Rational Advisor

In investing as in life, it’s important to understand that the one decision you make can be important. And that one decision should not be made on the current events or some hot topic.

Much of the mistakes being made now in the market, is to NOT make changes to appropriate investments, instead it’s to “ride” along with the markets. Well, the markets are in the habit of making the most number of people fools at the most inopprtune time.

The United States has had severe or secular bear markets, often linked with financial crises, averaging more than one per decade for the past 150 years. Even during the golden period of 1982 to early 2000, there were several crises, such as the combined real estate, savings and loans, and junk bond disaster of 1990, and the 1998 Long Term Credit debacle. And, while most such markets unfold slowly over time like a disease, the October 1987 crash was more like having a tooth pulled without anesthesia – painful, but mercifully quick.

We’ve recently experienced this decades financial crisis. But that does not mean that some other crisis does not lurk out there - maybe not financial but some other asset/sector.

The point of this history lesson is not to open old wounds but rather to explore Santyana’s dictum that those who do not learn from history are doomed to repeat it. The sad fact is that after the bear markets of recent years investors blithely carrying on making the same mistakes, apparently assuming that it would never happen again. The still investing with the same ol’ disregard to risk management. Assuming that this something that is running so hot will continue, orr that they’ll be better able to time it this time.

The problem is that there are still a lot of little worries and no major one. Remember that small amounts of carbon, oxygen, nitrogen or hydrogen are easily handled. When combined in a particular way, however, they turn into nitroglycerine.

Seemingly unrelated components can be combined to create dangerous economic effects also.

Every decision you make, every action you take matters
To not make a decision is also a decision
So, even the decision we do not make matters
- Any Andrews – The seven decisions

Every time you do something – things change

One guy made one move 140 years ago. a 34 year old teacher on July 3rd 1863 – said he wasn’t a teacher, he was a Colonel, not because of his experience, but because he was the first guy to volunteer. If he did not do what he did, the US would be part of the UK.

Chamberlain, (http://en.wikipedia.org/wiki/Joshua_L._Chamberlain) with no ammo, put the bayonets on the guns of his 80 soldiers and captured 400 at Gettysburg. If the South had one that battle, you would have had a state like Europe, a bunch of small countries put together and not the United States (All States United in one nation - one country – all because of one man, and his decision.

So, as you can see making a decision is very important

In May I had the great opportunity in New York to meet some of the most talented investment specialists around the US. Of particular interest was David Dreman, a US Value Manager, and also Tom Marsico, a US Growth manager. For international investing we had perspectives from Daniel Geber of GLG, based in the UK.

David Dreman and Tom Marsico are some of the most famous and well respected investors in the US. David, is acknowledged as the father of contrarian investment strategy, and has written what I consider as the bible of investing - Contrarian Investment Strategies for the next generation.

Tom Marsico is the founder of Marsico Capital Management, and best known as a concentrated growth manager, who had built a great track record at the helm of the Janus Twenty Fund, before creating his own firm.

Below are key points that each manager made.

1. David Dreman and Cliff Hoover of Dreman Value Management of New Jersey.

The Dreman team had indicated that we are back to basics investing – fundamental investing, where the numbers and balance sheets mattered more that the hypes and stories. Companies with great valuations and dividends would offer better potential than those that are based on some product or future magic.

What’s interesting is that this recent crisis in financial services can be laid at the feet of one person, and one mathematical formula – those feet and formulas belong to David X Li, a Chinese citizen, who moved to Canada then the US. David had a Masters in Mathematics, an MBA, and a PhD in statistics - a very qualified propeller head. David went to work for CIBC, then Barclays and finally Goldman Sachs in the US. In 2000 he came out with a paper to quantify risks in one symbol Gamma. Prior to this the only way to measure risk was to use historical performance data. In Li’s paper he used correlation data of various defaults in credit instruments to offset risks (the rate of failure of credit), he called this result Gamma. Then, because the world wanted to boil down risk to one number (something that I disagree with) the financial system fell in love with this formula, and began to sell complex risky investments as less risky because the correlation of all of these together led to low risk. And then the proverbial waste matter hit the proverbial oscillating device. When events not factored in began to happen simultaneously, like defaults on mortgages happening at the same time. But because a lot of leverage in banks and hedge funds were based on this magic formula, we saw a massive collapse. Had the events not happened David may well have received the Nobel Prize. Where is David now, he’s working for the Chinese government doing risk management! (Here is a link to a great article from Wired magazine that goes into greater depth http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all )

Dreman believes that the term correlation does not have the same significance in risk management as it did in the past. The issue we currently is that the world is all correlated. Thanks to technology, the internet, shared resources and employment – different markets around the world go down and up at the same time.

What we have seen recently is a ten year negative number in the equity markets. These are rare events, since 1836 there have been 3 negative ten year rolling periods - and in the past every time this has happened, the forward ten years have been very positive. It did not matter significantly whether you invested one year before, or after these periods.

If we were to compare this current year to the past, we are currently closer to 1984 kind of levels and sentiments. This was a particular confusing year that arrived just after the recession of 1982. it was also the year that preceded the large recovery years of 1985 to 1987.

This recent recovery has been stoked by an unprecedented global stimulus. Dreman believes this recovery could last a year or two. However, because of this generous stimulus they do believe that inflation will be a serious force to contend with in a few years.

Much of the concerns around the leverage in the market have been removed by the recent reduction in hedge funds and leveraged accounts at brokerage firms.

Dreman’s current strategy has not changed since 1974, and it is to concentrate on dividend paying stocks, with attractive valuations, that are out of favour for short term irrational reasons, such as certain financial firms with strong management and balance sheets.

They believe that oil will return to favour, and have been adding to strong resource companies as oil prices dropped. Being contrarian does not mean blindly choosing what is out of favour, as such they believe that the auto sector will continue be in trouble for a some time, there is no easy solution to this.

A question was asked around inflation and what assets tend to do better in appreciating inflation environments. Dreman’s reply was that stocks of companies that have the ability to increase their prices during inflationary times tend to do better.

The Dreman team has an optimistic view of the markets considering the pessimism and distrust still in the markets,

2. Tom Marsico of Marsico Capital Management, Denver Colorado.

Tom finds that this maybe the most compelling opportunities he has seen since 1997, when he created his firm. Valuations are very attractive for growth managers.

As per Dreman, he believes that the Fed intervention is helping. There has been over $5 Trillion of global intervention so far. This will impact the system and provide a base of support.

Comments were made on President Obama striving to keep his word on changes. So, confidence should be had on key decisions that are being made based on the presidents acceptance speech.

You can expect, the auto sector to be much smaller in the future, and to shift its technology to more alternatives as opposed to Oil based.

Energy and Healthcare will also be changed by the Obama administration. We can expect Oil to remain within a price range because of administrations focus to foster alternatives.

One of the most attractive areas for investments, will be the financials, as Obama focuses on creating a historical win for himself as the savior of the economy. This is very akin to the FD Roosevelt era in the 1929’s when FDR’s policy led to his status as one of US’s most popular presidents.

Marsico believes that the economy has changed such that lifetime employment will be rare. Unemployment will remain high as it is a lagging indicator, and recovers after the economy has risen. New jobs will be created in areas that are not foreseeable now. An example was given of developers of application programs for the Apple iphone - these jobs were not there 3 yrs ago

Marsico believes that inflation will remain low for the next few years; it has been a primary focus of Fed Chairman Bernanke. It will not be a concern for 3 or 4 yrs. High inflation and high rates would lead to a depression, and this is something that Obama does not want that before his second term

Tom had an excited market view, if we were to return back to P/E of 16 that would mean markets would have to rise by approximately 85% to return to a new normal.

3. Daniel Geber of GLG in London, UK.

Daniels’ view is that markets have gone up to fast, and need to retrench, come back to reality, and that from this point we would appreciate at more normal rates. He however does not expect a return to recent market lows.

The main problems that caused the markets to be so volatile can’t be fixed this quick. Regulations take time to implement.

Daniel believes that recoveries will be stronger in areas like Brazil, which has a strong rising middle class, a good financial system, and a strong political base.

The main area of worries around the world belong to Russia, which has too much dependence on Oil and poor political structure. Pakistan is also a concern with its unstable political environment. Daniel believes we may see issues in Pakistan becoming headline news, as geopolitical concerns and terrorism rise up again. We are intending to avoid areas around these and surrounding countries.

Like Tom Marsico, Daniel believes that inflation will remain lower for a few years then rise up, and that this may be positive for equities.

Because of demand and supply considerations, Oil is to remain close to current levels, we are at the right price.

The international scene for autos is a lot more encouraging than in the US, GLG likes them, especially smaller European and emerging market companies and suppliers. The US may move to alternatives, but the higher prices for these vehicles means they will be avoided in emerging markets. They will still buy old fashioned oil burning cars

Daniel remains cautious in the short term, but optimistic in the long term for international equities. There are still causes for concern, but not causes for panic. We may still see periods where the equity markets pull back, some retrenchment, but it’s unlikely that there would be wholesale selling or capitulation as we saw in the latter part of 2008.

In Summary

The overall consensus was that we may well be beyond the worst parts in the markets. Valuations are exceptionally attractive, and careful selection is critical. Remember that investing is a probability game. The key to successful investing is to carefully select investments, which given their probabilities and characteristics, are the closest match for your investment objective, time horizon and risk tolerance. Then sit back and be patient.

Investing is still a smart long term idea.

Charlie Munger is perhaps one of the wisest people when it comes to investing. He’s also Warren Buffett’s partner in crime.

Here’s key points from a Q&A he did for Stanford Law Review

Q&A: Matters with Charles T. Munger
http://www.law.stanford.edu/publications/stanford_lawyer/issues/80/

Charles T. Munger is a man of many interests, much like his hero Benjamin Franklin. Self-taught in a range of disciplines, he’s a strong advocate for interdisciplinary education saying, “If I can do it, many people can.” A student of physics and mathematics before entering law school, he left his mark on the legal profession early in his career by co-founding Munger, Tolles & Olson in 1962—a firm that is today consistently ranked at the top of its field. Now an icon of the business world, he joined forces with Warren Buffett in the mid-1960s—leaving law to become vice chairman of Berkshire Hathaway and a partner in one of the most successful firms in the world.

Over the years Munger has gained a reputation as something of a no-nonsense voice for sound investment strategies and responsible business practices—as well as simple common sense. But lately it is the mythical Greek character Cassandra who is much on his mind. After living through the Great Depression, serving in WWII, and entering the business world in an era of restraint and sensible regulation, he is irritated by what he calls “the asininities” of today’s government and business leaders that led to the current crisis. He saw the financial train wreck coming and voiced his concerns loudly. But almost no one shared them.

“It is painful to see the tragedy coming, to care about all the people who are going to be clobbered, and not to be able to do one damn thing about it,” said Munger,

As we look at the current situation, how much of the responsibility would you lay at the feet of the accounting profession?

I would argue that a majority of the horrors we face would not have happened if the accounting profession developed and enforced better accounting. They are way too liberal in providing the kind of accounting the financial promoters want. They’ve sold out, and they do not even realize that they’ve sold out.

Would you give an example of a particular accounting practice you find problematic?

Take derivative trading with mark-to-market accounting, which degenerates into mark-to-model. Two firms make a big derivative trade and the accountants on both sides show a large profit from the same trade.

And they can’t both be right. But both of them are following the rules.

Yes, and nobody is even bothered by the folly. It violates the most elemental principles of common sense. And the reasons they do it are: (1) there’s a demand for it from the financial promoters, (2) fixing the system is hard work, and (3) they are afraid that a sensible fix might create new responsibilities that cause new litigation risks for accountants.

Very few people realize how much we’ve screwed up. Even in leading law schools and business schools very few people realize that the mess at Enron never could have happened if accounting customs hadn’t been changed.

As part of the response, the U.S. government and governments worldwide are printing money at a rate that is absolutely unprecedented. Should people be worried about deflation?

Sure. But the dangers from what we have to do are less than the dangers that would come if we responded much as we did in the ’30s.

I think it is dangerous to have big disasters in a modern economy. I regard pre-World War I Germany as an advanced, decent civilization. After all, little Albert Einstein got a very good, subsidized primary education in German Catholic schools. But in its economic misery, Germany became dominated by Adolf Hitler. We’ve seen some god-awful people come to power in various miseries in various countries. Enough misery has huge dangers in a world where we have new pathogens, atomic bombs, and so forth. So we can’t afford to have huge economic collapses. I think we have to do what we’re doing. We’re hooked. And so are the other advanced nations.

What I’m hearing from you, Charlie, is “so far so good”?

It is very reasonable to react with the extreme vigor that’s been shown. In retrospect the vigor wasn’t quite enough. I would argue that it was pluperfectly obvious the government had to save all these banks and major investment banks.

How and why do you think economists have gotten this so wrong?

I would argue that the economists have not been all that good at working concepts of good and evil into their profession. Nor do they understand, at all well, the economic consequences of bad accounting.

In fact, they’ve made a profession of driving value judgments out of the subject.

Yes. They say it’s not economics if you think about the consequences of good and evil, and good and bad business accounting. I think what we’re learning is that when you don’t understand these consequences, you don’t have an adequately skilled profession. You have big gaps in what you need. You have a profession that’s like the man that Nietzsche ridiculed because he had a lame leg and was very proud of it. The economics profession has been proud of its lame leg.

So in order to cure the lame leg, you would lean more toward an approach to economics that takes human nature into account?

If you totally divorce economics from psychology, you’ve gone a long way toward divorcing it from reality.

You’ve often said that one of the keys to your success has simply been to avoid making the garden-variety mistakes that you see other people make.

Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.

If you had to characterize a few mistakes that you see executives making, which ones jump out at you?

An extreme optimism based on an inflated self-appraisal is one. I think that many CEOs get carried away into folly. They haven’t studied the past models of disaster enough and they’re not risk-averse enough. One of the very interesting things about Berkshire Hathaway is how chicken it is, how cautious, how low is its leverage. But Warren and I would not have been comfortable with more risk, entrusted with other people’s net worths. There was no reason for our financial institutions to stretch as much as they did, with the leverage, the shady people and the compromises.

A crisis is…

We may be forced into much desirable change. If there aren’t a lot of new jobs in derivative trading, maybe the engineers will have to do more engineering. If you look at the history of Berkshire Hathaway, you will find that time after time we did something that I describe as turning lemons into lemonade. Part of my Berkshire Hathaway holdings came from a dumb investment.

I didn’t realize you made dumb investments.

I certainly did. I think it’s part of a life lived right that you learn how to make some lemonade out of your lemons.

So turn the clock back, what advice would you give to a graduate looking at the world today?

Well, that’s easy. I would avoid fields where prosperity depended to a considerable extent on misbehavior. And I would want to work for people at a business that I admired, and I would take less money to do that.

The official results of the US stress-tests on 19 of the nation’s largest financial institutions are in, and the federal government has projected that the banks could sustain losses of up to $599bn in the event that the global economy takes another leg down.

So, as a result, 10 firms are required to raise an additional $74.6bn in capital. The institutions which are required to raise additional capital will be given a month to provide the US Treasury and the Federal Reserve with their plans. The capital will need to be raised within a further 6 months. US authorities are hopeful that the firms will be able to raise the capital privately, either through new stock offerings or converting preference shares to common equity. Another alternative is to sell assets to beef up the balance sheet.

Here are the results:

American Express - no capital required

Bank of America - $33.9bn

Bank of New York Mellon - no capital required

BB&T - no capital required

Capital One Financial - no capital required

Citi - $5.5bn

Fifth Third - $1.1bn

GMAC - $11.5bn

Goldman Sachs - no capital required

JPMorgan Chase - no capital required

KeyCorp - $1.8bn

MetLife - no capital required

Morgan Stanley - $1.8bn

PNC Financial - $600m

Regions Financial - $2.5bn

State Street - no capital required

Sun Trust - $2.2bn

US Bancorp - no capital required

Wells Fargo - $13.7bn

Citi is to convert $5.5bn of preferred stock to common, Morgan Stanley is to raise $5bn by selling equity and bonds, and Wells Fargo plans a $6bn common stock offering. Bank of America has already sold $3bn of 5-year notes - without the support of the FDIC.

Wells Fargo recently announced its highest quarterly profits ever! It cited a dramatic gap between deposit costs and lending rates - the interest rate spread, and also talked about the boom in mortgage refinancing and write-downs of mortgages and other loans as reasons for these profits.

And then not to be out done, JP Morgan and Goldman Sachs are surprised on the upside with good profits despite significant additions to reserves and write-offs.

The real killer was when Citigroup, the biggest bum and most reckless of all the mega banks, reported its best profits since 2007. And even more amazing was it’s $1.6 Billion quarterly profit came despite incurring $7.3 billion in loan defaults, and putting aside $2.7 Billion for future crap credits. Wow, it would have had a $11 Billion profit!

So, the skeptic in me says. lets dig deeper - how could these have all of a sudden all at once have such rosy, incredible numbers.

Well, we would have to understand another recently adopted accounting rule (FASB 159). This crazy standard permits corporations, including banks, with publicly traded debt to recognize profits because their bonds decline in value, and are allegedly less of a liability because of the decline. The stupidness of this is that if a company is in or is is thought to be in trouble, and its debt crashes in value, the issuer is allowed to book profits! Is this ever Nuts! Because you are in trouble and your debt value falls you have more profits! Therefore the worse off an entity is from a creditworthiness standpoint, the more illusory earnings it can book and look great! In the case of Citigroup, this stupidity created a $2.4 Billion benefit in the quarter; if you took this rule out, Citi would have lost some $800 billion - Now, that would not have revived this market, would it!

Aggressive Chinese stimulus spending has steadied Chine’s economy but it’s real estate market remains in jeopardy. there is now a 14 year supply of office space in Beijing , and a government affiliated research organization is predicting overall property prices to be cut in half - Hays Advisory, April 24, 2009

Citigroup chief financial officer Ned Kelly was trying to explain an aspect of the bank’s better-than-expected first-quarter results when star analyst Meredith Whitney interrupted him. “Could you dumb that down for me?” she asked.

This si probably the most important question ever asked to financial people, “Can you please dumb it down to real talk, and cut the BS”. Just a few months after the near meltdown of the financial system, Citi, JPMorgan Chase and Goldman Sachs all reported billion-dollar-plus profits for the quarter ending March 31. Man, how things have changed, all of a sudden these CEO’s whose jobs were in peril, came out with some brillant moves - amazing what pressure does to you.

Whitney’s question was specifically about Citi’s $1.7 billion in investment-banking profits in Europe, and Kelly’s eventual answer was basically just that business had been good. (that’s it - business has been good!!)

Bank financial statements are never that simple: Citi’s overall investment-banking earnings were boosted by a $2.5 billion derivatives valuation adjustment “mainly due to the widening of Citi’s CDS spreads.” Uhmmm, this is what they consider dumbed down language - personally I think they were speaking Vulcan: credit-default swap (CDS) spreads represent the cost of insuring against Citi’s default. That cost went up in the quarter as investors fretted about Citi’s solvency, so Citi was able to book $2.5 billion in gains. Got that?

Without that boost, Citi’s $1.6 billion in quarterly profit would have been more than wiped out. As it was, holders of Citi’s common stock still had to take a $966 million loss because of accounting adjustments related to the planned conversion of preferred shares owned by the U.S. government and other investors into common stock. Again, got that?

The “result” is that, while the quarter was Citi’s best since mid-2007, it’s awfully hard to say what it really means. The chances that the bank might eventually be able to earn its way out of its troubles without more taxpayer help seem to have increased. But it will take many more quarters before anybody can say that with confidence.

The same goes for the country’s big banks as a group. The mirage of positive results we’ve been shown, which had been anticipated by a month long rally in bank stocks, are certainly better than last year’s multibillion-dollar losses. But bank earnings are extremely sensitive to assumptions about the future, and whether the banks are actually on the road to recovery will depend to a great extent on how the economy performs in the coming months.

That said, there are a few dumbed-down points that can be taken from the earnings news thus far:

• The killing of off competitors is good for profit margins. Many smaller banks have been closing, and people want to go to better protected (by the gov) banks. As Wells Fargo shareholder and Goldman Sachs bondholder Warren Buffett put it on CNBC in early March, “This is a great time to be in banking, you know, if you just get past the past.”

• There’s still more mess to come - while mortgage losses seem to be moderating, banks still have a lot of credit-card ugliness to work through. At JPMorgan Chase, card services was by far the worst-performing division, with a loss of $547 million. When in an analuyst call CEO Jamie Dimon if the business would return to profitability this year, his answer was a succinct “No.” At Citi, “credit-card losses seem to be breaking their historical correlation with unemployment,” CFO Kelly said. That is, credit-card losses normally rise with the unemployment rate. Now they’re rising faster.

• Annual report date shenanigans - It’s nice to forget December. Investment banks traditionally end their fiscal year in November, commercial banks in December. Since Goldman Sachs and Morgan Stanley shifted to commercial-bank status late last year, they decided to shift their fiscal years starting this year. In doing so, they orphaned the month of December 2008. For Goldman, it was revealed that meant saying goodbye to $780 million in losses that will never show up on the bottom line of an earnings report. Whoppee $780 million, not accounted for! Luv the games being played. Just Luverly

- FASB 140 coming on May 6th, that measn previously hidden off book entities willhave to now be on-book, this includes all the liabilities - this means in the next year Citi has to account for $800 Billion, and JP Morgan $600 Billion.

I bet they fire Vik Pandit CEO of Citi before that - thsi way he gets a better severance pay!