Random Articles for the Week ending June 7 2008

Random articles I find interesting for the week ending June 7 2008...

(Illustration by Satoshi Kambayashi for The Economist)

I can't stop cracking up at that image. Maybe something is wrong with me but I find it humourous. The only thing is, if the pigs in suits are the investment bankers and their associates, who is the wolf? The government? Short-sellers? Investors? The public? Free-market forces?

1. End of the Free-wheeling Wall Street Ways? (The Economist)
   
2. Iceland: Living Beyond One's Means Starts to Bite Back (The Globe & Mail)
   
3. Discussion with Warren Buffett (March 2008 discussion at the Richard Ivey School of Business (Canada))
   
4. Roundtable with Jean-Marie Eveillard (Wealthtrack with Consuelco Mack)
   
5. Fortune's 35 Largest Private Companies (Fortune)
   
6. Oil Badguy Conspiracy Theories and Arguments Against It (Fortune)
   
7. Why Oil Will Fall--But When? (on an opposite note, if you are interested in commodities or are bullish on them, you might also check out this video interview with Don Coxe, a long-term commodity bull)
   

Click above to read the linked articles... or click on "Read More" to get my opinion thrown in :)



Investment Banks Under Attack

(Illustration by Satoshi Kambayashi for The Economist)

Investment banks are under attack. No. I'm not talking about being under attack from David Einhorn ;) I'm talking about the wolf in the above picture. The Economist has another good article talking about the changes faced by Wall Street investment banks. The article also touches on how there is disagreement between the banks (successful ones like Goldman Sachs doesn't want a leash placed on them; while Lehman Brothers seems to like the idea of greater oversight). The article also mentions how anything to restrict the banks can backfire.

“THE worst is behind us,” proclaimed Dick Fuld, Lehman Brothers' boss, in April. If only. Although the overall financial system may be safer, thanks to extraordinary central-bank interventions before and just after the rescue of Bear Stearns, America's investment banks still make investors nervous, not least in the market that puts a price on the risk of default (see chart). The longer this goes on, the more onlookers are tempted to conclude that Wall Street's business model is broken. With tougher regulation on the cards, this crisis may, they fear, be less a cyclical slump than the start of an era of less risk-taking and lower returns—in effect, the neutering of Wall Street's finest.

Historically, it has been the public (jealous) and government (want their hand in everyone's pockets) that has attacked the rich pigs in fine suits (sorry about the condescending description but it's kind of true). Lately, however, investors in these banks are getting concerned with excessive leverage, high compensation for what amounts to spinning the roulette wheel (i.e. proprietary trading), and lack of accountability by anyone (no one still knows who is actually to blame for all the subprime losses even though senior executives earn $20million+ per year). I think the banks will never be the same again. It's one thing for the public or the government to attack the banks, but when their own investors are unhappy, changes will have to be made.

As the article mentions, investment bank valuations are discounted and have generally traded at P/Es around 10 due to black box risk (i.e. no one knows what these companies are doing). Lowering the risk will increase the valuation multiple placed by the market, but will lead to lower profits. It'll be interesting to see what investors end up doing: a higher valuation with lower profit margins, or a risky business with higher profits. As I have said before, if the investment banks have access to Federal Reserve funding, they should not be allowed to do business with the "shadow world" (i.e. hedge funds, overseas investors, anonymous foreign governments, etc). There is just too much leverage and massive risk in the hedge fund world and I wouldn't want the government backstopping all that risky action.

Iceland: The Downside to Living Beyond Your Means

If anyone wants to see the pitfalls of living beyond your means, you need to look no further than Iceland. This small country has become the poster boy for excessive leverage and is starting to take on the role that Thailand did during the collapse of the Asian Tigers back in 1997.

On this resource-rich island in the North Atlantic, the global credit crisis has claimed its first national casualty, undermining a fragile currency and driving inflation and the official interest rate into double-digit territory.

Stagflation has struck with a vengeance. Over the past fifteen months, the rate of inflation has nearly doubled and is forecast to hit 15 per cent by July.

Economists are forecasting growth of less than 1 per cent this year and next, and official interest rates are at 15.5 per cent - the highest of any developed economy...

Even before the credit crunch and the surge in commodity prices, there were warning signs of danger ahead, because of rising costs and high consumer and corporate debt levels. The ratio of private sector and consumer debt to GDP was about 130 per cent at the end of last year.

But the Central Bank of Iceland was slow to react and was caught completely off guard by the credit mess.

I hate to say it but I feel that Canadians and Americans are also living beyond their means by relying on too much debt (but corporate balance sheets are clean in America and Canada).

Warren Buffett Interview

Transcript of a lengthy interview with Warren Buffett from the Richard Ivey School of Business at the University of Western Ontario. This interview was conducted in March 2008 and was covered previously in Fortune and various other sources, but this is the full transcript that I hadn't seen before. I find almost everything coming from Warren Buffett to be repetitious (this is the downside to being a successful investor for 30+ years :) ) but this touches on stuff I haven't seen him talk about.


A Few Thoughts from Jean-Marie Eveillard

Wealthtrack with Consuelco Mack featured Jean-Marie Eveillard along with a few other guests (thanks to FatPitchFinancials for the original mention). Jean-Marie Eveillard is unique in that he is one of the few value investors who has never lost money in any single year over the last few decades as far as I know. Avoiding losses during the bear market from 2000 to 2003 was extremely difficult and if you want to see the skillful positioning by a superinvestor, you can't find too many better than Jean-Marie during that time period. Jean-Marie didn't say much in the roundtable interview but most of it hammers home key points that any value investor or contrarian with a value focus should pay attention to:

JEAN-MARIE EVEILLARD: Well first, I've run the First Eagle Global Fund for 30 years. Over the past 30 years, there have been very few opportunities to lose money in any given year, except between the spring of 2000, and the spring of 2003, when the stock markets, and particularly the American markets, went down 30 or 35% or 40%. We didn't lose money.

CONSUELO MACK: No you didn't, right.

JEAN-MARIE EVEILLARD: We made money. I think we made money because we're value investors, and in 1999 we were not buyers of Cisco Systems at 100 or 200 times earnings. I think value investing is the sound investment approach that helps you reduce risk. But to me, risk is certainly not volatility. In fact, volatility provides opportunity for the value investor to take advantage of the fact that Mr. Market will show you a price that is very high to you, and you say, "that's an opportunity to sell"; and volatility, on the way down, Mr. Market will show you a price that is too low, from our point of view, and that would be an opportunity not to sell, but to buy.

CONSUELO MACK: And this Mr. Market of course is Ben Graham's famous description of the market.

JEAN-MARIE EVEILLARD: That's right. So risk is certainly not volatility. The risk is not easily quantifiable, I think. Risk is what Marty Whitman calls permanent impairment of capital. So risk is not market risk; risk is primarily business risk. At the extreme, you buy the stock of a company that goes bankrupt, and goes bankrupt badly enough so the lenders and the bond holders take what they can, and there is nothing left for the equity holders, so the stock is worth zip. There is also valuation risk- you overpay for a security. Again, in value investing, there is the idea of the margin of safety, the cushion, and so you try not to overpay. But it is a lesser risk than the business risk because if you're right about the strength of the business, time will be on your side, as time goes by, time will be on your side. So, risk is the risk of permanent impairment of capital.

He also is unique in holding a sizeable quantity of gold (if I'm not mistaken, all of the Third Eagle Funds own something like $1 billion worth of physical gold). However, unlike many gold investors, he uses it as quasi-insurance, given that it is one of the rare assets that is negatively-correlated to the broad market (but this hasn't been the case in the last few years so I think gold will collapse along with the broad market). In contrast, most people invest in gold because they expect it to go up for various other reasons (decline in US$, end of the world ;), etc).

Jean-Marie Eveillard will be retiring next year (if I'm not mistaken) and it would be a shame to see him dissapear. Another guy that we won't hear much from in the future is probably Martin Whitman. I need to find a young version of Eveillard or Whitman that I can learn from :) Anyone have any thoughts? There are a lot of hedge fund guys running around but (i) it's hard to get information about them, and (ii) hard to tell talent from luck when you have highly-leveraged hedge funds using secretive tactics.


Thirty Five Largest Private Companies in the US

This isn't a new list (I think it was published early in the year along with the Fortune 100 list--not sure) but for some fun facts, check out the largest private companies in the US. This isn't going to help your investing acumen but it is some fun stuff to know. As usual, you can rank companies by different metrics, such as market cap, profit, revenue, and so forth, and Fortune uses its standard of using revenue to rank the companies. The three largest private companies are Koch Industries (industrial manufacturing), Cargill (agricultural commodities), and United States Postal Service (postal service).


Still Hunting for Oil's Bad Guys?

Fortune has a slideshow summarizing various conspiracy theories used to speculate on the reasons for the rising oil prices. Several reasons debunking the theories are also presented.

As is the case with anything in life, from politics down to economics, multiple factors play a role. The real question to me is what is the primary force. In my opinion, the primary reason for the rising oil prices is due to incremental marginal demand from developing countries such as China, India, and East Asia. All these theories trying to figure out the bad guy is just as misguided and misleading as trying to explain a complex topic like terrorism by pinning it on a single bad guy. The oil prices are heavily subsidized in those aforementioned regions that are driving demand. However, as I have alluded to in several posts, most of those countries can't afford their subsidies and are backtracking one way or another.


Why Oil Will Fall--But When?

Fortune magazine has a feature article written by their editor, Shawn Tully, speculating that oil prices are bound to fall. It's a good article that covers the bear side of the oil argument (disclosure: I'm bearish on oil and commodities in general.) I think everyone should read it because it touches on something that is often overlooked, both by the bulls and bears: marginal cost to produce a commodity. Commodity prices are set at the margin by the last incremental demand for a barrel of oil.

In a normal oil market, the cost of producing the last, most expensive barrel of oil needed to satisfy worldwide demand sets the price for every barrel the world over. Other auction commodity markets work much the same way.

So even if Saudi Arabia produces at $4 a barrel, if the final, multi-millionth barrel required to heat houses and run cars costs $50, and is produced, for argument's sake, at a flagging field in West Texas, the world price is $50. That's what economists call the equilibrium price: It's where the price that customers are willing to pay meets the production cost, including a cushion, naturally, for profit or "the cost of capital."

But today, the sudden surge in demand and the production bottlenecks have thrown the market radically out of balance...


The story is much the same with oil, with a twist. A big swath of the market isn't really paying that $125 a barrel number you hear about seemingly every hour. In China, India and the Middle East, governments are heavily subsidizing oil for their consumers and corporations, leading to rampant over-consumption - and driving up prices even more.

But sooner or later the world won't keep paying those prices: Eventually, the price must fall back to the cost of that last barrel to clear the market.

So what does that barrel cost today? According to Stephen Brown, an economist at the Dallas Federal Reserve, that final barrel costs just $50 to produce. And when the price is $125, the incentive to pour out more oil, like homebuilders' incentive to build more two years ago, is irresistible.

The real question is the timing. I actually think oil is in a bubble but who knows where the top is or when it will burst? Just like how people said the technology stocks were in a bubble in 1998 ("irrational exuberence") yet the peak was in 2000 and at much higher prices or how quite a few said that housing was in a bubble in late 2003(!) yet the peak was in 2005 and at much higher prices, it's difficult to say where the peak in oil is.

Marc Faber said one of his biggest mistakes was shorting tech stocks in the late 90's (his view was ultimately right but his timing killed him). I shorted the Canadian stock market (TSX) through an inverse ETF about an year ago (primarily due to my bearish view on commodities and what I perceive as high multiples being placed on commodity companies) and it may have been a bad decision (I made up my mind not to short anything in the future--especially a macro trend). My guess is that the max peak for oil is probably around $250 so you are looking at around 100% more upside in the best case. I don't really see it going past that (this is assuming the US$ doesn't drop too much). If you hit that level, my guess is that almost half the downstream oil companies in Asia would be bankrupt (or the governments providing subsidies would be near bankruptcy). There was an article I read a few months ago saying that the two biggest government-owned Indian oil companies would be facing serious cash flow problems within a few months if the government didn't give more free money to them or raise prices (India actually ended up raising prices last week). Similarly, I recall articles from a few months ago saying that some of the biggest Chinese oil companies with downstream operations, like Sinopec and CNOOC, would be losing hundreads of millions without more money from the government or price hikes. But, as Shawn Tully says in the article, oil, like housing, has a huge lag. So even though things won't unfold instanteously, the market will rapidly re-price commodity stocks.

Just to provide some bullish support, two of the biggest commodity bulls (who actually were bullish long before the Street was bullish), Jim Rogers and Don Coxe are still bullish (do check out Don Coxe's interview if you are interested in some thoughts on commodities and why this is not quite like the 70's. He makes an insightful point about how the ratio between the forward price and the spot price is what matters. The spot price doesn't mean much in his view).