Wednesday, December 24, 2008

A Philosophy of Market Efficiency

I would define financial market inefficiency as a breakdown in the fundamental relationship between risk and reward. If an asset is priced such that one has a very high probability of excess gain and a very low probability of loss, then this is an inefficiency or undervaluation.

Conversely, if an asset is priced such that one has a very high probability of loss and a very low probability of gain, such as dot-com shares in the late 1990s, then you have another inefficiency, or an overvaluation.

This is associated with the participant’s bias, meaning that most market agents have a flawed view of reality and thus believe that the asset is correctly priced. In other words, they are either undervaluing or overvaluing reality, as a result of their own perception.

The mainstream and variant perceptions all have different views on an asset, and the price clears because most people do not see whatever the true inefficiency is. Thus, to have an inefficiency, most participants must vote that the market is, in fact, efficient.

Other elements come into play: boom-and-bust processes, self-fulfilling prophecies, information cascades, dysfunctional pricing models, barriers to exploitation, panic, euphoria, and so on.

To define it academically, one would need to draw from research in dynamical systems, behavioral finance, game theory, and other disciplines. One must look at the history of financial theory to recognize its flaws, and the flawed framework upon which it was built.

Financial theory and much of economic theory was modeled after 19th century physics; yet with the birth of quantum mechanics and relativity, physicists no longer look at the world in the same way. The logical underpinning of financial thinking remains outdated by two-hundred years.

Monday, December 22, 2008

Buffett on Buying

We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess?

We purchased National Indemnity in 1967, See's in 1972, Buffalo News in 1977, Nebraska Furniture Mart in 1983, and Scott Fetzer in 1986 because those are the years they became available and because we thought the prices they carried were acceptable. In each case, we pondered what the business was likely to do, not what the Dow, the Fed, or the economy might do. If we see this approach as making sense in the purchase of businesses in their entirety, why should we change tack when we are purchasing small pieces of wonderful businesses in the stock market?

Before looking at new investments, we consider adding to old ones. If a business is attractive enough to buy once, it may well pay to repeat the process. We would love to increase our economic interest in See's or Scott Fetzer, but we haven't found a way to add to a 100% holding. In the stock market, however, an investor frequently gets the chance to increase his economic interest in businesses he knows and likes. Last year we went that direction by enlarging our holdings in Coca-Cola and American Express.

Our history with American Express goes way back and, in fact, fits the pattern of my pulling current investment decisions out of past associations. In 1951, for example, GEICO shares comprised 70% of my personal portfolio and GEICO was also the first stock I sold – I was then 20 – as a security salesman (the sale was 100 shares to my Aunt Alice who, bless her, would have bought anything I suggested). Twenty-five years later, Berkshire purchased a major stake in GEICO at the time it was threatened with insolvency. In another instance, that of the Washington Post, about half of my initial investment funds came from delivering the paper in the 1940's. Three decades later Berkshire purchased a large position in the company two years after it went public. As for Coca-Cola, my first business venture – this was in the 1930's – was buying a six-pack of Coke for 25 cents and selling each bottle for 5 cents. It took only fifty years before I finally got it: The real money was in the syrup.

My American Express history includes a couple of episodes: In the mid-1960's, just after the stock was battered by the company's infamous salad-oil scandal, we put about 40% of Buffett Partnership Ltd.'s capital into the stock – the largest investment the partnership had ever made. I should add that this commitment gave us over 5% ownership in Amex at a cost of $13 million. As I write this, we own just under 10%, which has cost us $1.36 billion. (Amex earned $12.5 million in 1964 and $1.4 billion in 1994.)

Warren E. Buffett, 1995

Thursday, December 18, 2008

Auto Economics, Eddie, and the Microsoft Founder

Here's an odd couple:

With all the opportunities available, across every market, it is interesting that Lampert and Gates chose used cars. AutoNation is selling for less than book value, but this is hardly rare in hard-hit sectors. What they might see, aside from undervaluation, is a shift in consumer decision-making.

Here is a basic observation on auto economics: Given the tremendous depreciation that occurs over the first few years of owning a car, and the fact that late-model used cars are essentially the same as new cars, there is no financially-logical reason ever to buy a new car.

Moreover, with Americans' household wealth eroding at a historic rate and real incomes declining over the past decade, the sticker prices on new vehicles look ridiculous
$30,000? $40,000? Forget your existing debt burden, maybe you want to finance it?

Despite the woes of the automobile sector, Americans will always need cars
they just don't have to be new cars. In fact, if the demand for used cars picks up over the coming decade, there is an obvious supply constraint if new car sales are down, the existing stock of used cars becomes more valuable. This could give a greater degree of pricing power to dominant dealers like AutoNation.

Indeed, Berkshire Hathaway recently reported a large stake in CarMax, which is a competitor of AutoNation. This may well be a new play on a deeply distressed sector, similar to the overtures into auto components companies by financiers like Wilbur Ross.

For some reason, I just never pictured Warren Buffett, Eddie Lampert and Bill Gates as used car dealers. But evidently the times have changed...

Tuesday, December 16, 2008

Some Thoughts on Short-Selling

With the backdrop of this year’s historic short-selling successes, I was recently asked why I rarely engage in this practice.

After thinking about it for a while, my answer is basically this: It is too difficult to be consistently right on timing and other factors. Timing matters much more with selling overvalued assets that you expect to depreciate, as opposed to buying undervalued assets that you expect to appreciate.

Over time, stocks generally increase in value, and holding long-term short positions is costly. Moreover, the possibility of unknown, intervening events gives shorting a different risk profile: for example, a weak company might get bought out, leading to a dramatic increase in the stock price.

Sharp surges in price are much more dangerous for the short-seller than are sharp declines for the stockholder. In the latter case, if one does not use margin, volatility scarcely matters as long as the equity remains attractively valued and the fundamentals have not deteriorated.

By contrast, to look at successful short-sales, consider that Bill Ackman had been short MBIA since 2002. In other words, he thought it would fail during the last recession. He took losses over an entire business cycle for the company to finally break down. David Einhorn waited a similar period of time with Allied Capital, as the stock rose smartly.

You can't get a margin call on equity. Or, in other words, the reverse of shorting is buying equity on margin. Imagine buying a stock at $50 and having it drop to $20 – being forced to sell – and then having the stock sharply rebound. This type of thing happens with shorting all the time, making it dangerous to short technology stocks or commodities or whatever else. Highly overvalued assets can get insanely overvalued, long enough for you to get tapped out.

The other option, no pun intended, is to use puts. The problem here is that equity doesn't expire worthless. But with puts, you can be exactly right with your decision, wrong on timing, and the put option expires worthless. (And then, the next day, the stock plunges to $0.) In my view, anything time-sensitive is absolute rat poison, unless the terms are exceedingly generous.

You want to look at it the way Warren Buffett looks at insurance: unless rates are incredibly appealing, relative to risk, then you simply do not write business. As he says, success at investing is all about temperament. The best action is often to take no action at all.

Monday, December 15, 2008

Where Do We Go From Here?

Something that always fascinates me is peoples’ inability – often extremely smart peoples’ inability – to have a true sense of context in history and an imagination outside of the time in which they live. There is a tendency to make absurd extrapolations of the future based on the recent past. Hence, some of my favorite “dumbest things ever said”:

“Everything that can be invented has been invented.” – Charles H. Duell, Commissioner of the U.S. patent office, 1899

“In ten years all important animal life in the sea will be extinct. Large areas of coastline will have to be evacuated because of the stench of dead fish.” – Paul Ehrlich, Stanford biologist, 1970

“Almost all of the many predictions now being made about 1996 hinge on the Internet’s continuing exponential growth. But I predict the Internet will soon go spectacularly supernova and in 1996 catastrophically collapse.” – Robert Metcalfe, 3Com founder and inventor of Ethernet, 1995

Bets against a brighter future, bets against growth, bets against innovation, bets against human ingenuity – these have never turned out well. The reason is that they are almost always relative to the recent past, and forecast the future based on whatever happens to be the current fad, fear, or state of affairs.

But what about the person in the early 1800s, sitting in a pasture – in the dark, in a world without electric light – who looked up at the moon and said: “In 150 years, we will travel there.” What about Wilbur Wright, who looked at the birds and remarked “for some years I have been afflicted with the belief that flight is possible to man” – that we could fly across countries or even the world.

They would have been ridiculed beyond belief.

Friday, December 12, 2008

Buffett on Stocks

Almost fifteen-years later, it rings truer than ever:

The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."

Academics, however, like to define investment "risk" differently, averring that it is the relative volatility of a stock or portfolio of stocks that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock its relative volatility in the past and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

For owners of a business and that's the way we think of shareholders the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market as had Washington Post when we bought it in 1973 becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?

Warren E. Buffett, 1994

Wednesday, December 10, 2008

The Future of Energy

Something that has always interested me is looking at the history of vital commodities and how their market values go through tremendous upheavals. An example might be whale oil – once a staple, but now useless. Or yellowcake, which is concentrated uranium that was once totally valueless but is now highly prized for its use in nuclear weapons and reactors.

Other examples include spices – for which people used to kill each other, but are now located on the McCormick rack at Wal-Mart – or items such as furs, crops, various animals, stones, and wood. If you use a century as your measuring stick, commodities (and virtually all assets) undergo seismic shifts in economic value.

Strangely, people do not seem to view energy resources in the same manner. Since energy is such a critical component of our daily lives, even minor fluctuations in price, in percentage terms, are of massive significance to individuals and the economy.

Over the next decade or two, if truly we are in a "Peak Oil" scenario, what says the gasoline price can't increase by a factor of, say, ten? Looking at virtually any other commodity, this is a very modest secular shift.

But for American-made SUVs – once the automakers' profit center – it means that the gas tank which now takes $70 to fill will cost $700 in the future. Clearly, gasoline-powered cars and trucks as we know them would no longer be viable. Oil at several-hundred-dollars per barrel would cripple entire industries.

Was the boom in crude and other commodities from 2002 to 2008 the harbinger of a new era of scarcity? Or will alternative energies become the new prize, leaving oil as a relic of the Industrial Age?

Tuesday, December 9, 2008

So You Want to Be the Next Buffett?

Here's a great talk on investing that was given at Harvard Business School by Mark Sellers. I highly recommend it.

"Personally, I'm amazed at how little conviction most investors have in the stocks they buy. Instead of putting 20% of their portfolio into a stock, as the Kelly Formula might say to do, they'll put 2% into it. can be shown that a 2% position is the equivalent of betting on a stock that has only a 51% chance of going up, and a 49% chance of going down. Why would you waste your time even making that bet?"

Sellers MBA Talk

Sunday, December 7, 2008

Sears' Real Estate

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment.
– Benjamin Graham, The Intelligent Investor

Sears Holdings is a quintessential example when it comes to examining a market-based perspective versus an asset-based perspective. Consider Sears' 257 million square feet of real estate. A look at market rates on this space, put to its best use, implies an intrinsic value upwards of $40 billion for Sears' real estate alone (or a conservative average of roughly $150 per square foot), without taking the value of Sears' other assets into account. The stock market currently values the entire company at $5.75 billion.

The market-based view of the world says that Sears stock is going to do poorly over the next few quarters because of macroeconomic concerns. Almost all the economic and financial news is bad, and the American consumer is reeling.

However, the large short interest in Sears strikes me as attempting to pick up nickels in front of a bulldozer; the real estate value is a massive imbalance that is incredibly clear-cut, paired with an aggressive stock buyback plan. Yet anyone who is market-fixated cannot see past the near-term outlook and price fluctuations. By focusing on the market instead of the assets, these investors are turning others' mistakes into their own.

It sounds simple, but investors cannot seem to act on the "buy low, sell high" principle when it appears. Many do exactly the opposite. And in this respect, the market works as Warren Buffett has described it: as a wealth-transfer machine.

If one follows where Sears stock has been going, it is being sold by bloodied institutions and blind investors who've read the news but not the financial statements. And it is being bought hand-over-fist by Sears' chairman Eddie Lampert and the Fairholme Fund's Bruce Berkowitz, men who've specialized in compounding money at rarefied rates.

The beauty of capitalism is at work. It is a process where assets are transferred from the hands of incompetents to those who make shrewd decisions.

Saturday, December 6, 2008

Bill Ackman's Wendy's Analysis

Interesting analysis and valuation from Bill Ackman of Pershing Square Capital Management, L.P., which owns 55,619,748 shares of Wendy's/Arby's Group, Inc. (NYSE: WEN), as of September 30, 2008.

Ackman Wendy's Analysis

2008 Sears Annual Meeting Notes

Notes from the 2008 Sears Annual Meeting.

Resource America Buyback

“…Energy is not the business of Resource America. Neither is real estate. Our true business is providing investment opportunities for the individual investor.

“It is primarily a financial business for us … so our senior people have backgrounds in banking, accounting, finance. We have people here with specific knowledge in the three fields in which we operate, and the company is then unified by the fact that these experts are all tied together on the financial side.”

– Edward E. Cohen, 2001

Resource America, Inc. (ticker: REXI) CEO Jonathan Z. Cohen recently presented at the FBR Capital Markets 2008 Fall Investor Conference:

Resource America reports Q4 earnings on Monday, December 8, 2008.

With a $50 million stock buyback plan in place and current market capitalization of roughly $70 million, Jonathan Cohen can deliver considerable value to shareholders by buying back stock. On the company’s Q3 conference call, Leon Cooperman, CEO of Omega Advisors and a significant shareholder in nearly all of the Cohen family’s public companies, asked:

“If you’re taking a forecast of roughly $1 for next year, so that’s about $17.5 million of net income, dividend is running around $5 million, assuming everything is the same, the total business is like it is, stock price is like it is, what will be the priorities for using that $12 million, $13 million of let’s say free cash flow in terms of usage?”

Jonathan Cohen replied: “That cash flow will obviously be used, once we’re finished retiring debt, to be a buyer of our stock as well as an investor in future businesses.”

Fair enough. So assuming Mr. Cooperman’s $12 million free-cash-flow figure remains flat for the next three years, Resource America will receive $36 million with which to invest. At an average price of $8 per share, the company can reduce its share count by 4.5 million shares – from 17.6 million outstanding to 13.1 million outstanding – or a decrease of roughly 26%.

Judging by the above FBR Capital Markets presentation, as well as the scalability of the business model, Resource America may well achieve significant growth without the reinvestment of much additional capital. But even in the case of flat profits for the next three years, the hypothetical share-count reduction will increase income attributable to each shareholder by roughly 33%.

The most important question, though, in light of the Cohen family’s prodigious record of building businesses, is whether or not buying back shares is the best use of capital?

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This work by Nicholas E. Radice is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.