Daily Reading: December 31, 2008

Initial jobless claims is better than expected, continuing jobless claims is worse than expected. Reuters.

A Russian academic is predicting the end of the U.S. by 2010. WSJ. Maybe this guy should use his prophetic powers to advise the Kremlin on how to fix his own piece-of-shit country!!!

Daily Reading: December 30, 2008

Add GMAC to the list of bailout recipients. Bloomberg. I am beginning to think I should have spent the last 5 years running a business into the ground so I could get a bailout too.

Here is an article about the rise and recent collapse of the Icelandic banking system. WSJ.

Consumer confidence hits an all-time low. AP.

Daily Reading: December 29, 2008

Here is a great article about some of the events leading up to Lehman's bankruptcy. WSJ.

Kerkorian sold the remainder of his stake in Ford. NY Times. Even well-known investors pick losers from time to time.

Daily Reading: December 24, 2008

Initial jobless claims up, Consumer spending, income down, personal savings up, Mortgage applications surge, mostly refinancing. That, my friends, is a lot of doom and gloom.

Madoff scheme turns deadly. WSJ.

Wachovia shareholders approve sale to Wells Fargo. WSJ.

Here is a blog post from the CNBC's Buffett Watch entitled "How to Tell the Madoffs from the Buffetts." It discusses some key differences between honest and less-than-honest money managers.

An interesting story about the impact Mexican consumers have on the U.S. economy. NY Times.

Has the proliferation of e-Books begun? NY Times. I really want a Kindle. Unfortunately, Oprah profiled the Kindle on her show and they sold out until February.

Daily Reading: December 23, 2008

Existing home sales fell in November. AP. Home values will not stabilize until the supply of homes and the demand for homes stabilize. Supply continues to increase-largely because of foreclosures-but demand cannot keep pace. The result is extreme downward pressure on home prices. Read my proposal for the stabilization of home prices.

Daily Reading: December 22, 2008

Re-default rates on modified mortgages are rising. Reuters.

Some background on Ponzi schemes from the NY Times.

John Meriwether's new hedge fund is experiencing major problems. WSJ. Coincidentally, Meriwether's last hedge fund, Long-Term Capital Management, collapsed almost exactly 10 years ago. As the old saying goes, "Insanity is doing the same thing over and over again and expecting different results." --John Dryden (I think???)

A key member of Congress is in support of releasing the second half of TARP before January 20th. AP.

Daily Reading: December 20, 2008

Canada will provide aid to Canadian subsidiaries of U.S. automakers. Bloomberg. Ayn Rand must be rolling over in her grave when the PM of Canada says they have a "social responsibility" to help the ailing companies.

The second half of TARP funds will reportedly be used to help distressed homeowners. Bloomberg. Can someone explain this to me? If a family in California makes $50,000 a year and they owe $500,000 on their house, how in the hell can the Treasury do anything to prevent a foreclosure?! I don't think mortgage modifications will do any good in stemming the mortgage crisis. My plan for housing market stability makes more sense.

Oil producers are cutting production and capital spending. WSJ. This is really scary stuff. The recession is going to be bad, no doubt about it. But it will end eventually. Our energy problems, on the other hand, will persist. Production cuts now equals reduced supply later. Combine reduced supply with post-recession demand and $150 oil will be a pleasant memory. Energy is a MUCH bigger problem than mortgage defaults in the long-term. Refer to Brent Voss's report on oil for more information.

An interview with President Bush on the Wall Street Journal's editorial page. It will be interesting to see how history remembers our 43rd president.

Daily Reading: December 19, 2008

Well, like it or not, the Federal government is giving GM and Chrysler a short-term lifeline. Bloomberg.

It sounds like Mr. Paulson will be requesting the second half of the TARP funds. AP.

Daily Reading: December 18, 2008

Initial jobless claims fell more than expected last week. The headline makes it sound better than it is, 554,000 initial claims is a HUGE number. AP.

Obama is reportedly considering $850 billion of stimulus spending. I have heard many economists argue that fiscal policy will do little to aid recovery. The basic argument is: The government has to borrow the money. As such they are not adding value to the economy. They are simply borrowing from the left pocket and spending in the right. The borrowed money should remain in the private sector where it will be used more efficiently. I absolutely agree that the private sector is more efficient than the public sector. The problem is the private sector is not spending nearly enough because they don't 'feel good' about the economy.

The economists are missing the 'feel-good effect' of fiscal stimulus, which of course is not quantifiable. Let me explain with a bit of history. Herbert Hoover was President when the stock market crashed in 1929. Throughout his presidency, the U.S. economy went from high-flyer to deep depression. And as a result nobody trusted Hoover; he didn't make them 'feel good'. Then, in the 1932 election, along comes FDR. Who promises sweeping fiscal stimulus (New Deal) to grab the economy by the bootstraps and throw it into renewed growth. Whether or not New Deal spending added value to the economy, it did dramatically improve consumer and business sentiment. After 3 1/2 years of despair people felt like they might be turning the corner. They trusted FDR, they felt more secure, and the economy began to improve.

The Obama stimulus plan will almost certainly not have the same quantifiable benefits that private sector spending could achieve. But it will make people 'feel good'. And when they 'feel good', they spend money. Strong consumer spending is one piece of the recovery puzzle.

Here is a good editorial from the National Review. It briefly discusses the good, the bad, and the ugly of our current monetary and fiscal policy.

The New York Times put out an opinion piece worth reading. No, I am not drunk. It discusses the world's perception of the American financial system and growing parallels between America's and China's economic system (they are moving toward capitalism while we are moving toward socialism).

Credit Suisse is going to pay year-end bonuses with illiquid investments. An interesting way of getting CMBS's off the balance sheet. WSJ.

I know Halloween is over, but if you want a good scare watch this 60 minutes interview of Whitney Tilson on YouTube. Tilson manage's a fund called T2 Partners and has set himself out as an expert of the mortgage crisis. He says that the subprime crisis was only the first half of the mortgage meltdown. Next on the docket is Alt-A and Option ARM's. As an aside, I had the pleasure of meeting Mr. Tilson at the 2008 Berkshire Hathaway shareholder meeting.

What is the Bush administration going to do with Detroit? The latest guess is an 'orderly bankruptcy'. NY Times.

Is there any correlation between the criticism the SEC has been getting for being "asleep at the wheel" and the timing of the latest insider-trading bust? Who knows? Who cares? At least they busted the SOB's. It is really irritating that a few jerks like this make all investment professionals look bad. WSJ.

Why High Oil Prices will Return, Reaching New All-Time Highs --Brent Voss

I asked a good friend of mine to write an essay in which he answers the question: Why will the price of oil increase significantly post-recession? Here it is:


The consumer has scored a victory in the midst of the financial crisis. Cheap gas! Drivers are thrilled that prices have returned to "normal" so that they may more easily continue the modern lifestyle. Last summer virtually everyone thought that $4 gas was literally highway robbery and could not continue. And as it turned out, they were right...for now.

Today both the world oil market and the consumer have ignored an all too important fact: World oil production went flat in 2004 at around 85 million barrel/day (mb/d), i.e. supply stopped increasing. A majority of current world oil supply comes from as few as 10 super-giant oil-fields, the youngest of which was discovered in 1969. These fields experience increases in production as wells are drilled and extraction technology improves, up to a point. Over time oil production plateaus and heads into irreversible decline.

In its 2007 World Energy Outlook, the International Energy Agency (IEA) predicted a rate of decline from the world's existing oilfields of 3.7%, only to admit 12 months later that the speed of the fall was more likely 6.7% and is expected to accelerate to 8.6% by 2030.
Assuming the IEA is correct in their 6.7% depletion rate, the world's oil companies need to discover approximately 5.7 mb/d of new oil production every year just to keep overall production flat. This is how the IEA came to this startling conclusion in their World Energy Outlook 2008:

"Even if oil demand was to remain flat to 2030, 45 mb/d of gross capacity – roughly four
times the current capacity of Saudi Arabia – would need to be built worldwide by 2030
just to offset the effect of oilfield decline."

Further, considering that demand will almost certainly not remain flat, and if the IEA's demand growth projections prove correct, by 2030 64 mb/d of new oil production is required to meet demand and counter depletion. That's the equivalent to 6 new Saudi Arabias. That's right, the largest oil producer in the world today times 6 in new production just to maintain the current supply and demand relationship. This strikes me as impossible.

Obviously, massive capital investment is necessary to discover and develop the world's remaining oil reserves. And herein lies the problem: The price of oil is too low to attract the badly needed capital.

"Below $70, it will be non-economical to invest in the hydrocarbon sector....Today there is no cheap oil" - Qatar's Energy Minister Abdullah Bin Hamad Al Attiyah

Even Saudi Arabia has come out with a "fair price" of $75 per barrel. It's not that Saudi needs that price, but it understands that oil at that level would encourage new output from marginal, higher-cost sources. For example in the northern Alberta, Canada oil sands, where oil prices of $75 a barrel had been adequate to ensure a good profit, UBS-analyst Andrew Potter now says $100 a barrel is likely needed to produce a 10% return. The IEA projects $6.3 Trillion is needed for investment in crude oil exploration, development, refining and shipping. And an additional $5.5 Trillion in projected investment is needed for natural gas exploration, development and transport.

As I write, West Texas Intermediate (WTI) crude futures are at $43.60/barrel. The marginal cost of a new barrel of production is between $65 and $75 per barrel. In order to make new discoveries and bring them to market, oil prices would need to rise 49-72% from current levels.
If the price does not rise to levels that attract investment, new production needed to simply offset oilfield decline/depletion will not find it's way to the local gas station. In the not too distant future the fundamental principle of economics, scarcity, will get the consumers attention.

You may be thinking that we'll never run short of oil and the price of a gallon of gasoline will never reach $7 in the next decade. With all the talk of energy independence you may think that we'll come up with viable alternatives that reduce our reliance on imported crude oil. The former Saudi Chief of Intelligence Prince Turki Al-Faisal recently said US oil independence "is non-applicable" despite US President-elect Barrak Obama's assurances. "Saudi should not be worried concerning Obama's attempts to launch oil independence, as oil remains the cheapest source of power, therefore it cannot be made indispensable."

I recently read that Toyota was cancelling their planned Prius plant in Mississippi. A friend just told me of $1.27/gal gas in Kansas City. I suppose these two events are related. Cheap energy and the credit crunch is killing investment in more efficient vehicles. The same goes for wind and solar energy investment. It would take trillions of dollars to replace our current vehicle fleet with the most fuel efficient models. This transition simply won't happen in a one year, five years or even in a decade even with fuel prices much higher than they are today.

We live in a world in which incentives matter. As long as crude oil costs remain low, there is no incentive to change behavior, keeping the world hooked on a substance the dealer of which may not be able to supply in quantities sufficient to get our fix. Yes, the withdrawal from crude oil will likely be one of the more painful experiences in modern history since virtually everything is fueled by or made from crude oil.

It is ironic that the very low prices that we're now celebrating will lead to even greater economic pain down the road.

Daily Reading: December 17, 2008

If the oil market won't correct itself OPEC will. WSJ.

Financial firms worldwide have experienced credit crisis related losses of over $1 trillion. That is a lot of zeros my friends. Bloomberg.

Constellation killed the deal with Mid American Energy in favor of the French. But don't feel bad for Warren Buffett, Mid American will be well compensated from the termination arrangement. WSJ.

Daily Reading: December 16, 2008

Consumer prices are falling due in large part to the price of oil. Do not get accustom to this phenomenon. There is a high probability that oil prices will spike after the recession. AP.

Buffett is buying common stocks. Indie Research.

The Fed is expected to look to new policy tools since interest rate manipulation is increasingly ineffective. My question is: How does the Fed plan to shrink its balance sheet once the economy begins to recover without killing the recovery? Maybe that is a "we'll cross that bridge when we get there" situation. Bloomberg.

The Bush administration is sending mixed signals about its intentions for Detroit. GM and Chrylser must feel like love-struck teenage girls who can't determine if their beau has reciprocating affection. They are resigned to picking pedals from a flower; he loves me, he loves me not, he loves me, he loves me not... AP.

The Fed continues to surprise. Fed Funds target lowered to an unprecidented range of 0.0%-0.25%. AP.

Here is the text of the FOMC statement. Yahoo Finance.

Note to self: Don't invest in funds of funds. They don't do shit to earn their fees!!! Read this Bloomberg report about Tremont Group investing client money in Madoff's ponzi scheme.

Great opinion piece about Detroit from the Wall Street Journal. $$$ might require a subscription.

Daily Reading: December 15, 2008

Will GMAC get a lifeline from bank regulators? It is beginning to look more plausible as debtholders agree to a security swap. The deal is intended to improve GMAC's capitalization in order that it can become a bank holding company. Holding company status would give GMAC access to TARP money. Bloomberg.

It seems quite irrational for Treasury yields to fall while the government issues record levels of new debt. Call me crazy but I think we are seeing an asset price bubble in the middle of a severe recession. The difference between this bubble and others we have experienced: Most are fueled by greed, the Treasury bubble is fueled by fear. Bloomberg.

An interesting interactive tool from CNBC. 10 states with highest unemployment.

The Bush administration gives public assurance that short-term aid will be forthcoming. AP.

Daily Reading: December 12, 2008

The 5 people who voted in the MOS poll will not like this article. The (not so) Big 3 might get TARP money. AP.

An under-reported story is the number of regional commercial banks that have been shut down by regulators. This article reports the number has recently grown to 25. AP.

Securities fraud is a big deal, just ask Bernard Madoff. How in the hell is it possible to run a $50 billion Ponzi Scheme? Bloomberg.

More auto bailout news from Bloomberg. I am really struggling with how I feel about the government bailing out decades of poor management and an inefficient industry. In normal times (when most Americans are fat and happy) I would say, "Let a bankruptcy judge sort it out. The Japanese make better cars anyway." But these are most certainly not normal times. My concern is that if GM and Chrysler aren't given some aid they will be forced to liquidate. The subsequent job loss could be devastating to an already weak economy. So I think short-term aid is appropriate if withholding said aid would have far reaching consequences (read: materially negative for the country as a whole). Believe me, I have no sympathy for Detroit or its entitlement minded citizens. My concern is strictly for America.

Daily Reading: December 11, 2008

Sorry for not posting yesterday (not that anyone reads this).

This article is extremely thought provoking and, frankly, scary. The scary part isn't that some people believe the S&P 500 could bottom out at 400. Rather, the limitless powers of the Federal Reserve is enough to scare the pants off of me. Bloomberg.

A great report about the fall-from-grace of Bill Miller, CEO of Legg Mason Capital Management. WSJ $$$ might require a subscription.

Ode to Mr. Market

Mr. Market:

You used to be so good to me,
I was making money as if it grew on a tree.
Your prices climbed to higher highs,
A daily advance was no surprise.
But then one day, no notice in advance,
You took a completely different stance.
Although the economy was looking dreary,
You had put your reliance on the "greater fool theory."
You began to stutter and get real scared,
As if out of no where, you finally cared.
That the prices you had set made no sense,
Some stocks you'd priced high weren't worth a pence.
You puked and belched and ran away,
As if America was nearing doomsday.
Some people think you are quite efficient,
But it's clear to me you are totally DEficient.
Your reputation is now in the tank,
Investors have a new lover-the Federal Reserve Bank.
You see, Mr. Market, you're now impotent and unable to please,
Like an elderly man who can't pleasure his main squeeze.
But we'll come back to you when the Fed has done the trick,
Until then, though Mr. Market, I think you're a PRICK!!

Signed,
WS

Daily Reading: December 3, 2008

Is anyone else concerned about the death of private enterprise? We seem to be on a one-way train to socialism. This WSJ article discusses the latest on the auto company bailout bill.

Daily Reading: December 8, 2008

Bad things can happen when you abandon your principles. WSJ article about the Reserve Money Market Fund (the Fund that "broke the buck" in September).

Short NY Times piece about court action (or inaction) related to the Bear Stearns deal and the legal doctrines: Unocal, Revlon and Blasius.

How bad will the recession be? Nobody knows, but it will be bad. Especially for the rank-and-file laborers. This NY Times article is a broad discussion of our economic woes.

We will recover from these bad economic times. This article discusses Obama's plan for recovery. I doubt Obama will have as much to do with the recovery as the media will give him credit. NY Times.

The Tribune Co. filed for bankrupcy protection today. The proliferation of the internet has wreaked havoc on print media. The combination of a tough business and excessive debt is a recipe for disaster. AP.

Daily Reading: December 6, 2008

It is quite possible that we are already in the worst recession since WWII. Bloomberg.

Does anyone believe this article? The auto CEO's claim that bankruptcy would cost the American economy more than their proposed bailout. It seems like scare tactics to me. Should Detroit sell out to Japan? Perhaps Wagoner et. al. have forgotten everything they learned about the economic theory of specialization. Japan is better at producing cars than Americans, so let's allow them to produce our cars. We can spend our time and resources on something more productive, like creating a better NFL team in Detroit. The Lions are just embarrassing. Bloomberg.

Quack quack quack. Lame ducks at work. For once, I agree with the populist Republican Dick Shelby. Congress and the White House agree, in principal, on auto company bailout. Bloomberg.

Combine Paulson's plan for lower mortgage rates with my proposal to stabilize home prices and we'll really be in business.

My Proposal to Stabilize Home Prices

Stabilizing Home Values

There are a great many ideas floating around about how to stabilize the market price of homes and prevent foreclosures. In this post I will add a new one to the list.

Economics 101 tells us that, in any market, an increase in the supply of a good or service will reduce the price without a proportionate increase in demand. This is the situation in the U.S. housing market. The supply of homes has increased substantially, due in large part to foreclosure sales, while demand has declined. As supply increases, prices decline leading to more foreclosures. More foreclosures increases supply causing more price declines and more foreclosures. And on and on and on. It is a cycle that will continue until the market has purged itself of all or most of the sub-prime-alt-a-low-doc-no-doc-liar loans.

I have a proposal for Mr. Paulson & Co. that could slow, or possibly reverse, the downward spiral.

The concept is quite simple: remove a significant amount of the housing supply by encouraging or mandating banks, or other mortgagees, to stop selling real estate owned (REO) for a certain period of time. In exchange for holding the real estate, the Treasury would purchase a 50% interest in each REO from the banks. The purchase by Treasury would give the banks some liquidity with which to lend. But also, by retaining a material interest in the REO's the banks would have an incentive to maintain the properties and seek top dollar for their sale when it is once again allowed.

The obvious problems with this proposal are:

1. The REO's could depreciate/deteriorate rapidly due to lack of use.
2. Administration of the program would be labor intensive and difficult.
3. The tax payers could lose money on the eventual sale of the REO's.
4. There would be significant cash outflows required of Treasury.
5. More government intervention in private markets might be inappropriate.

I am sure there are many more problems but I am merely trying developing the concept.

With regard to problem number 1, we could have a moratorium on REO sales for a short period of time, 2-3 months. After which only a percentage, say 10%, of the REO's in the program could be for sale at a given point in time. In this way, there would be a continual stream of REO's being sold so that they are not sitting unoccupied for long periods of time. The program would serve to 'bottleneck' the supply of homes.

I'm not sure there are solutions to problems 2 and 3.

Problem 4 could be limited by capping the funding appropriated to the program to $100 billion.

Problem 5 is a matter of personal ideology.

The Benefits

The National Association of Realtors reports that the median home price in the U.S. for the 3rd quarter of 2008 was $200,500. Given $100 billion for the program, if the Treasury paid $100,250 (half of the median home price) on average, for each 50% interest, nearly 1 million homes could be removed from the housing inventory. I couldn't find reliable data on the number of REO's currently for sale but I assume there are less 1 million of them; meaning, a $100 billion program would cover the entire inventory of REO's.

According the the National Association of Realtors, there are currently 4.6 million new and existing homes for sale. My proposal would reduce that number to 3.6 million, a 22% decrease. We can be sure that a 22% reduction in the supply of homes would have a meaningful positive impact on price.

Other indirect benefits might include:

1. Reduction in foreclosures-Homeowners could sell their house before being foreclosed. Prices would be stable (not decline or possibly increase) and the homeowner would not be competing against dozens of REO listings.
2. Realized losses on mortgage-backed securities could be limited, or at least deferred.
3. Prices on mortgage-backed securities could improve, lessening the impact of mark-to-market losses on bank and insurance company balance sheets.

The potential for unintended consequences is huge. One in particular is the reaction of homebuilders to an artificially improved housing market. If prices stabilize (or rise) homebuilders would increase production of new homes. The resulting increase in housing supply could make it difficult to sell REO's as the program progresses. Treasury would need some flexibililty as to when, and in what volume, the REO's could be sold.

From a theoretical perspective my proposal is sound. The problem with theory is that it rarely translates well into reality. I would love to receive your comments.

Daily Reading: December 5, 2008

Unemployment is on the rise. Bloomberg.

Warren Buffett's NY Times Op-Ed titled "Buy America. I Am." from Oct. 16. NY Times.

Daily Reading: December 4, 2008

This will be the only article today. A piece of this quality deserves to be posted by itself. Warren Buffett has publically called the direction of the stock market 4 times in his career. ClusterStock

Daily Reading: December 3, 2008

I'm sure this comes as no surprise: Private employers were cutting jobs in November. Reuters.

Although it is probably skewed a bit due to declining payrolls, productivity growth is better than expected in the 3rd Quarter. AP.

Mortgage applications rise significantly due to lower interest rates. Not a lot of surprise news today. CNBC.

The pros and cons of less expensive oil. Yes, there are cons to cheap oil. As a matter-of-fact, there are many more cons than pros in the long-term.

Riding Coattails

In previous posts I have referenced famous investors, e.g. Warren Buffett and Mohnish Pabrai. I think it is important to study what they have to say and learn from their wisdom and experience.

But wisdom is not the only thing we can get from well-known, proven investors. From time-to-time we can get their investment ideas, more affectionately known as 'ride their coattails'. Some of my most profitable investments have come from someone else's idea.

But you must exercise caution. Warren Buffett may have an incredible track record but he is not infallible. You would be a fool to blindly buy what someone else is buying without developing your own opinion of its merits. Riding coattails is merely a starting point for thorough analysis.

There are a handful of investors to whom I pay attention. If I see their name in a headline I read it immediately. The following are a few of their names:

• Warren Buffett, Berkshire Hathaway
• Mohnish Pabrai, Pabrai Investment Funds
• Whitney Tilson, T2 Partners
• Bill Miller, Legg Mason Capital Management
• Chris Davis, Davis Funds
• Walter Schloss, retired

One problem with riding coattails is you won't be the first or only person to receive the information. So you will not have an information advantage over the rest of the market. In fact, the market will probably have the information before you. Generally, when news breaks that Buffett has been buying a stock the price of said stock jumps well before most of us could react. So, again, a word of caution: Use coattail riding only as a starting point for your analysis.

Why do these guys disclose what they are buying? It obviously could create problems for their own buying programs. The simple answer is: They are required to do so by the SEC. Bill Miller and Chris Davis run mutual funds. The SEC requires them disclose, on a periodic basis, everything their funds own. The others run hedge funds or other non-mutual fund entities. In that case, they are required to disclose to the SEC some or all of the securities holdings under various circumstances.

Keep your eyes open for news about great investors with whom you are familiar. It might lead to your next great investment.

Daily Reading: December 2, 2008

Reuters reports that Ford expects to breakeven by 2011. This ties-in to the discussion of Hope. Hope and reality can be quite divergent.

Goldman can no longer delay the inevitable. Reuters.

The UAW had better become amiable in a hurry, that is if they like having jobs. AP.

We have a monetary system in which the Federal Reserve can create as many U.S. dollars as it wishes and all of the U.S. Treasury debt outstanding is issued in U.S. dollars. In that light, how is it possible for the U.S. Treasury to default on its debt? It doesn't seem possible to me, but apparently some folks think it could happen. Reuters report on the CNBC website.

Wow, the Big 3 CEO's really do want bailout money. They are reducing themselves to automobile travel in the upcoming trip to Washington. AP.

Sears Holdings post poor results. It is hard to believe that, the once revered investor, Eddie Lampert was buying SHLD at more than $100 per share. Maybe he knows something we don't know. NY Times.

Countrywide is being sued by mortgage investors. Mortgage servicers modifying contracts that they do not own sounds like a recipe for disaster. Is it not obvious that legally enforceable contracts is paramount to our economic system? NY Times.

The most shocking headline of the day: U.S. auto sales are down significantly. AP.

The latest asset price bubble: U.S. Treasury Securities. WSJ $$$ Subscription required. If you don't have, at least, an online subscription to the Journal you should get one now.

Daily Reading: December 1, 2008

Spend, baby, spend!!! Reuters report of Pelosi's proposed stimulus package.

The Treasury might bailout homeowners in trouble while those of us that didn't buy a house we couldn't afford foot the bill. Rewarding improper behavior seems to be a theme in Washington. Bloomberg.

Daily Reading

OPEC decides not to cut production YET. Bloomberg.

Consumer spending and the labor market are weak. NY Times.

This Wall Street Journal article helps to explain the purpose of MOS Investor.

GM is trying to come up with a plan. WSJ.

Don't forget to celebrate the 75th anniversary of the repeal of Prohibition this Friday, December 5th. WSJ.

CNBC compiled a list of companies who have announced layoffs.

Hope is Public Enemy Number One: An Extension of the Margin of Safety Discussion

Hope is a wonderful thing. It allows us to dream of a brighter future. Without hope, all of humanity would exist in a perpetual state of depression. A life without hope would not be worth living.

But hope, for all of its good qualities, is enemy number 1 of the prudent investor.

Hope causes us to believe a situation will improve without a reasonable basis in fact. Let's suppose, for example, we are analyzing a company that has experienced a 25% decrease in annual earnings from its all-time high. Hope causes us to shortcut the analysis by blindly making the assumption that earnings will eventually rebound to the previous highs. If we make the decision to purchase shares based solely on that assumption we become slaves to hope. We run the risk of not making money, or worse, losing money, if earnings do not recover. The only escape is to be hopeful of a brighter future.

It is certainly possible for a company to have a large drop in earnings followed by an equally large increase in earnings. But that is beside the point. The problem arises when the investor's expected return is entirely dependent upon the eventual rise in earnings. If earnings do not rise he loses money, either in absolute terms or in opportunity cost. What he needs is a backstop, i.e. a margin of safety. He has to ignore the hopeful desire for earnings to increase and only purchase shares if he can reasonably expect to realize an adequate return even if the situation doesn't improve.

When analyzing stocks, you should look for situations where you have a high probability of profit even if things do not improve for the company. In other words, buy stocks at a low enough price that even if earnings do not grow you have a good chance of price appreciation and if earnings decrease further you won't lose too much (Mohnish Pabrai calls this "heads I win, tails I don't lose too much"). Do your analysis, and make your decisions, based on reasonable case and worst case scenarios. Ignore the best case because it is the result of hope. If your expected return is not dependent on the best case scenario, but it subsequently materializes, so much the better. You exceeded your expected return. The best case scenario is nothing more than a free option to the prudent investor. GRAVY!

Daily Reading

Black Friday might be Red this year. Bloomberg.

The Federal Reserve Backstop, Money Supply is Growing Fast. I wonder if the Fed's actions will result in unintended consequences. Who can say INFLATION?

Value Investing Part III: Margin of Safety

Be sure to read Part I and Part II of this series.

Warren Buffett calls Margin of Safety "the three most important words in investing."

Margin of Safety is a concept originally described by Benjamin Graham in "The Intelligent Investor" (This is a must read for any serious investor. Follow the link to Amazon and buy it NOW).

Margin of Safety is an integral part of Graham's definition of Investment. It increases the probability that we will achieve "safety of prinicipal and an adequate return." Without a Margin of Safety we are not investing, we are speculating.

The process of determining the value of a stock is imprecise. It is dependent upon estimates and projections of future events. There is a high probability that even the greatest investor will make mistakes when valuing a company. To compensate for errors in our estimate of value we must purchase stocks for less than the value. For example, if I think XYZ Corp. has a value of $20 per share I wouldn't want to buy it for $20 a share. Sure, if my value estimate is spot on, I probably won't get hurt by paying $20. But the chance that my value estimate is absolutely correct is nearly zilch. As a result, I want to buy XYZ Corp. for less than $20.

How much less? The answer is completely subjective. It depends on how comfortable you are with your estimate of value and the risks the company faces that could impair its value. If you are confident that your value estimate is highly reliable and there are few risks that could impair value, then you might be willing to buy at $15. Conversely, if the risks of impairment are high you might require a price of $10 to trigger a purchase of shares. You should think of Margin of Safety as a concept rather than a specific number. The Margin required in any specific situation depends on the circumstances surrounding that situation.

Mohnish Pabrai, in The Dhandho Investor, describes Margin of Safety as buying $1 bills for $0.50. A value investor searches the market for situations where he can buy a stock for half of what it is worth and sells it when the price is at or near value. In Pabrai's words, buy a $1 bill for $0.50 and sell it when the price recovers to $1; an extremely profitable proposition. The Dhandho Investor is another book on my 'Must Read' list. Follow the link and buy it now.

What should be clear by now is the relationship between Margin of Safety and Graham's definition of investment. A larger Margin of Safety lowers our probability of permanently losing money and increases our probability of earning an adequate return. Said another way, Margin of Safety decreases risk and increases expected return.

This concept runs counter to what our emotions would have us do. When stock prices are going down, fear sets in and we want to sell. But if you believe in the Margin of Safety concept, declining stock prices is exactly when you should be buying. Because when prices are declining the Margin of Safety is going up.

Value investing is contrarian by nature. Prices go down when there are more people willing to sell then there are people willing to buy. Therefore you have to be able to operate against conventional wisdom. Warren Buffett says it best, "Be greedy when others are fearful, and fearful when others are greedy." To be a successful value investor you must be able to think independently and trust your judgement. If the prices of your stocks are going down and you are questioning the wisdom of your purchases take solice in the words of Ben Graham, "You are neither right nor wrong because the crowd agrees with you. You are right because your facts and reasoning are right."

Daily Reading

Although I realize nobody is actually reading this, I apologize for not posting yesterday.

This Bloomberg article describes the problem with making decisions based on fear.

This CNBC article discusses the problems baby boomers face because of the stock market crash. Maybe the credit crisis will solve our Social Security problems. Boomers can't retire thus they continue to work and add to the system rather than retire and take from it.

OIL IS NOT GOING TO STAY CHEAP FOREVER!!! Take the appropriate measures to protect yourself.

The AP reports that there is a new source of economic pain.

Things are tough all over, as this CNBC article explains.

Ouch, Fitch cuts Toyota's AAA credit rating. It happened a couple of days ago but I forgot to post it at the time.

Daily Reading

Reading for 11/25/2008

The Fed throws a Hail Mary.

Daily Reading

Reading is of the utmost importance to any successful investor. Warren Buffett says to "read everything." As you saw in the Investment Analysis post, we spend a great deal of time reading company specific reports. But it is also important to be aware of general business and economic news.

I am going to have a 'Daily Reading' post, ironically enough, daily. It will contain a number of the articles I feel are appropriate for all investors. I plan to edit the post throughout the day adding new links as I find them. Enjoy.

Citigroup receives government bailout.

A great post by a friend of mine about crude oil.

A Wall Street Journal article about the Federal Reserve's monetary policy tools. $$$ requires subscription.

An interesting take on the current market turmoil.

If you are curious about who is receiving funds from the bailout program, check out this interactive tool from the New York Times.

In this NY Times op-ed, Tyler Cowen, of George Mason University, says that most fiscal stimulus policies will do little to aid economic recovery. I agree and tend to think that most fiscal stimulus policies do nothing more than aid in the re-election efforts of our esteemed members of Congress.

The stabilization of home prices is a critical ingredient for the resolution of our economic woes. But as this CNBC article explains, we aren't there yet.

Before you go buy a new SUV read this CNBC article.

The government is going to spend a lot more money. I wonder where it will come from?

Value Investing Part II: Investment Analysis

Be sure to read Part I of this series.

The analysis of an investment must be thorough. We should strive to understand the company in all material respects. Without a solid understanding of the business (its capital needs, the competitive nature of its industry, etc.) we will not be able to value the business with any level of confidence. The first question you must ask yourself before beginning an analysis is: Is this business simple and understandable? If the answer is no, forget about it and look for a different company to research.

Simple and understandable means different things to different people. Larry Ellison's (the founder of Oracle) understanding of Oracle is second nature. I, on the other hand, couldn't begin to understand how Oracle makes money. I would not attempt to research Oracle because the effort would be futile. As Charlie Munger would say, "that one goes in the too hard pile."

To ensure my research is thorough I like to use two checklists, the Preliminary Workup and the Final Workup. The two checklists are as follows:

Preliminary Workup

Where do I expect to find value in this company?
Balance sheet?
Income/Cash Flow?
Intangibles?
Others?
A combination thereof?
Is the company heavily dependent upon human capital, e.g. investment banking?
What risks does the company face that could impair its value?
What factors influence the balance sheet values?
How sensitive is the balance sheet to those factors?
What are the risks to income/cash flow?
Factors?
What is the competitive structure of the company's industry?
Is the industry in decline?
What is the company's position in its industry?
Does the company have pricing power?
Is the company a slave to its suppliers?
Is there a risk/history of unethical or criminal behavior within the company?
Others?
Does the company have negative exposure to, or benefit from, commodity prices?
Explanation.
What is management doing with free cash flow?
Does it make sense? Is it in the best interest of shareholders?
Or is it stupid?
What are the risks of financial distress?
Look at various metrics, e.g. Cash Flow to Debt, Debt to Equity, Net Current Asset Value
Other risks.
Other positives
If the price is right, would I want to own this company?
If the answer is yes, perform the Final Workup.

Final Workup

What is the company's normalized cash earning power?
What is the intrinsic value of future earnings? Provided in a range, not one absolute number.
List and explain assumptions. Are they reasonable?
Is there excess capital?
What is the value of excess capital? Provided in a range, not one absolute number.
What is the range of total value?
The range should be the "reasonable scenario" (neither best case nor worst case).
What events, actions, etc. could permanently impair the value?
What is the probability of these events happening?
What is the total value under a worst case scenario, given reasonable assumptions?
What is the probability of the worst case scenario?
I do not consider a best case scenario.
What is the market price? How does it relate to value?
What is my margin of safety?
Non-existent? Not sufficient? Neutral? Sufficient? Excellent?
At what price would I commit 10% of my net worth to this company?
At what price would I commit 50% of my net worth to this company?

Decision: After performing your thorough analysis you have a decision to make. It comes down to 3 choices: Start a position, Wait for a better price, Throw it in the trash.

The Thesis

If I decide to buy, I like to write a little statement in which I answer two questions: Why am I buying this security? Under what circumstances would I consider selling?

It should be clear that you have to put forth a significant amount effort before you can begin the workups. You should be able to answer all these questions with the 2 or 3 most recent annual reports of the subject company. Find the reports on the company's website and start reading.

Value Investing Part I: The Basics

Value Investing, for all intents and purposes, is the only method of investing (if executed properly) that promises long-term investment success.

Investment Defined

Before I define and explain value investing, let us first consider the definition of an investment. Benjamin Graham, in his classic investment treatise "The Intelligent Investor", defines an investment as follows:

"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return."

The act of simply buying a common stock does not qualify one as an investor. According to Graham's definition there are several criteria that must be met. We have to thoroughly analyze the stock. After such analysis, we must concluded that we have a low probability of permanently losing money and a high probability of generating a return that exceeds a threshold. We'll call the threshold our opportunity cost, i.e. the return we could realize on other investment options.

Price vs. Value

There is a distinct difference between price and value. Warren Buffett says:

"Price is what you pay, value is what you get."

The decision to buy or not buy a common stock boils down to two numbers, the price of the stock and value of the stock. Price is easy, it is given to us in minute-by-minute market quotations. At any given moment, price is a specific and known number. Value is a bit more tricky. It is the number we hope to arrive at following "thorough analysis." Determining value is a tedious, yet imprecise, task. We will discuss the process of valuation later in the series.

Value Investing is simply buying stocks, or other assets, for less than their value.

Investing is as simple as that statement; determine the value of a stock and buy when the price is less than value.

Introduction

For my first post let me provide a quick background.
My name is Jeremy Horn. I am a securities analyst for a life insurance company. In addition, I am the founder and Managing Partner of a private investment partnership. I hold a bachelor's in both finance and accounting and I am a Level III CFA candidate.

My target audience is anyone who is currently, or has future plans of, participating in that wild auction arena we call the stock market. I hope to keep most discussion topics general. I will do my best to avoid esoteric topics such that everyone can read, understand and, most importantly, learn.

I will not discuss securities that are being considered for purchase, are in the process of being purchased, or that have already been purchased for either the insurance company or the investment partnership (I do not trade for a personal account. Besides some mutual funds in 529's for my kids, all of my personal investment is in the partnership). I will use past securities (those that have been sold) for illustrative purposes. NOTHING CONTAINED HEREIN SHOULD BE CONSTRUED AS INVESTMENT ADVICE OR RECOMMENDATION. We are here to learn how to invest, not to be told what investments to buy.

It is important for me to note that I am unoriginal. You will read nothing here that is the result of extraordinary intelligence or incredible foresight on the part of yours truly. The knowledge I apply to the investment decision-making process, and to this blog, are the result of my study of other extraordinary investors. To name a few: Benjamin Graham, David Dodd, Warren Buffett, Charlie Munger, Philip Fisher, John Burr Williams, etc. It is they who deserve credit for extraordinary intelligence. Consider me nothing more than the conduit through which their knowledge passes to you.