodities, via futures contracts or ETFs (such as DBA or RJA), seems like a one-way bet.

But, before getting too giddy over such an investment, I refer you to one of my older posts:

http://changealley.blogspot.com/2008/12/where-do-we-go-from-here.html

The human record on lofty macro predictions ranges from abysmal to comical. Yet, with the many recent successes in global-macro speculation – short-selling financials and the dollar, riding the commodities and globalization boom – it becomes easy to forecast these trends far into the future. Lo and behold, the Bloomberg News article above quotes a commodities investor who makes the claim that "we are in the early stages of a rally that could last 20 years."

Maybe so.

But it is very easy right now to be fearful of a second Great Depression or sell stocks at deep losses. This is simply the mirror image of what people felt at the apex of the stock market.

Back then, they could have produced a list of reasons why stocks and the economy would continue humming along nicely. In fact, I recall that Robert Hormats of Goldman Sachs made such an erudite forecast – and it was precisely wrong, right at the top of the market.

Thus, while I do believe that agriculture is a very attractive investment, one caveat is that individual commodities will be highly volatile and spike up only for short periods of time, as they did in the 1970s and have throughout their history. Supply and demand can shift quickly, as producers respond to high prices; and the shortage scenarios simply might not materialize.

In other words, it strikes me that the best approach to commodities investment is a very conservative one. While the inflation-hedge characteristics are attractive, commodities might be more suited to short- and medium-term traders, not long-term index investors.

Land, labor, capital and commodities are combined to create businesses that increase productivity. And while any one of these factors may become relatively attractive during a boom, owning excellent businesses is the best investment over the long haul.

Jim Rogers on U.S. Stocks

"In my view, U.S. stocks are still not attractive. Historically, you buy stocks when they're yielding 6% and selling at eight times earnings. You sell them when they're at 22 times earnings and yielding 2%. Right now U.S. stocks are down a lot, but they're still very expensive by that historical valuation method. The U.S. market is yielding 3% today. For stocks to go to a 6% yield without big dividend increases, the Dow will need to go below 4000. I'm not saying it will fall that far, but it could very well happen. And if it gets that low and I'm still solvent, I hope I'm smart enough to buy a lot. The key in times like these is to stay solvent so you can load up when opportunity comes."