Saturday, February 28, 2009

The Oracle Speaks

Warren Buffett's annual letters to shareholders are legendary. We were treated to another one on Saturday morning. This year's letter and 10-K provided some interesting insights. Buffett, who is a fan of higher taxes on the rich, was surprisingly critical of government. He says government intervention in the financial crisis "will almost certainly bring on unwelcome aftereffects." He thinks inflation is a very likely outcome. He also predicts municipalities will soon be looking for federal bailouts of their own. The good news is that Buffett says "America's best days lie ahead."

Berkshire's book value per share fell 9.6% in 2008, its worse performance ever. Yet I think the biggest surprise is that the company did not do worse. Given the financial crisis and Berkshire's heavy exposure to the finance industry, I think the results were actually quite commendable. The company turned a profit and even troubled subsidiaries such as General Reinsurance showed marked improvement.

Still, Berkshire lost a lot of ground in 2008. Gross unrealized gains in equity securities fell $16.5 billion. Gross unrealized losses grew by $4.9 billion. There was a $25 billion decrease in the value of equity securities on the balance sheet. The company also wrote down $6.8 billion of derivatives on the income statement. It is important to understand, however, that the write down had no effect on cash flow. It is simply the result of the same mark-to-market accounting rule that is making our nation's banks look unprofitable. Even though it took a toll on Berkshire, Buffett says, "We endorse mark-to-market accounting." It would have been nice if he explained exactly why. Maybe he realizes that because of mark-to-market, Berkshire and other financial companies will report much larger earnings in future periods when market conditions improve.

I was very disappointed by the kinds of questions posed by shareholders at last year's meeting. Instead of asking good questions about the company's business operations, we got questions such as "What should I do with the rest of my life?" Apparently, Buffett was fed up with those questions, too. He says in his letter that at this year's meeting, he will "steer the discussion back to Berkshire's business." That is welcome news indeed.

Friday, February 27, 2009

Nationalization the "Atlas Shrugged" Way

I am posting this from Austin, Texas. I traveled here yesterday to participate in a panel discussion at the CFA Society of Austin. The panel was moderated by Vincent Catalano. Other panelists included former Fed governor Bob McTeer, David Abramson from BCA Research in Quebec, and Tim Hayes of NDR.

The discussion focused on the growing role of government in the private sector. The United States, which is supposed to be the model for free market capitalism, is taking a big step toward socialism. The budget put forth by our new president is a repudiation of the Reagan revolution. It seems our government is trying to outdo other governments in nationalizing some of our biggest companies. It's a good time to reread Atlas Shrugged by Ayn Rand.

So I guess it was fitting to awake this morning and find out that our government is about to hold a huge stake in Citigroup. If this is not evidence of nationalization, I don't know what is.

The latest GDP report was also disconcerting. The preliminary estimate for fourth quarter contraction was revised down to 6.2% from the 3.8% advance estimate. That's what I call a revision. This means the 8.1% unemployment rate projected for 2009 in President Obama's budget looks laughable. The employment situation will not improve until private sector investing improves. Don't hold your breath for that to happen now that Obama wants to raise taxes on the so-called rich. With higher taxes on the way, there is little chance the economy will revive enough to slow down the acceleration in the unemployment rate.

Wednesday, February 25, 2009

The Fat Tail

Last night I attended the book launch party for the
The Fat Tail, a new book co-authored by Ian Bremmer and Preston Keat. Bremmer is President and Keat is Director of Research at The Eurasia Group, a political risk research firm. Admittedly, I have known Bremmer for almost 10 years and my opinion may be biased, but I consider him to be the foremost expert on political risk. I have heard him deliver a number of speeches over the years. He is an excellent speaker who makes extremely cogent arguments.

The title of the book comes from the bell curve. In a normal distribution, there is a 67% probability that an outcome will fall within one standard deviation of the mean. Unlikely outcomes occur at the tails. In a distribution with fat tails, the probability of unlikely outcomes is higher. Bremmer and Keat are implying that investors often underestimate the probability that unlikely outcomes will occur. For example, they begin the book with the 1998 crisis in Russia and tell us how the leading experts assured investors that Russia would not default on its debt. Yet that's exactly what happened. The book is full of such examples.

Because I have just begun to read the book, I can't provide a complete analysis. So far, however, I find it interesting and timely. It also fits nicely with Bremmer's recent assertion that financial regulation and the U.S. Congress represent the greatest political risks of 2009.

Tuesday, February 24, 2009

More on the UAE

As my readers know, I traveled to Abu Dhabi and Dubai two weeks ago. I was invited by the CFA Institute to address investors at the Abu Dhabi Investment Authority (the world's largest sovereign wealth fund), Mubadala, and Hawkamah. Perhaps I am now more aware of events in that part of the world because of this trip. Maybe this is why I have noticed quite a bit of news about the United Arab Emirates since I returned home. For example, immediately following my return, Dubai made news by denying an Israeli athlete a visa to compete in a major tennis tournament. Soon after it made news again when it received a $10 billion bailout from the UAE central government. Dubai, which just a year ago was one of the world's greatest financial success stories, now seems plagued by poor decisions and economic turmoil.

Yet one of the best articles I have read in recent weeks was one written by Zvika Krieger in the Wall Street Journal. The title of his commentary says it all: "There's No Reason to Gloat Over Dubai's Fall." Mr. Krieger argues that the UAE is not perfect, but it is moving in the right direction. I agree. His op-ed inspired me to write a letter to the editor in support of his view.

Friday, February 20, 2009

Greenspan Was Right in 1996

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

Alan Greenspan, Dec. 5, 1996

On the day Alan Greenspan spoke those now famous words warning that stock prices might be too high, the Dow Jones Industrial Average closed at 6437.10. Yesterday, more than 12 years later, the Dow closed 16% higher at 7465.95, which comes out to about 1.2% on an annualized basis. Of course, the Dow peaked at more than 14,000 before falling back to current levels. If anything, this should cause investors to question the wisdom of long-term, buy-and-hold investing. That approach is akin to simply sticking your head in the sand and ignoring signs of trouble. A strategy of active asset allocation, i.e., taking money off the table after rallies and buying more after selloffs, produces much better results over the long term.

Monday, February 16, 2009

Dubai May Be Struggling, but Abu Dhabi Looks Strong

I'm back from Abu Dhabi and Dubai. I'm still a little jet-lagged, but I got a good night's sleep for the first time in a week. Here are some more thoughts about my trip.

The United Arab Emirates consists of seven emirates. The best known are Dubai and Abu Dhabi. When it comes to economic development, Dubai is considered the more aggressive one. Dubai embarked on a plan to quickly become the major financial center in the Middle East and one of the most important in the world. There was a tremendous amount of money spent on infrastructure. (Reminds me of the Obama stimulus plan.) Beautiful buildings and roads were planned and constructed. As I said in an earlier post, Dubai is at the cutting edge of architecture and construction.

While I was in the U.A.E., The New York Times published an article warning that the economic boom in Dubai has come to an end. (I thank Vitaliy Katsenelson and Todd Weintz for bringing this article to my attention.) I had already heard rumors of many of the things discussed in that article. Because I spent less than 24 hours in Dubai, I did not get a complete picture of the economy. I had to wonder, however, how there could possibly be enough demand to justify all of the construction going on. To my eyes, Dubai certainly seemed like a busy place. There was plenty of traffic on the streets and the Al Bustan Rotana Hotel where I stayed was busy enough, but I do not have a personal point of reference to make any comparisons.

I was told by some individuals that business activity is way down. Construction has apparently been suspended on some buildings. Most workers in Dubai--from laborers to executives--are from someplace else. One young finance executive told me he was concerned his company would be laying people off soon. A driver told me things were getting bad and many people were going back home or looking for jobs elsewhere. (Sounds a bit like the situation in the U.S.). Given a new law that imposes a heavy fine for disparaging the economy, I wondered if they were being cautious with their comments.

I spent about six days in Abu Dhabi and things there seemed perfectly fine. Abu Dhabi has been more conservative with its economic development plans. There is plenty of construction going on, but there are no obvious signs of overbuilding. People in Abu Dhabi appeared more confident about the local economy. Those in the finance industry were extremely concerned about the global economic slowdown, but not so much about the situation in Abu Dhabi.

Abu Dhabi also has one major advantage over Dubai. It has plenty of oil. While the plunge in oil prices has delivered a blow, this emirate can still generate tremendous cash flow from oil production. Yet those managing the Abu Dhabi economy understand the importance of diversification. Abu Dhabi appears to have struck just the right balance between relying on oil and seeking other sources of income. In fact, Abu Dhabi has the potential to become a major tourist spot. The Emirates Palace Hotel is right on the beach and has several swimming pools. The weather is almost always sunny. It is a perfect spot for a family vacation. The Sheikh Zayed Mosque is magnificent and open to the public for visits. Indeed, during my stay I noticed that Abu Dhabi was full of tourists, many of them German speaking. Abu Dhabi also has a world class golf course. The Abu Dhabi Golf Championship is on the European tour and offers $2 million in prize money.

There may be some friendly competition going on between Dubai and Abu Dhabi, yet at the end of the day, these emirates are a part of the same nation. If things get bad enough for Dubai, Abu Dhabi will likely come to its aid, especially if oil prices rise as global economies emerge from their collective recession.

Friday, February 13, 2009

Impressions of Dubai

I am back in Abu Dhabi after a short trip to Dubai. Before going there, I had heard a lot about all the construction going on in Dubai. Yet it was still a surprise to see it with my own eyes. With all the skyscrapers, Dubai reminded me a little of New York City except that everything is brand new and sparkling clean. There are so many buildings, and perhaps even more that are still under construction. It is hard to believe there is enough demand for all that space. In fact, I heard some projects have actually been stopped midway through. Given the global recession, it seems funding is drying up and some of the projects may not be completed at all. I've also been hearing that many foreign workers are losing their jobs. Some are returning home, others are trying to find jobs in Abu Dhabi where the economy is still good.

Nonetheless, Dubai is an architect's dream. Imagine having a client ask you to design the most outrageous building you could think of without regard to the expense. The Bourj al-Arab Hotel looks like a sailboat (dhow). Another building looks like a jet airplane. Some buildings are straight; others are curved. Some look like they could be fitted together like Lego pieces. The building that houses the indoor ski slope looks like it could tip over. They are really at the cutting edge of what can be done with construction.

While in Dubai, we made presentations to members of Hawkamah, the institute for corporate governance. This was also sponsored by Mudara at the Dubai International Financial Center. There was intense interest in our presentations and we were peppered with questions. There is keen interest in promoting good corporate governance practices in this part of world.

I finally got a chance to relax and catch up on some sleep. Unfortunately, I am returning home just as my body has adjusted to local time. I'm sure there will be more sleepless nights to come.

Monday, February 09, 2009

First Impressions of Abu Dhabi

As the Obama team gets ready to stimulate the U.S. economy, I flew off to Abu Dhabi to see how things are on the other side of the world. I will be giving a talk tomorrow to the Abu Dhabi Investment Authority (ADIA), then I'm off to Dubai.

So far I am very impressed. I flew over on Etihad Airways, the national airline company. It is a very long flight. Fortunately, I was in business class. Both the service and food were great and the time went by rather quickly. After clearing customs, we took a drive through the city. There is a lot of construction taking place and there are cranes everywhere. Although I hear the economy has taken a hit from the fall in oil prices, that is not readily noticeable.

I am staying at the Emirates Palace Hotel, which without a doubt is one of the finest hotels in the world. It really does look like a palace inside and out. The hotel is located right on the beach on the Persian Gulf. The architecture is beautiful. Everything is very geometric. The inside of the hotel has marble everywhere. I am going to catch up on some sleep, then it's off to dinner. There are several interesting restaurants in the hotel. More later.

Monday, February 02, 2009

January Roundup From Forbes Growth Investor

The following is from the February issue of the Forbes Growth Investor.

Despite staging a bit of a rally toward the end of 2008, stocks plunged again to kick off the start of a new year. According to data from Ibbotson Associates, last month’s selloff in large-cap stocks was the worst ever for a January. An old Wall Street adage says,“As goes January, so goes the year.” This is not an encouraging sign for investors who are long. Those who believe in adages and indicators should at least take some solace from the Super Bowl, since it pitted two teams from the old NFL against each other; a good omen for stocks.

Unfortunately, the news continues to be bad on the economic front. Most economists were expecting a large retreat in fourth quarter GDP. Yet the Advance estimate, a decline of 3.8%, was better than the consensus expectation. Investors seemed relieved at first. However, they quickly changed their minds once they realized that increased government spending, a $6.2 billion build in inventories, and an $80 billion decline in imports largely explained why the GDP report was not worse than it was. This was the first build in private inventories in at least two years. Companies were producing more than they could sell. During the current (first) quarter, however, businesses have been laying off workers at an accelerating rate so production should slow. As for international trade, it too is slowing appreciably. And it wasn’t just imports that declined. Exports were off $83 billion.

There is a real lack of demand on the part of consumers. Other than necessities, people are not buying anything. This is not simply due to a lack of available credit. There has been a real change in the mindset of American consumers. We are rapidly transforming from a nation of spenders into a nation of savers at precisely the wrong moment. No one wants to spend money—even those who are relatively well off and gainfully employed—when coworkers and neighbors are losing their jobs. Large numbers of clothing stores, electronics stores, and automobile dealerships are simply shutting down for good.

Lack of demand is also plaguing the housing market. New home sales have fallen off a cliff. Just a few years ago, home builders were selling 1.2 million new houses a year at an average price of almost $300,000 each. These days they are selling only one-fourth as many houses at an average price that is almost 20% less. At the current rate of sales, it will take 16 months to clear the inventory of new houses. It is inevitable that at least a few of the publicly traded home builders will not survive this crisis as independent entities.

Things are a little rosier for existing homes. Sales climbed 6.5% in December thanks largely to falling prices and growing interest in foreclosed properties. Inventory fell almost 12% in just one month. It is possible that we are finally approaching a bottom in existing home prices. I’m still calling for that to happen by late spring. While stable housing prices are key to restoring confidence in the economy, the days of thinking about residential housing as an asset class are probably gone for a long time. It is good to get rid of the speculation in this sector.