market news and articles @ firstadopter.com

The Ben Graham Centre for Value Investing had a great video conference with Seth Klarman of the Baupost Group on March 17th, 2009. These are my notes. Mr. Klarman has produced a net annual return of over 20% since 1983 with only one down year and no use of leverage. Source – H/T to Todd

-Graduated from Harvard Business school in 1982 during a time of high interest rates (12% U.S. treasuries going to 14%) and with a stock market at Dow 700 which had done nothing in 18 years
-Worked for Mutual Shares for couple of years when it was a $40 million no-load mutual fund
-Value investing is a risk-averse approach – first focus is on risk before you focus on return
-Ben Graham, Buffett, and himself started with a small amount of capital rummaging around for mis-priced situations. He likes to find the reason for the mis-pricing and a catalyst to cause you to make money
-He is not in favor of investing by a few simple math formulas like P/B, P/E, P/CF, and dividend yield. Value investing by itself only adds 1-2% a year vs. the market. Why trust a blind formula when you can do better with your own analysis?
-He can tell if something is superficially cheap from 1) inventories being obsolete 2) receivables being uncollectible 3) bad assets on the books 4) off balance sheet liabilities like litigation and environmental problems
-He suggest following value principles, but improve upon them through in-depth fundamental analysis and detailed research
-3 underlying pillars: 1) Focus on risk before return using multiple scenarios. How much can you lose? What are the probabilities of each scenario? 2) World is oriented to relative performance as everyone is an asset gatherer. He is focused on “absolute returns” 3) importance of being bottoms-up, not top-down (macro)
-When he formed Baupost in 1982, he wanted 1) flexibility from his clients for a broader mandate. He wanted more weapons at his disposal to investing in real estate, equities, debt, or stay in cash 2) He put his own money alongside his clients 3) He identified his “edge” that is legal and legitimate and reasons why he thinks he will out-perform. a) biggest edge is long-term orientation. Since he only has clients that are wealthy families and institutions. No fund-of-funds, pensions funds, sovereign wealth funds, and public mutual fund money. How can you invest for a 3-5 years long-term hold when you might get a redemption in 6 months? b) relationships with best brokers. He wants to be the best or 2nd best client, especially in real-estate where he gets first shot at mis-priced assets and can move fast
-He doesn’t think they are the word’s best business analysts. He does think they are very good at complicated situations, “the messier the better.”
-His favorite areas are 1) distressed debt. Senior debt has it’s own catalyst going into a bankruptcy. There is a huge constituency of forced sellers as many of owners can’t own debt in a bankrupt company. You wanted to buy when people don’t know what they are doing. 2) spin-offs 3) index changes.
-For equities, he likes off-the-beaten path type ideas that have some kind of event catalyst. He wants egregious mis-pricings, low risk/high return situations, and is very careful with his analysis
-They never hold for the last nickle. They sell near fair value. If a stock is worth $20 and they bought it at $10, they are out by $18-18.50. Always sell too soon and always buy too soon. Never use margin, don’t use leverage, and have minimal short exposure. Position sizing is 3-5% and at times 8-10%. Always act with integrity
-To hedge they use out of the money put options for disaster insurance. He doesn’t think shorting adds any value most of the time. It makes you focus on short-term analysis, whether they will beat or miss a quarter. This impacts your thinking into a short-term orientation, which is not good for a long-term investor
-They entered 2008 with 35% cash (did he mean 2009?). They are in the high-teens/low 20s now
-Financials got to be 40% of SP500′s earnings. In early 2007, he realized things could be really bad as the housing market started to turn down
-When doing analysis, they look for a range of value using book value, PV of CF, P/E, P/CF, sum of parts, and private market value. If it’s below this range, it’s of interest. If it’s in the middle of this range, it’s not interesting. Try to look at things differently than consensus. When the world thinks of a stock as a business, he thinks of it as pile of assets.
-He owns a couple Oil/gas LPs that are trading at 20% and 30% yields and 1/2 or 1/3 of their reserve value.
-He owns PDL Biopharma, which he thinks as a 30% IRR due to its royalty stream
-He like News Corp. Fox News is incredibly valuable. He thinks break-up value is $10-20 today and $20-30 in a normal environment. Debt maturities are 10 years out. They bought it too soon, but they have been adding
-He admires Buffett and Munger. On long-only side, he like Bob Rodriguez at FPA Crescent, Southeaster Management, and Tweedy Brown. On hedge-fund side, he likes Paul Singer, David Abrams, Perry Capital, Jeff Hallis at Tindall (sp?), Mike Lowenstein at Kensico, Steve Mandel at Lone Pine, and Brookside Capital

-U.S. economy: “It’s fallen off a cliff” “Luxury goods (business)… sort of stopped”
-This is close to the “worst case” scenario. “We are in a very negative vicious cycle”
-Economy: “can’t turnaround on a dime”
-”Unemployment will go a fair amount higher”
-He is critical of the 8000 earmarks Congress rammed through in this time of economic crisis
-Job 1, job 2, and job 3 should be to “win the economic war.” You should not use crisis to push through things you know is contentious (implying carbon cap and trade energy taxes, earmark pet-projects, card check “secret ballot”, etc.)
-M2 is growing very rapidly as you can check on the Federal Reserve web-site. Potential of being worse than inflation in the 1970s
-In 19th century had 6 financial panics when people lost confidence in the banks
-FDIC moved 8% of deposits last year and has assisted 3600 banks in its life-time
-We have a system that works started with 4 million people in 1790. Free markets, rule of law, and equal opportunity that “unleashed the human potential”
-World almost stopped last September when the Reserve fund broke the buck and money market/commercial paper markets hemorrhaged. He gives credit to Bernanke for doing the right thing and saving the system then
-Government should guarantee all deposits at all banks to give clarity and confidence to the financial system. The President should speak to this to be totally clear to the American people
-Over a 10 year period, you will do considerably better in equities vs. 10 year or short-term Treasuries. With Treasuries, you are guaranteed to lose purchasing power
-2008 mistakes include buying ConocoPhillips when oil was over $100 and buying two Irish banks
-He likes Wells Fargo and U.S. Bancorp. Wells Fargo has 1.44% average cost of funds. In 2-3 years can have $40 billion in income and $10-12 billion in losses. The spreads are enormous today and earnings power is great. Prospects 2-3 years out is better than ever
-250 million cars and trucks on road today. U.S. auto companies need to restructure where the business model can work at 13 million cars a year
-Free markets over-shoot, but works better than anything else
-Forget the (stock) quote, look at the business (fundamentals)
-Best asset during inflation is invest in your own abilities, be the best at what you do. Second best is own good businesses
-$14 trillion dollar economy U.S. GDP, stimulus bill won’t have that much impact in short-term. More important other things to do (fixing banking and financial system)
-4.5 million houses will change hands out of 80 million this year
-Obama should defer pushing his big agenda and focus on the economy
-He supports mark-to-market
-Bringing back the uptick rule is a good idea
-He is against union card-check and supports the secret ballot

Net-net: Economy is currently horrendous with no turnaround in the short-term.   He goes after Obama pretty directly to not “muddle up” job 1 of fixing the economy with the other things on his agenda.  He still likes his bank positions of Wells Fargo and U.S. Bancorp.

These are my notes from a book signing event Alice Schroeder gave on her Buffett biography called “Snowball.”

-Buffett as “very hurt” during the tech bubble on any criticism that he “lost his touch”
-She got on Buffett’s 200 people Christmas card list
-He has a silly child-like side. He is like a little kid that wants to be loved by everyone
-When he organized a Hooter’s gag Christmas card photograph with Bill Gates, he was upset that all the girls wanted Bill’s autograph on their shirt, not one asked for his
-He was excited for weeks when Asia Carrera, online porn star, cited Buffett as one of her heroes
-In a way he wants everyone to be his mom. Alice felt that tug also, but at the end of writing her book she had to back away from that role. It is “really awkward” between them now. There is “no friction” per se, but he has “mixed feelings” and “ambivalent” about the book. She thinks it was “painful” for him to have all his personal details out there for everyone to read. They have some “email correspondence”, but other than that they don’t talk
-She had extensive interviews with Charlie Munger. He said, “I only listen when I’m talking”, which she says is “very true”
-The most surprising thing about Buffett was how “very vulnerable and insecure he is” personally compared to his unshakeable confidence in his business decisions.
-Warren is one of the toughest negotiators. He is a “dangler”. He never commits to anything, but makes you feel if you do what he wants, maybe he’ll give you want you want
-”Writing a biography is difficult if you don’t have a life.” It was hard to structure the book between his personal and business sides as they were completely separate. Also there were extended periods of time where he didn’t have a personal life. He was obsessed with investing, money, and working. He was driven. He loved it. He “didn’t have a choice, it’s who he is”
-One of his important qualities as a leader was his ability to stay on message. He can repeat the same 10 things over and over and never deviate
-She enjoyed being around Bill Gates as he and Buffett had a wonderful relationship. Bill looks up to Buffett like a father. Bill also has broader interests and is a really good investor
-She doesn’t think Ajit Jain will be the next CEO of Berkshire. He doesn’t want it and isn’t a manager
-Buffett gets no pleasure from giving away or spending money. His life’s purpose was growing the snowball
-Buffett’s biggest mistake, he would say in private, is doing whatever it was that caused his wife to move away. He would do anything to get her back, dancing etc., but Alice says “except change who he was”
-She is working on her next book. She will also continue public speaking and work on different kinds of writing

Avoiding 99% of frauds like Madoff and Bayou is pretty easy if you do some basic due diligence. Madoff used itself as the administrator and custodian for its own assets. Every reputable investment fund uses 3rd-party administrators and custodians. For obvious reasons, it’s a lot harder to fake numbers if a 3rd-party is holding your assets and doing administration.

If you only invest in firms that use reputable 3rd-party administrators, custodians, auditors, and law firms, you will avoid most frauds PERIOD. Be sure to verify that they are using the firms they say they are by calling and asking for email verification from the partner in charge of the investment firm client.

1) Custodians: You want prime brokers and custodians that are part of the chosen nine, explicitly backed by the U.S. government: JP Morgan, Goldman Sachs, Bank of New York Mellon for cash custodial accounts, etc.

2) Administrators: IFS, division of State Street and Citco Fund services.

3) Auditors: You don’t want unknown 3-person audit firms like the one Madoff used. You want brand-names like Deloitte & Touche, Rothstein Kass, etc.

To reiterate if you only invest in firms that use reputable 3rd-party service providers and verify that those providers are serving the firm, you will avoid Madoffs and Bayous.

-Their largest fund, Paulson Advantage Plus, was up 37.6% net vs. SP500 -36.9%
-They aggressively added to Anheuser Busch position in October 2008 becoming the largest shareholder as the deal spread blew out on InBev’s $70 cash offer. When it closed, they made the largest profit on a spread deal in their history
-Their merger arb funds had a good year up 6.3% and 12.55% for their 2x enhanced product. They have a conservative strategy of hedging market exposure, focusing on corporate spreads, targeting competitive bid situations, and the occasional short opportunity
-Their main “event arbitrage” fund, Paulson Advantage Funds, had “another extraordinary year.” Their short event exposure was concentrated on financial firms that they believed were at the risk of failure
-They estimated what the losses would be looking at bank balance sheets and then compared it to “tangible common equity”. They did a ranking of high to low and shorted accordingly
-8 out of the top 10 on their list either failed or had to be recapitalized by governments
-The most over-valued were Fannie Mae and Freddie Mac. The companies’ assets were extraordinarily leveraged. Their analysis showed they were both insolvent if you excluded goodwill, marked their assets to market, eliminated deferred taxes, and properly reserves for non-performing loans. Freddie had negative common equity of $65 billion compared to reported regulatory capital of $37 billion. They felt a government bailout was inevitable
-Their analysis was accurate. Performance of their short portfolio was 90% on average in 2008
-Their long event portfolio was concentrated in areas that do better during recessions like healthcare, utilities, and consumer staples. Nevertheless they lost money in almost all their long positions
-Fortunately they had more shorts than longs and their shorts went down more

2009 Outlook
-For first half of 2009 they have:
1) Slight short exposure to equity markets
2) Remain short financials
3) Focus on long distressed opportunity: mortgages, bankrupt debt, distressed, and capital restructurings
4) Focus on strategic merger deals

-They remain short financials as they don’t believe we are through the financial crisis. Goldman Sachs estimates total U.S. credit losses to be $2.1 trillion this cycle compared to $1 trillion realized losses to date indicating we are only half way through the crisis
-As credit crisis spreads from subprime, all other credit categories will have higher losses threatening the solvency of more financial firms
-The problem with banks is they don’t have enough tangible common equity to absorb anticipated losses
-That being said, he believes the biggest driver of returns in 2009 and 2010 for their fund will be long distressed opportunities. They estimate the total distressed opportunity to approach $10 trillion in mortgages, corporates, financials, and sovereigns. They are targeting a 50% allocation in their Advantage Fund to distressed debt
-Mortgage securities have fallen to a level where they are now buying previously AAA-rated tranches
-As mortgage bonds are being downgraded many holders are selling simply because they don’t have the ability to analyze the underlying collateral, this creates mis-pricing opportunities
-Defaults are accelerating resulting in billions of dollars of defaulted bonds and levered loans. There is no leverage available from banks to buy, so prices fall huge on bankruptcy announcements. Levered buyers are now forced sellers. They can sift through and find good opportunities
-There are also event arb opportunities in debt. GMAC 2011 note appreciated 65% in value when it was announced they would receive TARP funding and become a bank holding company
-They still believe it’s too early to buy financial stocks. They are being very company specific and research intensive
-They took a 24.9% stake in the $1.6 billion recap of IndyMac

-AUM is $28.8 billion at the beginning of 2009, down 1% from 2008
-Madoff fraud highlighted several areas important for investor protection: custody of assets, administration, and auditor selection. Madoff was both the custodian and administrator for his fund and used a 3 person auditing firm
-Paulson uses JP Morgan and Goldman Sachs as prime brokers. All assets reside within them or for cash custodial accounts at Bank of New York Mellon. The administrator is IFS, a division of State Street Bank. Auditors are Deloitte & Touche and Rothstein Kass

-They remain bearish on the U.S. economy and believe the recession will extend to late 2009 and likely into 2010. U.S. stimulus package will likely cushion the decline, but it won’t halt the down-turn and likely have long-term consequences

Notes from a speech by Alice Schroeder at Darden Value Investing Conference 2008. This is so much better than her mass audience oriented book for insights on how Buffett invests.

-So much of Warren’s success has come from training himself into good habits. Aristotle said, “We are what we repeatedly do.” Excellence is not an act, but a habit.
-First habit of Buffett – hard work. What more can I do to get an edge on the other guy?
-Charlie Munger says, “The guy is a learning machine.” It does help to have a photographic memory, which he has.
-Horse Handicapping. First step is what is the odds that this business could be subject to any catastrophe risk that will make it fail? If there is any chance, he won’t go there.
-Figured out the one or two factors that can make a business succeed or fail. Then look at all the historical data, quarter by quarter, for every single plant and every competitor. Filled pages with this information. Rely totally on historical figures with no projections.
-What is the cat risk? You save yourself a lot of time and energy. Focused on efficiency. Being realistic about cat risk, don’t convince yourself otherwise later.
-Compounding. I want a 15% return on day one return-of-investment and compound growth from there using a huge margin of safety. Very simple thing. No DCF model.
-Doesn’t really care if the price goes up or down for the next year or two. He just knows at this price, odds are it will do well
-In 1999 he said it’s good idea to invest in the market when stock market’s value is 70-80% of GDP
-Inner Scorecard: The only person really qualified to advise you on what you can do is yourself. You know yourself better than anyone else does. You and you alone know how determined you are to make a success of any undertaking. And in the last analysis, about 90% of being successful in business is that indefinable thing which for lack of a better name we call guts.
-Follow your passion. Do what you really want to do. Don’t waste time with resume filling jobs. Don’t work for anybody that makes your stomach turn. You can’t get ahead that way. The odds are better for you to succeed if you love what you do.
-The purpose of margin of safety is to render forecasts unnecessary.

From her book:

The Buffett Method
-estimate an investment’s intrinsic value
-handicap its risk
-buy using margin of safety
-concentrate
-stay in circle of competence
-let it roll as compounding does the work

People who exploited [inefficiencies] them generally had a steady pulse and deep knowledge based on long study, and the willingness to put in full-time concentrated effort

Lots of news today on Warren Buffett buying American stocks for his personal portfolio from CNBC and this editorial he wrote for the New York Times. He has done this before in 1974, 1999, etc., where he tells people publicly in his witty way now is the time to buy or sell.

Buffett is almost always right, but let me clarify… in the slightly longer-term. He is usually a few month off from the exact top or bottom. For example, he went negative on the market in November 1999. The market topped out in March of 2000. He started selling his Petrochina (PTR) stake in mid-July of 2007. Petrochina rallied for a 3 more months another 66% from his initial sell and peaked on October 31, 2007.

His best call was October 1974, where he pretty much nailed the exact bottom in his an interview with Forbes. When asked about what he felt about the stock market he said, “Like an oversexed guy in a whorehouse,” he shot back. “This is the time to start investing.”

October 10th will go down as one of the most frantic days I’ve ever experienced. When the market opened and went straight down 698 points (Dow) in the first 8 minutes and then rallied back to positive by 10:08AM, you could hear the cheering roars of the NYSE trading floor on CNBC. That gave me goose bumps.

Then you had Bush come on TV to calm the nation; however as soon as he started speaking, the Dow plummeted again near the lows of the morning by 1:50PM. Near the end of the day there was another huge rally around 2:56-3:36PM to even higher highs up 322 points (1019 points from the low) for the day and then a selloff the rest of the day to close down 128 points.

“There is only one side to the stock market; and it is not the bull side or the bear side, but the right side”

Comparing Paper Trading vs. Real Trading
“Are you a good shot?” “I can snap the stem of a wine glass at twenty paces” “That’s all well, but can you snap the stem of a wine glass while the wine glass is pointing a loaded pistol straight at your heart?”

“A man must believe in himself and his judgement if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip, I must sell those stocks on Smith’s tip. I am depending on him”

“Speculation is a hard and trying business, and a speculator must be on the job all the time or he’ll soon have no job to be on”

“The more I made, the more I spent. This is the usual experience with most men. No, not necessarily with easy-money pickers, but with every human being who is not a slave of the hoarding instinct. Some men, like old Russell Sage, have the money-making and the money-hoarding instinct equally well developed, and of course they die disgustingly rich”

“If a stock doesn’t act right, don’t touch it; because being unable to tell precisely what is wrong, you cannot tell which way it is going. No diagnosis, no prognosis. No prognosis, no profit”

“The big money was not in the individual fluctuations but in the main movements-that is, not in reading the tape but in sizing up the entire market and its trend”

“It was never thinking that made the big money for me. It always was my sitting. Got that? My sitting tight!”

“Me who can both be right and sit tight are uncommon. I found it one of the hardest things to learn”

“He had not only the courage of his convictions but the intelligent patience to sit tight. Disregarding the big swing and trying to jump in and out was fatal to me”

“Without faith in his own judgement no man can go very far in this game. That is about all I have learned-to study general conditions, to take a position and stick to it”

“The big men of the Street are as prone to wishful thinkers as the politicians or the plain suckers. I myself can’t work that way. In a speculator such an attitude is fatal.”

“Sell down to the sleeping point (own so much cotton, can’t sleep thinking about it, wearing me out)”

“It sounds very easy to say that all you have to do is to watch the tape, establish your resistance points and be ready to trade along the line of least resistance as soon as you determined it”

“Prices, like everything else, move along the line of least resistance”

“A man cannot be convinced against his own convictions, but he can be talked into a state of uncertainty and indecision, which is even worse, for that means that he cannot trade with confidence and comfort”

“It is simple arithmetic to prove that it is a wise thing to have the big bet down only when you win, and when you lose to lose only a small exploratory bet”

“Of all the speculative blunders there are few greater than trying to average a losing game”

“Always sell what shows you a loss and keep what shows you a profit”

“He must fear that his loss may develop into a much bigger loss, and hope his profit may become a big profit”

“What does a man do when he sets out to make the stock market pay for a sudden need? Why, he merely hopes. He gambles.. he is after immediate profit. He cannot afford to wait.. he hugs the fallacy that he is merely taking a fifty-fifty chance.. particularly on purchases made at the height of the bull market just before a moderate reaction. It certainly is no way to trade”

“A great many smashes by brilliant men can be traced directly to the swelled head – an expensive disease everywhere to everybody, but particularly in Wall Street to a speculator”

“Whenever I have lost money in the stock market I have always considered that I have learned something; that if I have lost money I have gained experience, so that the money really went for a tuition fee”

“A trader.. must also know himself and provide against his own weaknesses”

“The game does not change and neither does human nature”

“A man does not swear eternal allegiance to either the bull or the bear side. His concern lies with being right”

“Another thing to bear in mind is this: Never try to sell at the top. It isn’t wise. Sell after a reaction if there is no rally”

-bet with the market leader with sustainable competitive advantage
-believe very strongly that stocks go up because a company’s earnings go up
-simple approach. “Is the story improving?” or “which way are the earnings going” or are earnings estimates going up or down?
-own Apple and Google – great innovative companies with bright futures
-”I want to be more like Ken Heebner. He’s my hero. His performance is staggering. What he does very well is marry the discipline of owning just the 25 names with the idea of wanting to be the best performer. That leads him to the very best-performing companies. He has an incredible knack for finding the market’s true leadership.”
-”Valuation is always the bugaboo. But you can’t get great companies at bargain prices.”
-Top 10 holdings: Google, Berkshire Hathaway, Apple, Schlumberger, ExxonMobil, Genentech, EnCana, Procter & Gamble, Hewlett-Packard, Research in Motion