Berkshire Hathaway, Sokol findings

For its ethical precepts, the just-released report on David Sokol's Lubrizol-related trading is an important read. Reading between the lines, this report sends a clear message: Buffett is pissed. Thankfully, it was released just ahead of the annual meeting this weekend. This ought to free up more time for questions about other matters and I'm very much looking forward to just that.

real interest rates fueling the M&A boom

With 7,834 mergers and acquisitions totaling $750 billion announced year-to-date, it's clear deal-making is back in full swing. These numbers clearly show business executives have increased confidence in their businesses, to be sure, and that capital markets are offering abundant capital, greasing the skids. But I think it's important to consider a higher-level fact to explain why we're seeing so many deals. Namely, real (inflation-adjusted) interest rates are near 30-year lows. Not such a great proposition for capital providers. With extremely low financing costs, discount rate assumptions fall and so new projects and takeovers have a much lower hurdle to overcome in order to post a positive net present value (NPV). Thus, more projects/deals brought to the C-suite make sense today. The key word is 'today' because capital market eagerness and rates can change abruptly. Today's baseline assumptions could be considered ridiculous tomorrow.

farmland values and the twenty-seven PE

In Iowa, farmland values are up 25% year-over-year, a boon to the financial health of the state and especially farmers’ net worth, of which farmland comprises the majority. I recently came across a very interesting paper that discussed farmland values. (The creative title “Farmland Values: Current and Future Prospects,” pretty much sums up its contents.) For those interested in more information on the asset class that has been speculated to hold the “next bubble”, it is an enlightening read. I wanted to touch on a few things mentioned in the paper and expound on a few points.

As with all assets, farmland value is derived from the income it generates as well as by the discount rate (opportunity cost of capital) and growth rate assumptions. First, and not surprisingly, current farm income is healthy. Commodity prices are high and cash contribution margins (roughly, profit/revenues) are elevated, increasing farm income and boosting current (and potential) cash rents - what an absentee landowner earns by renting the land for productive use. The discount rate is very low, with ten-year Treasury bonds, the ‘risk-free’(?) benchmark rate), at just 3.4%. I discuss the growth rate assumption more below.

I’ve used price-earnings ratios in past posts, mostly for stocks. They are valid, though, for a variety of assets. Today, stocks trade around 18 times trailing twelve-month earnings. Using the inverse of their interest rate, ten-year Treasuries trade at 29 times ‘earnings’ while farmland is 27 times. The latter two are pretty high numbers. Now, which has shown historically higher growth? The growth rate for corporate (stocks’) earnings tend to track nominal GDP, or about 6%. Bonds don’t grow in value, the yield is mostly fixed as is the payoff at maturity. Farmland, which has lower earnings volatility than stocks and, like them, a (theoretically) infinite life, has tended to grow with the general rise in inflation plus another 2% for productivity improvements (same land, more crop). On a price-earnings ratios alone, it looks like stocks are the best relative deal. Still, cash remains attractive given the below-average projected returns on several asset classes. Cash has the advantage of what I call the “opportunity yield” – the ability to take advantage of cheaper prices when investors revise their return requirements higher.

On the most striking revelations in the piece was that farmland turnover – the percentage of land stock that changes hands in a given year – was lower than its historical average of 3-5%. (Currently, turnover is estimated to be about 1.5% annually.) As we know, the more demand there is for an asset, the greater prices tend to rise. Couple this with a constrained supply of land being ‘offered to the market’ and prices can quickly rise. This is because the whole of the land stock is priced off these marginal, infrequent sales, making the whole appear more valuable on paper. Annually, 98.5% of landowners aren't buying/selling; it's the 1.5% that make the 98.5% a lot of paper wealth. This 'low turnover combined with high demand' phenomenon is also evident in the secondary market trading of several Web 2.0 companies today.

So is the current PE sustainable? As with most investment questions, the answer is nuanced. Farm income can experience sharp corrections when commodity prices sink. This would bring the multiple (land value/farm income) even higher than it is today. In addition, interest rates are very low and have been trending down for most of the last three decades. Should rates rise significantly, investors' opportunity costs rise and the cash rent 'yield' must rise, which means prices must fall. Today, I can't say we're in a bubble. What I can say is that the current expectations baked into the price - continuing high cash rents, low interest rates, and/or good growth rates - might prove to have been overly optimistic when viewed in hindsight.

Farmland is an intensely local market so each parcel is different. Further, prevailing prices are based (as mentioned above) on marginal sales which comprise a very small portion of the total land stock. As long as landowners don't lever up based on current land values to buy still more land, a sharp reduction in land values will not ripple through in the same fashion as the housing 'collapse'. Current evidence suggests those taking on incremental farm debt are mostly larger operators, with younger farmers and livestock producers in the least-optimum financial condition. But anecdotally, I've heard that farmers know two things, 'dirt' (land) and (bank) CDs. The rate on the CDs become their comparison and these folks think, let's buy more land with a 3% cash rent yield if a three-year CD is paying less than 1%. Thinking that way could put more than a few in trouble. So if there are to be detrimental economic impacts in the future should farmland prices come down, the $64B question is how much debt is being underwritten based on current values. Unfortunately, it's probably more than we think.

the deficit and our future

Great article by Greg Mankiw on our potential future as a nation. One of the scariest thoughts I had while reading it is that he's probably a bit late on the date.

Google and innovation

Who says Google is falling behind on the innovation front?

http://mail.google.com/mail/help/motion.html

commodities and inflation protection

It’s clear from the commodity price increases experienced over the past couple years (see this post) and anecdotal evidence -- but not official government numbers -- that inflation has returned and that price increases will be making their way through the economy. Several consumer staples companies have already raised prices 5-7% (P&G, Kimberly-Clark, and Fruit of the Loom, for example). This is just the beginning.

Often, money moves into commodities as an inflation hedge, but do commodities actually protect one's purchasing power after the onset of rising consumer prices? Based on the last time we saw this in the U.S., the answer is "mostly, no". Commodity prices, not surprisingly, tend to lead increases in actual inflation. But once inflation emerges, their ability to purchasing power protection diminishes. Thus, commodity ‘investors’ (aka speculators) who get in near the end of the pricing uptrend do not tend to fare as well.

The above charts illustrate this phenomenon over the same period I discussed in the last two posts, 1964 through 1988. They show commodity prices (Commodity Research Bureau spot price index) rising prior to a major jump in CPI inflation, with the bulk of the price spike clustered into just a couple of years (up 22.1% in 1972 and 59.8% in 1973), while actual annual inflation was just around 4.0%. From 1964 through 1973, average annual inflation was just 2.5% while commodities rose 8.4% per annum. After 1973 and through year-end 1988, annual inflation averaged 7.1% while commodity prices rose just 1.9%. Today’s commodities investors might be disappointed in their future returns while consumers may similarly be displeased with future price increases.

I do not want to be fatalistic and state unequivocally that inflation is inevitable, but I am not optimistic that it can be avoided at this point. The longer commodity prices remain high, the more they lead to higher structural costs for the economy as a whole. Once companies raise prices, they do not tend to lower them. Likewise with wages.

The final chart illustrates commodity prices versus actual inflation since 2000. To me, this looks similar to the period from 1964 through 1974, when commodity prices rose ahead of actual inflation in the face of inflationary government policies (namely, deficit spending). We see similar policies in place today, coupled with unprecedented monetary intervention that isn’t likely to abate anytime soon, especially in the face of a still-stagnant economy. And our national balance sheet is in worse shape. Are the mistakes that led to stagflation in the 1970s being repeated? Unfortunately, it appears so.

stocks and inflation (part 2 of 2)

(This is an update from yesterday's discussion on inflation's effect on markets.)

To augment the information presented in yesterday's post, I wanted to add additional perspective with respect to earnings. Stock prices can be reduced to two components: (1) earnings and (2) a multiple against those earnings. Yesterday's post dealt with the latter without much discussion of the former. So, I've added the chart below to address this oversight.

Readers will note that earnings (dark blue) more than kept pace with inflation over the twenty-five year period from 1964 through 1988. Certainly, if it were possible to invest in corporate earnings alone during this period, an investor would have fared quite well. This is the crux of the argument made by those who believe stocks will keep pace with inflation -- that corporations will raise prices and earnings will largely keep pace. Unfortunately, it's the 'multiple' component that hurts investors during inflation - if ending valuations are meaningfully lower than beginning, an investor may not fare well even if earnings grow nicely. And over this period, they certainly did -- real earnings were 50% higher in 1988 than in 1964.

stocks: inflation hedge or vedge?

I want to spend a little time thinking about what markets do when inflation hits. Common knowledge seems to believe that when inflation rears its ugly head stocks will rise in line with inflation. I think we have seen the monetary stimulus from the Fed show up in financial asset prices lately and I want to dispel this fundamental misconception of stocks as a hedge for high inflation with some market history. Note that my comments are not valid for hyperinflation. Almost anything is better than paper money during such time periods. During Brazil's high inflation of the late 1980s and early 1990s the stock market roughly held its own with domestic paper money (but looked flat to a foreign investor). If you’re like me and believe we’ll see elevated, but not catastrophic inflation in the near future it makes good sense to look at what periods of elevated (again, not hyper-) inflation have done to the stock market.

I looked back at a period of time where inflation was low, rose to quite elevated levels, and fell back again to low average levels. In other words, a period containing three "regimes": before inflation reared its ugly head, during high inflation, and back again to more stable, predictable levels. I chose the twenty-five year period from 1964 through year-end 1988 because it nicely exhibits these characteristics.

The chart to the left shows inflation (consumer price index) in red, the S&P 500 total return in green and the real return (total return minus inflation) in purple. Each is indexed to 100 at 1/1/1964. Clearly, stocks (green) did not keep up with inflation over this time period while the real return on the market over was negative. That’s a pretty poor showing over a period when inflation boosted the consumer price level to almost 4 times its starting point. If stocks were a good inflation hedge we’d expect the green line to be persistently higher than the red, and meaningfully higher at 12/31/1988 if real returns were positive. However, this does not seem to have been the case.

Why were stocks such a poor inflation hedge over this period? The answer lies in valuation. Using Shiller’s cyclically-adjusted PE ratio, which I’ve cited often, the S&P 500 traded at 21.6 times earnings in 1964. By year-end 1988, they were just 14.7, a P/E decline of 32%. The chart below shows the inverse relationship between inflation (red) and stock valuations (cyclically-adjusted PE, green). Over this time period, the correlation between the two was negative 0.956, representing an almost perfect inverse correlation. High inflation proved to be an enemy when stock valuations started high.

Why is inflation so hostile for stock valuations? It comes down to interest rates; nominal interest rates must include compensation for inflation plus a real return component. Investors ultimately compare this rate against the "coupon" available on stocks - that is, corporate returns on equity (ROE). Since ROE does not tend to fluctuate much over long periods and is more likely to fall than rise during high inflation, the yield available on stocks can only change if their prices move lower (coupon "yield" relative to book value moves higher). Maturities are also compared – bonds have a definite maturity while a stock’s maturity is infinite. I’ll defer to Warren Buffett for further clarification: “Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent return on equity versus, say, 10 percent return on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

Historical stock returns are likely to have looked much different if starting valuations were much lower than the 22 PE we see in the above illustrations. Because of these elevated levels, inflation had a demonstrably large impact on longer-term returns. While starting valuations always matter for subsequent returns, they seem to matter even more during high inflation.

Could this happen again? Well, today the cyclically-adjusted PE ratio is 23.7, so valuations are even higher than where these charts begin (1964). Even if you believe the Fed has everything under control and we won’t see high inflation anytime soon, it’s worthwhile to consider the aforementioned data when allocating your portfolio. The importance of stable prices is most noticeable when they go missing.

market bottom: feliz cumpleanos

Interesting perspective on the two-year bull run we've had since the market bottom.

earnings guidance not as extensive

Since I started investing I've always shaken my head at the quarterly guidance game, which seems to be played extensively. (Who cares if you the mid-point of your own guidance (which analysts home in on as their point estimate) by a penny?) Of course, it's always been concentrated among larger companies and these are disproportionately mentioned on CNBC. Speaking of CNBC, Herb Greenberg has some interesting statistics here that elucidates just how extensive (or not) this practice is.

Buffett on inflation

press reaction to the Buffett letter

Warren Buffett's annual letter came out Saturday and I found it to be one of his better. Amidst a wealth of insight, Buffett discussed the short- and long-term prospects for the U.S. economy. Not surprisingly, overwhelmingly the (mainstream) press reaction has focused on his bullishness about the United States' future prospects and the ingenuity of its people. Close followers know this is nothing new for Buffett.

I've observed this cheer-leading getting more frequent, and it's no surprise. Why? Berkshire is levered more than ever to the future prospects of the U.S. - rail, utilities, manufactured housing, building materials, furniture. In a major economic collapse, Berkshire would be hurt more than ever.

I'm not even implying that a major downturn is likely so Berkshire is a major risk. I am a personal stockholder so my own money is betting on my long-term belief in this company and its prospects.

I just don't think it's possible for Buffett to offer a completely candid view on broad issues like the economy. He will always be "talking his book" to some extent because he can actually influence how people behave. With public figures, as with researching investments, it's important to "read the footnotes."

Buffett letter out today

A few things that immediately struck us from Buffett's annual letter:

On the institutional imperative: "'The other guy is doing it so we must as well' spells trouble in any business, but none more so than insurance."

On housing policy: "Our country's social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford."

On market declines: "As one investor said in 2009: 'This is worse than divorce. I've lost half my net worth - and I still have my wife.'"

On value estimates: "It is appropriate, nevertheless, to including improved [interest] rates in an estimate of 'normal' earning power."

On investment managers: "It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed."

On manager compensation:

"We have arrangements in place for deferrals and carryforwards that will prevent see-saw performance being met by undeserved payments."

"Should we [add one or two investment managers] we will probably have 80% of each manager's performance compensation be dependent on his or her own portfolio and 20% on that of the other manager(s). We want a compensation system that pays off big for individual success but that also fosters cooperation, not competition."

On false precision:

"Part of the appeal of Black-Scholes to auditors and regulators is that it produces a precise number. Charlie and I can’t supply one of those. We believe the true liability of our contracts to be far lower than that calculated by Black-Scholes, but we can’t come up with an exact figure – anymore than we can come up with a precise value for GEICO, BNSF, or for Berkshire Hathaway itself. Our inability to pinpoint a number doesn’t bother us: We would rather be approximately right than precisely wrong."

"You can be highly successful as an investor without having the slightest ability to value an option.'

On debt: "...to finish first, you must first finish."

There are more concepts we'll likely discuss at a later date, these were some initial highlights that resonated for one reason or another.

Great letter again this year. We never cease to be amazed at how after all this time, he nonetheless manages to discuss something he's not openly addressed in the past. That doesn't mean they haven't been speculated about and, often, nailed by others. But to read his own words about, for instance, GEICO, is fascinating. Thanks again, Warren.

the 21st century education

Since I was in college, I've been frustrated with the way the modern academic system works. Over time, that dissatisfaction has only grown more severe. As a value investor, my goal is to get the most value for the price paid. Yet formal education is an investment whose value seems to have decreased over time - it provides less and costs more every year. At my alma mater, students today are paying more than double the tuition I did to receive an education that is a commodity. I believe there are much better ways to deliver education that don't involve formal education or degrees, but rather systems that potential employers agree offer a comprehensive assessment of skills. In short, it'd be a, "I don't care how you learned it if you know it" approach. Folks with the wherewithal to learn the requisite skills through self- or small-group study would be encouraged to do so. Others could pursue a more formal path but not by following the pre-determined, formal curriculum that now exists.

One university is taking some concrete steps to shift the model, and it sounds promising. Steve Blank wrote a nice blog entry about it. It's available here.

a couple quotes

A couple recent quotes that speak volumes.

Michael Pettis, in this week’s research note, on the economics of China’s growth :

“Not only do I believe that the combination of very low cost of capital, socialized credit risks, and strong short-term political incentives to fund massive projects always leads to capital misallocation, but I also believe that the explosion in [Non-Performing Loans] a decade ago, and the fact that total [State Owned Enterprise] profits are just a fraction of the interest rate subsidy they receive, is strong evidence that misallocated capital has long been a serious problem in China.”

Jeffrey Gundlach, on high-yield bonds (Barron's):

“The current 300 basis-point, or three percentage-point, spread between yields in the high-yield market and on 20-year (Treasury) bonds is as narrow as it has been at any time in the latest credit cycle.”

friday afternoon filing fun

It's always fun to see what filings roll in around 6 pm eastern on a Friday.

Todays is Wellcare (WCG), which despite making the decisions on bonuses and an increase in base salary on Monday (the 14th), just now got around to filing the paperwork. (emphasis and additions mine)

On February 14, 2011, the Compensation Committee (the “Committee”) of the Board of Directors of WellCare Health Plans, Inc. (the “Company”) determined bonuses under the Company’s annual cash bonus plan for 2010 of $1,015,625 for Alec Cunningham, the Company’s Chief Executive Officer; $546,250 for Thomas L. Tran, the Company’s Senior Vice President and Chief Financial Officer; and $320,000 for Scott D. Law, the Company’s Senior Vice President, Health Care Delivery. These bonuses are expected to be paid on March 4, 2011.

The Committee also approved increases to base salary for Mr. Cunningham from $650,000 to $800,000 (note: +23%) and for Mr. Tran from$475,000 to $500,000, each effective as of February 13, 2011. For 2011, Mr. Cunningham’s short-term and long-term incentive targets will remain as 125% and 300%, respectively, but will be applied to his new annual base salary. Mr. Tran’s short-term and long-term incentive targets will remain as 100% and 150%, respectively, but will be applied to his new annual base salary.

a few words about inflation

The basket of goods and services consumed is different for everyone, so inflation is experienced uniquely by all. The person who lives in a lower-cost area and drives into a high-cost one for work might have above-average transportation expenses but below-average housing costs. The retiree might spend less on housing but much more on medical care. College students spend a lot on education.

Here is the “basket” used to compute the Consumer Price Index (CPI):

I see glaring differences between what I personally spend on many of these categories, and I suspect a lot of the population would, too. The CPI is used “adjust incomes, lease payments, retirement benefits, food stamp and school lunch benefits, alimony, and tax brackets.” But the government is keeping the books. So what’s the incentive here? It goes without saying that they stand to benefit most by keeping it as low as possible.

The current commodity environment is undoubtedly inflationary. The rising prices of base metals, food inputs, cotton prices, among others, don’t just affect electronics, food and apparel costs but ripple into other areas as well. The longer high prices persist the more they have the potential to permanently raise structural costs (including wages). It may be a while before these increases show up in the official statistics, though, as the most recent 1.6% year-over-year print indicates. Nonetheless, these increases can profoundly affect consumers without a commensurate increase in the Consumer Price Index (CPI).

Below are year-over-year prices changes (through yesterday) on several basic commodities. Not a pretty picture if these prices are sustained for a length of time. Even grease is up almost 80%. Grease!

To close I’ll mention one of my favorite statistics the BLS publishes, the Special Index called “Purchasing power of the consumer dollar (1967=$1.00)”. That number -- $0.152. Purchasing power clearly erodes over time, even if it doesn’t show up in the statistics in real time.

complacency built, and building

Yesterday, the NYSE saw 365 new 52-week highs and just 9 new lows.

How much longer can this relentless, low volatility run continue? Since the end of September, we have seen only six days where the market has declined by 1% or more (just two of those this year). And the last time the market declined 2% or more was on August 11th -- and it's happened only twice since the end of June last year! That's a long time to go without substantial downside volatility.

Now, it's one thing to see the market climbing but we must consider its context. To do that we juxtapose this against prevailing valuations. On that front, it’s not encouraging. The S&P 500 stands at 18.5x earnings (over 24 cyclically adjusted) and is discounting decade-ahead per annum returns under 5% (1.8% of which is from dividends). Sure, interest rates are low which means stock *should be* worth more, but I don't buy it because investors can revise their return expectations relatively easily (and quickly).

So volatility is low and valuations are elevated, but the market keeps going up?

"It feels safer."

"There is money to be made."

Low volatility to the investor, to borrow from N.N. Taleb, is like the farmer feeding the soon-to-be-Thanksgiving-dinner turkey. Just as the safety appears greatest (based on backward-looking data), the danger is actually at its highest.

private market froth-iness

While it's not clear there is a bubble yet, some of the private market valuations I've seen are bubble-icious. My evidence is more anecdotal since I'm not an "on the ground" venture capitalist. But here is something from Fred Wilson, offering a good overview from a very credible source that there is a froth in the private markets. Money is sloshing around the bathtub, and I'd argue it's spilling over into all asset classes.

Remember W.B.: "The first rule of investing: Don't lose money. The second rule: Don't forget Rule #1." Remember the downside, grasshopper.

the Fed and housing

Whoops.

BUSTED: Unsealed Docs Show The Fed Was Fully Warned Of A Housing Crisis