Tuesday, April 27, 2010

Shorts vs. Net Shorts

I don't want to put myself in the awkward position of defending a bunch of overpaid bankers from Goldman Sachs, but today's Congressional questioning was a bit ridiculous. The first thing that struck me was how evasive many of the current and former executives of Goldman Sachs were. However, this was no surprise. After all, these guys are being sued by the SEC. They must be very careful about what they say.

The second thing that struck me was Senator Carl Levin's apparent misunderstanding of short positions and net short positions. Goldman CFO David Viniar kept trying to explain to Senator Levin that Goldman's net short position wasn't material. Yet Levin did not want to hear it. Instead, he kept trying to get Viniar to admit that Goldman had a large short position.

Viniar is right. In order to understand Goldman's exposure, you must compare the size of its short position to the size of its long position. It is meaningless to say that the company made a lot of money on its shorts unless you also consider how much money it lost on its longs. Senator Levin did not seem to understand this point.

By way of comparison, suppose an individual with $1,000 to his name borrows $100,000 and puts the full amount into his savings account. Senator Levin would argue that the value of his assets went up materially. That's true, but it's meaningless because the value of his liabilities also went up by the same amount. In fact, this individual's net worth hasn't changed at all. You can't look at just one side of the balance sheet.

If you make a lot of money on a trade, the IRS does not tax you on that trade alone. Instead, it allows you to net your gains against your losses and taxes you only on your net gains. Why can't Senator Levin understand a concept as simple as this?

Goldman may have done a lot of things wrong, but David Viniar is absolutely right to insist that examining the company's short position in isolation is completely misleading.

Tuesday, April 20, 2010

The Future of Entrepreneurship Looks Bright

Just a couple of months ago, I had never heard of The Kairos Society. However, I received an invitation from Kristen Santerian, president of the University of Pennsylvania chapter, to attend their annual summit and make some remarks about opportunities in emerging markets. So I did a little research. What I learned was amazing.

The Kairos Society is an entirely student-run organization whose aim is to promote entrepreneurship. It was started three years ago by Ankur Jain, another undergraduate student at the University of Pennsylvania.

Imagine the effort that goes into pulling off a multi-day conference in New York City. You have to find a venue, you have to make hotel arrangements, and you have to provide meals and transportation. There are professionals who make a living putting together conferences like this, yet all of it was done through the efforts of Ankur and a whole cadre of student volunteers. They even managed to arrange a dinner cruise around lower Manhattan for all the attendees, which I would estimate numbered about 500. All of America's top universities were represented. There were also delegations from all over the world including China, India, Hungary, Spain, and the U.K.

These students managed to pull in some of the most impressive speakers I have heard. The list included Carl Schramm, who heads the Kauffman Foundation, Peter Diamandis, founder of the X-Prize Foundation, Bruce Mosler of Cushman & Wakefield, and Admiral William Owens, former Vice-Chairman of the Joint Chiefs of Staff. Even the ever-popular Maria Bartiromo of CNBC was on hand.

Without doubt, however, the most impressive portion of the conference was learning about the student's business ideas. And where do you think they demonstrated their ideas? On the floor of the New York Stock Exchange, of course.

A true entrepreneur sees a problem that needs to be addressed and tries to solve it. Or, he/she thinks of a product or service that people don't even realize they want, and develops it. Ideas are great, but they are not enough. As the old saying goes, ideas are a dime a dozen. Execution is the most critical step. People come up with great ideas all the time, but it takes a special talent to do something about it. An idea is useless unless it is put into action. The amazing part of the conference was that many of the ideas these students had come up with were actually being implemented.

Here are a few examples:

*Installing moisture sensors in farms that control irrigation systems. The students who came up with this plan estimate it will cut water usage by 10%.

*Streamlining the on-line college application process through a website that consolidates applications to all universities.

*Providing an on-line campus service network that allows students to advertise their services and find the services they need from other students. Want someone to do your laundry? Find them on-line. Students use credits purchased from PayPal to pay for services.

*Selling custom-made fixed-gear bicycles, a hot urban craze, at a substantial discount by directly connecting the buyer and manufacturer.

*Fish farms that go way beyond salmon.

Many nations, including the U.S., are currently dealing with difficult economic times. We may continue to struggle a while longer. However, hanging around these incredibly bright young students for a couple of days raised my level of confidence about the future. I suspect I just met some of the people who will be changing our lives for the better in the very near future.

Friday, April 16, 2010

Goldman Tarnishes Buffett's Image

Each year about this time, the media gears up for a major event: Berkshire Hathaway's annual shareholders' meeting. This year's meeting will be held on Saturday, May 1. As usual, everyone's interest turns to Berkshire CEO Warren Buffett, who is perhaps America's most-loved business executive. Not only is Buffett considered one of the world's greatest businessman, he is also thought to be one of the most ethical.

Because I wrote a book about Buffett, I am often asked about him. Usually, people want to know how he became so rich, what stock or company he might buy next, or what they should do to be like him.

About a week ago, Betty Liu of Bloomberg television interviewed me about Buffett. Her questions were a bit more sophisticated. She seemed particularly interested in his investment in Goldman Sachs. Given today's announcement that the SEC is suing Goldman Sachs for subprime mortgage fraud, her timing couldn't have been better.

Liu wanted to know if Buffett had tarnished his image by getting involved with an investment bank that is not exactly loved on Main Street. After all, Goldman's executives seem to exist in a world of their own. They have little in common with the ordinary "man on the street." These are people who think nothing of getting paid several million dollars each year. No doubt, some of them think they are entitled to more. In comparison, Buffett is one of the most underpaid executives. He gets just $100,000 per year to run Berkshire Hathaway. Despite Goldman's excesses, I defended Buffett's investment in the bank. Buffett felt he was getting a great deal, so he took it.

Over the years, Buffett has strongly criticized the investment banking industry. However, he has also made it clear that Goldman Sachs was the best of the lot. He often praised former Goldman executive Byron Trott. And during the recent financial crisis, Buffett invested $5 billion of Berkshire's money in Goldman Sachs preferred stock. Berkshire also received warrants to buy Goldman's common stock at $115 per share.

Today, after the SEC made its announcement, shares of Goldman plunged 13% to close at just under $161 per share. Berkshire lost a ton of money on paper. Although its warrants are still well in the money, Buffett's armor looks at least a little bit less shiny.

Tuesday, April 13, 2010

Special Situation Survey Ranked As One of the Best.

I'm happy to say that our stock picks in the Forbes Special Situation Survey have done extraordinarily well over both the short and long term. In fact, according to the Hulbert Financial Digest, we have generated a 17.8% annualized return (excluding dividends) over the past five years. In no small part, this is due to my crack staff of equity analysts including Taesik Yoon and Sam Ro. Mark Hulbert recently singled us out as a top-performing investment newsletter in an article he wrote for MarketWatch. This follows an article written by Peter Brimelow for MarketWatch about a year-and-a-half ago. WBBM radio in Chicago noticed our performance record and interviewed me about our stock picking strategy.

Based on our record, we have received a number of requests to manage money. That is not a service we offer at the present time, but it is something we may do in the future. I'll certainly keep you all posted if anything develops on that front.

Monday, April 12, 2010

When Better-Than-Expected Isn't Good Enough

Earnings season is upon us again and, for the most part, analysts' forecasts are rather rosy. After all, corporations have slashed costs over the past two years. With some companies now seeing a pick up in sales, their bottom lines could see a nice jump.

Furthermore, as optimistic as the analysts are, their history in recent periods suggests caution. In other words, they have underestimated earnings more often than they have overestimated them. To some extent, they do this on purpose. After all, unless they are short, investors are more likely to get upset if a company falls short of the earnings estimate than if it beats it.

So we shouldn't be surprised if the majority of earnings reports for the first quarter come in ahead of the forecasts. The bigger question is how will the stocks react? Will beating the "number" by a penny or two be good enough?

The S&P 500 is up 7.5% year-to-date suggesting that investors are expecting stellar results for Q1. Given the strength of the rally, there is a good chance that stocks could sell off even if earnings beat the forecasts. I suspect this earnings season, "better-than-expected" will not be good enough.

Tuesday, April 06, 2010

A Review of "Investing Without Borders"

I've been reading a new book by Daniel Frishberg called Investing Without Borders: How 6 Billion Investors Can Find Profits in the Global Economy. Frishberg, a former Marine, is the founder of BizRadio Network and the host of the MoneyMan Report, a radio program I have been a guest on many times.

The foreword to the book is written by Arthur Laffer, the father of the so-called Laffer Curve, which is a graphical depiction of the relationship between tax revenues and tax rates. In fact, Frishberg credits Laffer in his opening chapter for his unique take on the classic tale of Robin Hood. As Laffer points out, if Robin Hood keeps stealing from the rich, the rich will simply avoid traveling through Sherwood Forest.

In general, Frisherg's book provides a refreshing take on investing and challenges much of financial theory. Frishberg is a man with a tremendous amount of common sense, a trait that has served him well over the years. For example, as Frishberg points out, financial experts would tell you not to try to time the market. In fact, they say no one can do this successfully over the long run. Frishberg, however, argues that you can and should time the market. The recent financial crisis showed us all how a buy-and-hold strategy will decimate your wealth. Furthermore, the experts say you should always hold an extremely well-diversified portfolio. Frishberg argues that you should not diversify too much. Instead, you should do your research, avoid the bad stocks, and buy only the good ones.

Frishberg is also a big fan of greater foreign exposure. He believes most American investors have too little exposure to foreign markets--especially the markets that will drive much of the global growth in future periods. This is not to say he is bearish on America. He isn't. In fact, Frishberg says, "The real long-term success of the United States is still ahead of us." However, he thinks it would be foolish to ignore the fact that the rest of world wants to be like us. They are catching up and there is a lot of money to be made by investing in those markets.

As the title of the book suggests, Frishberg wants you to think about investing in global terms. Traditional borders are becoming less of an obstacle than they once were. Entrepreneurs can set up shop almost anywhere. They will go where conditions are most friendly. Governments will have less ability to force consumers to buy overpriced products simply because they are manufactured at home. These are the trends that Frishberg thinks will dominate the future. They are also trends Frishberg says will make investors rich if they are smart enough to exploit them.

Sunday, April 04, 2010

FGI Commentary

The following commentary appeared in the April issue of the Forbes Growth Investor.

It seems that no amount of bad news will keep this market down. Stocks soared in March, a month that saw a horrific terrorist attack in Moscow, rising trade tensions with China, and the passage of a major government healthcare bill that will no doubt add to the national debt and deficit no matter how loudly Democrats insist that it won’t.

That’s not to say there was nothing to cheer. Housing prices appear to be firming and even rising in some parts of the country, state governments are projecting better-than expected tax revenues, consumer sentiment and confidence numbers appear to be trending higher, the IPO market is coming alive, M&A activity is picking up, economists are forecasting real GDP growth, and some corporations are finally seeing a pickup in demand and sales.

Yet there is still plenty to worry about. Most notably, employment is still a concern. Initial jobless claims are still too high even though the latest nonfarm payroll figures were encouraging. However, even if the economy creates 100,000 net new jobs per month, it would take seven years just to get back all the jobs we’ve lost since the recession began in Dec. 2007. And that doesn’t take population growth into account. As a result, the unemployment rate could remain elevated even as job creation strengthens.

In addition, the government is playing too large a role in the economy. The recent announcement that it plans to reduce its stake in Citigroup is welcome news, but what government gives with one hand, it usually takes away with the other. For example, chances are investors are underestimating the true cost of healthcare reform. Already, several major corporations have announced plans to take huge writeoffs as a direct consequence of the new healthcare law. Instead of applauding their executives for honest accounting, Democrats are accusing them of playing politics.

Investors are also underestimating the real possibility of a trade war with China. Last month, China tried and convicted an Australian national employed by Rio Tinto for accepting bribes. Because the trial was held behind closed doors, there is no way to know the extent of the evidence. The accused man may indeed be guilty, yet the lack of transparency during the trial makes global businesses wary.

Rio Tinto was not the only company to raise China’s ire. Google, one of the world’s largest companies, decided to pull out of China. Now it is trying to serve Chinese users from Hong Kong. Google was particularly upset about censorship issues and hacker attacks that appear to be government orchestrated. Google clearly decided that the possible rewards of doing business in China are no longer worth the risks. It remains to be seen how many other companies, if any, follow Google’s lead.

Another worry is the rising level of interest rates. The Fed insists that it won’t be raising the fed funds rate any time soon. However, it is planning an "exit strategy" that involves selling assets. Higher interest rates may be needed to entice investors to purchase those assets. Furthermore, recent government bond auctions raised worries as the yield on the 10-year note moved closer to 4%. China, a big buyer of U.S. debt, has reduced purchases in recent months. There is speculation it may cut back further; and not just to send the U.S. a message. As hard as it may be to believe, China is expected to report a trade deficit for March—its first monthly deficit in six years.