The Investor's Consigliere

Charlie Munger Slate Essay

Charles Munger of Berkshire Hathway writes a sobering parable.  This may be the main disagreement between him and Warren Buffett.

Disclosure: Long Berkshire Hathaway.

Warren Buffett New York Times Op-Ed

The last one urged people to "buy American" stocks.  This one is a warning about the side effects to be expected from the extraordinary fiscal and monetary measures that have been taken to turn around the economy.

A little background:  Buffett's father Howard was kind of a psychopath about inflation--he thought FDR would turn the US into the Weimar Republic.  His son was never as bad, but throughout his career the specter of inflation has always guided his investment decisions.  In 1977 he wrote an essay for Fortune called "How Inflation Swindles the Equity Investor" which is the best analysis of the effect of inflation on corporations I've ever read.

Buffett almost guarantees that one day the United States will face higher inflation as a result of the actions being taken.  Yet here we sit with the 10-Year Treasury yielding 3.53%.

P.S.  Some might argue that this op-ed conflicts with the last op-ed he wrote, in which he urged Americans to buy equities.  If we're in for inflation, stocks will do poorly, like they did in the 1970s.  But read the first op-ed closely and you'll see that Buffett recommended only that Americans buy equities as an alternative to cash, which is perfectly consistent with his thinking in the second op-ed.  In fact, if you fear inflation your money may be best off in equities (public or private, in the sense of being a business owner), even more so than gold.

Disclosure: Long Berkshire Hathaway

P.P.S.  If you're a member of SumZero, you can see my write-up of a stock I think will do well in an inflationary environment.

Paul Singer Wall Street Journal Op-Ed

Paul Singer calls for less more regulation of financial institutions.  A big deal-trust me.

Peter Tanous Op-Ed

Peter Tanous is one of the manager selectors better-known to the public, having written a book of interviews with successful money managers.  In an op-ed in yesterday's WSJ, he argues that it will likely take longer than expected for US stocks to re-reach their October 2007 highs.

The reason for this is firstly, that stocks have fallen a lot.  If you assume the bottom occurred on March 9, the S&P has to go up by 131% to reach its earlier high. 

Secondly, if stocks were to rebound quickly, that would imply very high compound annual rates of return during the rebound period, annual rates which have seldom occurred historically. 

The lesson, Tanous concludes, is that the recovery in stock prices is likely to take longer than hoped for, that investors should reduce their expectations accordingly, and that they should avoid increasing the risk of their investments in an effort to recover their losses more quickly.

I don't disagree with the article, but I have the following comments:

1)  A good Baynesian (I hope I'm not  misusing this term--NateCarrFan, help me out.  Maybe I should say "a good conditional probability theorist") would have looked at how many times the stock market has compounded at high rates over a multiyear period given a substantial bear market immediately prior.

2)  I think the piece dwells a little unwisely on sunk costs, which are nearly always irrelevant to the task of an investor investing today. "Sunk gains" are pretty irrelevant too--whether a stock has gone up or down in the past should be of little import.  What really matters, what should most occupy the attention of investors, investors in investors, and their clients, is the current expected returns of an investment based on its price, its intrinsic value, and the alternatives available today and in the future.  Even the greatest investors often elide this distinction--they'll say "I quadrupled my money in two years on this name so I sold it."  What they should have said, and what you hope they thought when they analyzed it, is "I sold it because at that price, its expected return was not as good as the alternatives available at the time and/or expected to be available in the future."

 

Berkshire Hathaway Letter to Shareholders

is here!  Raise your hand if you sat there clicking "reload current page" until the 2008 letter showed up. I'll have a longer commentary later, but here are some initial thoughts:

1)  Your consigliere is on record saying that value investors who venture into macroeconomics do so at their peril.  I was afraid, I'll confess, that Buffett would do just that in his letter.  But he didn't.

2)  Buffett is well-known for preaching against diversification, but states that one of goals is for Berkshire to maintain "dozens of sources of earnings and cash" and that another is to find "new and VARIED streams of earnings."  In fact, Berkshire is probably the most diversified company in the world.

3)  Kremlinology alert--I'm about to read too much into Buffett's wording:  On page 4 Buffett very precisely writes that the three large PIPE deals he made were "In our insurance portfolios."  Meaning they were funded in large part by cheap/free float.  So a 10% coupon on one of these deals is less than the return on equity to a Berkshire shareholder from doing the deal. 

4)  Berkshire's large equity put portfolio can be understood as partly a bet on future inflation, as they were written on indices that reflect nominal currency values.  There is a chart on page 206 of Barton Bigg's Wealth, War and Wisdom that I'm too stupid to know how to reproduce.   It shows that from 1932 through mid-1957, a period that included both the Great Depression and World War II, the Italian stock market enjoyed near-uninterrupted growth.  But it's a nominal index--in real terms the market fell.  But if you'd written a long-term put on that index on similar terms as the ones Buffett made, you would not have had to pay anything.  Of course Buffett must also navigate inflation when trying to invest the premium he's received on those puts.

5)  Berkshire Hathaway the stock declined 32% in 2008.  Berkshire Hathaway the company declined only 9.6%, as measured by book value.  Keep in mind that the company is now largely in the business at "borrowing" money from policyholder at very low/free/negative rates in order to invest in regulated utilities.  Those two parts of the business did very well.

More later. 

David Einhorn and Michael Lewis New York Times Essay

This two-part essay has been receiving a lot of attention.  Whitney Tilson said the following about it in an email:

STOP THE PRESSES!!!  RUN, don't walk, to read these two articles by Michael Lewis and David Einhorn, two of the best writers and thinkers about the financial crisis.

I read the essay twice, both to learn what the two thinkers think, and as an exercise in evaluating Einhorn as a money manager.  I've written before that how well an investor writes can offer clues into how well he invests.  It may seem like a marginal activity for a money manager selector to focus on (along with tracking the conspicuous consumption habits of investors), and it's not the main thing I look at, but the logic of active investor selection, especially hedge fund manager selection, is ruthless:

1)  Active investment managers are very expensive
2)  There is a wide performance gap between the best ones, the mediocre, and the worst
3)  In most cases, low-cost passive investment alternatives are widely available
4)  Unless you manage to invest in the top ten percent of active managers (or even better if you pay someone like me or a fund of funds to select for you), your money and efforts spent on active manager selection rather than passive investing will have gone to waste.

Therefore, the manager selector must look hard at anything and everything that could be of use, both art and science. 

With that self-justification out of the way, I was less impressed with the Lewis/Einhorn essay than Whitney Tilson.  Although I agree with them that there is a lot wrong with the financial world that needs to be fixed, I don't think they proved that the various cited "causes" of the current crisis in fact caused the current crisis.  Yes Wall Street is too short-term oriented, but that's been true for a long time (and Japan's vaunted long-term thinking of the 1980s, celebrated in airport books everywhere, did not prevent it from experiencing a crisis of its own).  Yes the SEC is a revolving door between the public and private sector, but it's been that way since Ambassador Kennedy.  Yes the ratings agencies face perverse incentives, but that's always been true. 

I'd be interested to hear your thoughts.  If you read the essay, force yourself to forget about the fact that one of the co-authors is a very successful and wealthy hedge fund manager. 

P.S.  By the way, I must take points off from Einhorn for his choice of collaborators.  Michael Lewis may be the Tolstoy of narrative business non-fiction, but as an investment thinker I would not rank him as highly.  Check out this takedown of Warren Buffett in the New Republic from 1992--17 years and about $38 billion (of Buffett net worth) ago.  Here is how Buffett biographer Roger Lowenstein described the article and Buffett's reaction to it: 

In "Saint Warren: Wall Street's Fallen Angel," Lewis charged Buffett with a series of investing and ethical flaws so all-encompassing that an unknowing subscriber might have supposed that he was reading of one of the century's great swindlers--and one of its great failures, to boot.  Lewis took the Efficient Market Theory as gospel and dismissed Buffett's career as a run of lucky coin flips.  That aside, "Fallen Angel" was rife with actual errors.
  
Buffett was livid over the Lewis piece.  Morey Bernstein, the author of The Search for Bridey Murphy and a Ben Graham devotee who had known Buffett casually, wrote Buffett a sympathetic note, damning Lewis's article, apparently in more profane terms.  Buffett--ever careful with words--responded: "Morey--Thanks for the empathy re the Michael Lewis piece.  He is everything you say he is." (pp 404-405)