David Dreman, author of  several books focused on contrarian investing, was quoted in one of his books as saying something to the affect of, nobody beats the market, except for the people that do.  And yes, there are people that do (like Seth Klarman).

Some people are still very resistant to that idea.  If you read Burton Malkiel‘s, A Random Walk Down Wall Street, for instance, it’s easy enough to believe that anyone that beats the market is just doing so by random chance.*  If you do, in fact believe that, there’s an alternative that takes some of the gamble out of the equation.  The answer, of course, is one that you already know: indexing.

*While at one time the most dominant theory in academic circles, the efficient market hypothesis has lost some of its credibility to the rise and prevalence of value investing.  Warren Buffett has been among the most vocal critics…but he has plenty of company, including people like Klarman and Dreman.  The people that have beaten the market by the largest margins over time don’t believe that their life’s work is nothing more than random chance.  I don’t believe it either.

Index investing is the brain child Vanguard founder and former CEO Jack Bogle.  I honestly think Jack Bogle is a great man.  He personally strove for things that actually helped the individual investor succeed.  Vanguard’s roots were about low minimums and very low management fees.  I think they’re moving away from that somewhat – but that was Mr. Bogle’s vision.  It was one that changed the entire investment industry.  Investing wasn’t just for rich people anymore.  If you’ve read any of Mr. Bogle’s work (or heard him speak), I think you’d agree that he makes a pretty compelling case for indexing.**

**You’re probably familiar with the idea of indexing.  If you are, feel free to skip this section.  If you aren’t, you’re about to be!  Indexing is, basically, the idea that because it’s so difficult to beat the market, the most important thing to manage is costs.  With an index fund, you’ll never beat the market, because essentially, you are the market.  You’re copying the market’s performance.  You’re controlling one of the few things you can control, which is cost, by paying lower fees than you would if you invested in a mutual fund with a manager that has no better than a 50/50 chance of outperforming the market.  An index fund copies the performance of a specific group of stocks.  The S&P 500, for instance, is a common bench mark that mutual funds, pension funds and hedge funds measure themselves against.  An index simply invests your money across the stocks in the S&P.  Since these stocks are chosen according to a precise formula based on size, there is no decision making on the part of the manager.  That’s why they can give you such low fees.

Not everyone is sold on indexing, though.  Specifically, many famous value investors think it’s a bad idea.  And why wouldn’t they?  If you’ve beaten the market like a playground bully, indexing would seem quite unappealing.  Seth Klarman points out that it’s essentially the opposite of contrarian investing, that is, instead of buying what’s out of favor, you set out to buy what’s popular.  In his own words:

“I still believe indexing is a horrible idea. Stocks trade up when they’re added to the index so the index investor is paying up. I’m more likely to buy the companies kicked out of the index. For the average person, however, they don’t do enough research to own individual stocks. The idea of owning stocks for the long run is a disservice to investors, because many are not there for the long run. Many got out in 2008 when they should have been buying, because the entry point matters most. Transaction costs and Taxes don’t matter if the market goes nowhere. I’m very worried about another 10 years of zero or low returns since the market has run up so fast.”

Klarman is talking about an index with a finite amount of stocks in them, like the S&P.  I think his quote ignores the fact that you’re perfectly capable of buying a Total Stock Market Index, that includes almost all the relevant publicly traded companies.  Still, his point is a good one:  if he had to buy every one of something, he’d rather be stuck with every stock kicked out of the index than every stock added to the index.  A contrarian strategy.***  Buy when stocks are being sold indiscriminately, and sell when they are dear.

***The expression contrarian investing was popularized by David Dreman in his book Contrarian Investing.

My Roth IRA is invested completely in index funds.  I think the strategy has value.  It’s better than the alternative of choosing higher cost mutual funds that may or may not outperform.  But I’m not a complete Boglehead.  I also have a taxable account that I own individual securities in.  In fact, I’ve been known to follow Klarman into some trades now and then.

In that taxable account, I attempt to practice value investing.  The problem with value investing is, while the broad strokes of the concepts are simple, the approach requires a tremendous amount of time.  I don’t have the requisite knowledge to understand many opportunities.  In fact, many of the situations that Klarman invests in are complicated.  In many (most, even) of these situations I have to pass on the opportunity because it’s outside my circle of competence.

It’s unlikely that your average investor is going to be able to produce success (over time – anyone can get lucky in the short term) on the level that Seth Klarman has.  By definition, about half of all investors have to underperform the market.  Index funds are a simple solution.  You could spend hundred of hours studying and evaluating stocks…and still underperform the market.  Or you could spend an hour rebalancing each year with index funds and pretty much tie the market.****

****Or, if you really want to automate things, a Target Date Retirement Fund does your rebalancing for you.  Vanguard offers these funds of funds invested entirely in index funds.

Anyway, I’m always interested in anything that Klarman has to say.  I thought I would share his comment about index investing here.  It’s not necessarily my opinion, but Klarman knows what he’s talking about.  If you’re only going to listen to one person about markets and investing, Klarman might be a good choice.  Good luck and thanks for reading.

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I’ve sat on this post for a bit because I’ve been excited about the Avera post going live.  I also worry that this post isn’t relevant enough to enough people.  Still, I think there’s something to be learned by talking and looking at individual companies.  Ed.

I followed Seth Klarman into Breitburn Energy Partners (BBEP) awhile back. I got in after the dividend had been cut, under the premise that the dividend was going to come back and Klarman was adding to his position.*  This stock is one of special interest to me, and I follow the news on it pretty closely. I have an average cost basis of about $12 per share.**

*Following people into trades is risky.  Besides the fact that they could be wrong, you don’t know when they’re going to sell.  What you’re doing is not value investing unless you’re doing your own analysis and determining what the fair value of a company is.  Otherwise, you’re speculating.  I know I’m saying that this is what I’ve done.  Nobody’s perfect;)

**Which is unfortunate, because I started following the company at about $8 per share. I didn’t pull the trigger because (a) I didn’t have much money to play with at the time and (b) I didn’t know as much about the company at that point.  Hindsight is always 20-20, isn’t it?

They did, of course, reinstate the dividend, which is currently about $1.50 per share, per year (just under 10% yield).   Making the stock even more important to me is the fact that I put a couple of friends in it at about $14 a share awhile back.  The stock recently pulled back to about $13 a share and I advised them to add to it.***   Because this is a Master Limited Partnership, I believe the yield is sustainable.****  At $13 per share, obviously, you have an effective yield of about 11.5%.

***I sort of wish they wouldn’t ask me.  I don’t like feeling responsible.

****Some yields are high because of a very depressed stock price.  If the company was originally attempting to offer a yield of about 2%, but the stock has fallen so much that it’s now yielding 10%, the yield may be in danger, because there might be some strong economic forces at work.  The company probably has a sound reason, like declining cash flows, why the price is being driven down, making the yield potentially unsustainable.  Certain types of stocks, like Real Estate Investment Trusts (REITs) and MLPs, operate under specific tax rules that require they distribute large portions of their income.  A 10% yield probably isn’t alarming if you see it on an MLP.

That’s competitive among MLPs, but I have always believed that there was more to this play than just the yield.   For one, Klarman tends to focus on special situations, such as spin-offs, takeover plays and distressed debt.   He bought most of his shares at around $6 per share, but he wasn’t just buying into the company because of the potential yield that it offers him.   I might do something like that – but Klarman has produced 20% annual returns for the last 30 years or something, and you don’t do that by getting excited by a little yield.

This is nothing but speculation, but it’s intelligent speculation, and I thought it was worth sharing.   In a recent interview with Seth Hamot over at Selected Financials, Hamot talks specifically about the BBEP situation, saying,

“BreitBurn Energy Partners (BBEP) – This company found they were overleveraged at one point last year and so they cut the dividend distribution, causing the stock to go down to $6. Dividend money went to cut down debt and now it’s at $15. We went from $6 to $15.  Baupost is there and the interesting thing is that they got involved with a proxy contest with the largest shareholder. Quicksilver, the largest shareholder, went on the board and removed 2 guys – the chairman and CEO, the two folks whose name is in the company name itself. They became management employees.

Quicksilver (KWK) is overleveraged and owned 21 million shares of this company at one point, or about 40% of the company. They had a proxy contest and those 2 were removed. You have to take a step back and wonder what’s going on. If there is nothing going on, why would they bother to remove people from the board who will object and not be happy about the situation? There’s a possibility that managers were taken off the board of directors so that potential M&A activity could be kept segregated from the operations, which offers a potential exit strategy for Quicksilver. In the meantime, I got a 10% dividend and 37.5 cents per quarter per share, not too bad at all, and mostly tax-free.”

Earlier in the interview, Hamot talks about the contrarian slant his fund takes, specifically looking for companies that have recently cut their dividend.  He knows that this prompts selling by the people holding the stock for its yield, and thinks that this is a good time to look at the merits of the actual company.

If you don’t know, Baupost is Seth Klarman’s hedge fund.  The entire comment is interesting, but the M&A speculation really jumped out at me.  BBEP is a relatively small company, with a market cap of about $800 million.  Are they a potential takeover target by one of the larger, diversified energy companies?  They’re also in the business of owning pipelines, which is, in part at least, why they’re able to retain their status as an MLP.  Any ideas on who would be interested in this company?

Disclosure:  Long BBEP

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It’s 9 pm on a warm Friday night in July.  The year is 2010.  But you know that.  My wife and I are in Florida visiting her family.  We’ve just arrived in town from St. Louis, and we’re on our way to see the facility for an automotive start-up called Avera Motors.

Avera’s CEO, RJ Scaringe, greets us looking disheveled in a loosened tie and invites us inside the Avera building.  The building has a distinctive start-up feel.  It’s clean, and the walls are splashed with bright, vibrant colors.  Adding to the start-up feel is that several members of what’s always referred to as the “team” are still hard at work when we arrive.  They briefly look up to acknowledge our presence, then go back to what they’re working on.

It’s an environment built to encourage creative minds.  In the middle of a room, partially hidden by a makeshift curtain, is the most dominant piece, and our eyes are instantly drawn in that direction.  It’s a full scale, clay model of what will soon be the first generation Avera vehicle, a car recently described in an Autoweek article titled What’s an Avera? as a “mid-engine, diesel-hybrid, four passenger sports coupe that should sell for about $25,000.”

We’re all drawn to the car, and pretty soon we’re examining it closely.  I raise my phone to take a picture, and Avera’s founder grins a little and says, “don’t publish it.”  We move on, asking questions, getting schooled on how the business and culture work.  The moving parts, if you will.  We hear about the exploits of Avera’s employees.  In the corner of the building are various toys from various projects.  They’re there for inspiration, but act as a sort of tangible resume for both the experiences and interests of the team.  One is the frame of the Ford GT, which Avera’s Director of Engineering helped design.  Next to it is a made from scratch car.  RJ tells us that a member of his team built the car.  My wife, Rachel, excitedly pulls on my arm, points to the car, and repeats the information, “one of his employees made that.”  I smile at her trademark enthusiasm…and so does Scaringe.

Next to the frame and the car are a smattering of other cars and motorcycles in various states of assembly and disassembly.  They’re a group enthralled by all things mechanical.  Scaringe continues to lead the tour, answering questions as we go, moving quickly from the topics that don’t interest him to the ones that do.  He responds to a question about the company’s culture (one of his favorite topics) with an interesting narrative.  He talks about a hierarchy that looks more like a horizontal line than a pyramid.  He talks about the talented team that he’s assembled, one that he clearly trusts and believes in.  He tells us some of the fun quirks associated with their particular company.*

*One of my favorites: car sharing.  The team takes turns driving each others cars.  Two team members will swap cars for about a week at a time.  Since it’s a team made of largely of car enthusiasts, they all tend to drive fun and interesting cars.  It also keeps them thinking about what they do or don’t like about particular cars as they design their own.  Scaringe, for instance, drives a Lotus Elise.

We move on, to the individual work spaces.  The design team’s area features a wall covered with colored drawings, sketches and information.  On a table in the center of the work spaces is a small, clay, model of what the car will look like in a bright green.  Many of the team member’s have various car models on the edges of their desks.  These are “car people.”  This is what they love.

Scaringe takes me over to a particular computer and starts to explain how the car industry has changed, why automotive start-ups are viable now, and how this car is different from any other car in the marketplace.  He talks about how costs have fallen as, for example, the use of simulators has replaced crashing dozens of cars into walls to compile safety information.

The tour continues from there, but you get the idea.  You might be wondering why/how a random Missouri attorney/blogger gained seemingly unfettered access to an automotive start-up based in Florida.  The answer is that I’m not random.  I’m married to the CEO’s sister.**

**Scaringe has even contributed a post or two to the blog in the past.

You might be thinking that starting a car company is an incredible undertaking.  I often think the same thing myself.  RJ Scaringe has heard every imaginable criticism from every type of naysayer.  He’s given presentations to investors and government officials.  He’s well versed in answering the concerns that such people inevitably have.  ”What about X?” they ask, as though they have a unique question that hasn’t come up since this project started, more than five years ago.

From this article:  ”It is not lost on anyone in the automotive business, much less Scaringe, that the industry has not been kind to those looking to outdo the major car companies.  Malcolm Bricklin, John Delorean, Preston Tucker and a long list of entrepreneurs would confirm that.”  But he believes they can succeed.  He recently told Autoweek, “we’re not going for the particularly high-end supercar.  We’re going for a part of the market we feel is very strong.”

Scaringe is a unique individual.  A reporter once asked Bill Gates and Warren Buffett (on separate occasions) what the secret to their success was.  They both responded, without hesitation, with a single word….Focus.  It’s a word I would use to describe my brother-in-law.  In a sense, Scaringe has been preparing to start this company his entire life.  As a sixteen year old, he was asked by a local news source what his plans in life were, to which he responded that he planned on getting his undergrad in mechanical engineering, then progressing on and getting his PhD in ME, after which he planned on starting his own company.  He knew what he wanted.

Scaringe finished first in his class (ME, in accordance with the plan) at Rensselaer Polytechnic Institute.  He went on to get his masters and PhD (ME again) from the Massachusetts Institute of Technology.  He returned to his hometown in Florida, armed with the credibility he’d need to start the next chapter of his life, a company he would later name Avera, a combination of America, verde (green) and terra (earth).

The company was built on a very specific vision Scaringe had for the car.  I won’t attempt to describe the vision, because I don’t want to mischaracterize it.***  I will say that the car challenges the conventions of the modern car, being lighter, greener and more efficient than your current options, but also being sporty and fun to drive.  It’s a fuel efficient, affordable, sports car (none of those words seem to go together, do they?).  Ambitious, eh?

***I’m the wrong person to describe the technology behind the car, or RJ’s vision, though I have been exposed to some of each on multiple occasions.  I do, however, have access to the right person to describe it, and hope to interview him sometime in the coming months.

The car is going to be made in America.  Obviously the design is already underway, and that will take place in Florida.  Where it will be manufactured is still somewhat up in the air, but it’s looking like it will be Florida as well.  Avera has received several very competitive offers from several states, including, notably, Kentucky.****  Avera, is, after all, a hot commodity.  Their projections indicate that they’ll create 1100 jobs by 2015.  Avera and NASA recently announced a strategic partnership that should be mutually beneficial – NASA will benefit from many potential jobs for some of their displaced engineers and technicians, and Avera will gain access to underused equipment and facilities that would otherwise require large capital investment on their part.  At this point, anyway, all signs point to Averas being manufactured in Florida.

****I haven’t trumpeted Missouri that much (at all, really).  I would love it if he wanted to build the car in St. Louis.  We have the infrastructure!  We want the jobs!  Low cost of living!  But it seems like a foregone conclusion that the car will be built in Florida.  Being the homer that I am, I’m still going to make a last ditch effort to try to get him to contact St. Louis Mayor Francis Slay and Governor Jay Nixon about what Missouri could offer him;)

Avera plans to have a functional prototype by the end of this summer.  2011 will be the year that they debut and promote the car at the major auto shows, and by 2013 the car will be available for purchase.  Between now and then, I’ll try to keep you updated on the process.  For the self-educated investor and student of all things business, I think it’s a great topic for the blog and one that I’m fortunate enough to have access to.  Anyway…buy one.  Or five!  And thanks for reading.

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I try to read the Freakonomics blog in the NY Times when I can find the time.  I still remember when the first book came out, and how I felt like everywhere I went people were talking about the book and the ideas it contained.  At the time, I think it was something unique.  Lots of similar books have followed suit.  People slap -onomics on the end of all kinds of things (it’s marketable).  Malcolm Gladwell‘s books are similar.  He has his own style, of course, and he’s more sociologist than economist.  Freakonomics demonstrated that there’s a market for challenging conventions and thinking about things in different ways.  But, as usual, I digress.

The blog does (or attempts to do) the same thing that the books did.  One of the contributors on the blog is Ian Ayers, a Yale economist and law school professor.  Ayers, in tandem with Barry Nalebuff, recently wrote a book called Lifescycle Investing.

I have not read this book, but I’m intrigued by the idea, which is, basically, that people do not diversify well enough over time.  What they mean is that people have large amounts of money invested over too short of time periods.  Most people would agree that it is advantageous to invest early to take advantage of long time horizons.  Ayers points out that the problem with this approach is that the time when you have the longest time horizons is also when you have the least amount of money.  Most of your capital when you’re young is tied up in untapped human capital.  The paradox of a long time horizon is that you either have a long time horizon or the money to take advantage of it, but not both.  The authors offer a solution: borrow on margin to finance investing more earlier.

They argue that using their approach actually decreases rather than increases risk – because of the increased time.  Part of their reasoning is that you can borrow cheaply right now in order to invest on margin (around 1% according to the video below).  Their recommendation is that you diversify less as the costs of diversity rise.

To use their example from this post:

“Yes, we do propose that young investors invest with leverage. But, as we explain below, this is fully in keeping with Samuelson’s own prescriptions. The reason for leverage isn’t that this is a way to double your bets and make quick money. Rather, this is the way to get around a constraint that prevents young investors from getting their desired exposure to equities. To put some numbers on this, take someone whose lifetime wealth is $1,000,000 and who would ideally like to expose half of that wealth, or $500,000, to stocks. The key point, and the source of confusion, is that we aren’t proposing that this person invest double their wealth, or $2,000,000, in stocks. No, we propose that the person invest something like $50,000, with leverage, in order to get exposure of $100,000 to stocks.”

More in their own words:

My thoughts:

Aren’t we already doing this in a sense? By this, I mean tapping into our human capital by taking on all sorts of leverage early in our lives and spending time trying to get even. I have money in stocks and retirement, but I still have student loans and two mortgages (one on the house I live in and one on a rental property).

Still, I like the idea. I don’t think it’s one that I will attempt in practice. I especially like the idea of automating this – forming mutual funds that do this for people at the prescribed levels. Obviously there are lots of funds out there that employ leverage, but I think the preference would be to see this done using index funds in exactly the way the authors have described. I’d love to hear/see some intelligent criticism of this idea, if there’s any out there. Anyone out there planning on trying this out? Anyone out there already doing this?  Has anyone read the book?  Good luck and thanks for reading.

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You’re probably familiar with the concept of earnings.  Earnings is investor speak for profits.  A company’s earnings should tell us how much money a company made in a given period.  This matters when choosing investments because the company can, theoretically at least, take the money that it makes and either (1) distribute it to shareholders, or (2) invest it in a way that helps the company grow it’s future earnings (which, of course, could in turn be re-invested in the company or distributed to shareholders).

For this reason, earnings has been a key metric investors have used to value companies.  Companies with a low price to earnings ratio are considered to be cheap, while companies with higher price to earnings ratios are considered more expensive.  Obviously, this ignores some important considerations.  Growth is one.  You’d be willing to pay more for a company that was going to double its earnings over the next 5 years than one whose earnings would decline over the next several years, right?  Another consideration are a company’s assets – a company might own valuable assets that don’t produce earnings.  Maybe you own a piece of land in Hawaii that produces no earnings.  Say this is the company’s only asset…the company is obviously not worth zero – this is an asset that could be sold.  So there are considerations other than earnings to be taken into consideration.

There are also all kinds of other considerations.  What about assets that are difficult to value – such as a brand?  Warren Buffett once said that if you gave him 100 billion dollars and told him to go out and replace Coca Cola in the marketplace, he’d give it back to you and tell you that it couldn’t be done.  At the most recent shareholders meeting, of Harley Davidson, he said, we like the idea of being invested in a company whose customers tattoo their name on their chest.

But I digress.  We were talking about earnings.  Earnings is something of a flawed metric.  The problem with earnings, is that it’s basically created by the Income Statement, which is generated, at least it part, so the company can determine how much it owes in taxes.  The problem with this reporting is the rigid set of rules that accompanies it.  For instance, these rules include reporting sales when they are made, rather than when the cash is collected.  So you may have revenues reported during your earnings period when you haven’t actually collected the cash (and may never).  This is just one of the challenges related to using earning reports off of the income statement.  Similarly, expenses are capitalized over time on the income statement, even if all the cash was paid up front.

The problem we’re facing when trying to use earnings to value a company, then, is that earnings as stated on the income statement are not an accurate representation of the cash that is flowing in and out of the company.  Cash flow is truly what we’re interested in because it’s this figure that actually shows, as is stated above (1) cash that can be distributed to shareholders and (2) cash that can be invested in an attempt to increase earnings in the future.

That’s why Warren Buffett ignores reported earnings on the income statement, and instead uses what he refers to as “owner earnings.”  In his 1986 shareholder’s letter,* Buffett gives us this definition/equation for owner earnings:

“….(a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items…less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”

*This letter is a real gem.  Buffett mentions at the end of the letter that the annual meeting grew from 250 to 450 in one year.  I’m sure he never envisioned that it would be what it is today.  Has there ever been someone so famous and beloved by the average person…for being an allocator of capital?  For being the hero of capitalism?  Anyway, check out the letter, especially the appendix, where the definition above comes from.

So basically we’re starting with earnings from the income statement and we’re adding in anything that’s a non-cash charge, then we’re subtracting expenses that are necessary to keep the business going.  Notice that we average capital expenditures if we use this equation.

Owner earnings is a superior method of computing what a company actual earns because it shows you how much cash you would have available to you if you owned the entire business.  A common example of a time that this would have come in handy is Enron.  Enron was doing anything they possibly could to show that they had made (or beat) their earnings numbers.  If you took a look at their capital expenditures, though, the company had negative cash flow.  If you’re investing more money than you’re making, over time you’re going to go out of business.

Even if there’s no fraud at play, owner earnings is a better way to compare two companies than regular earnings, simply because owner earnings allows us to paint a clearer picture of how the business is actually doing.  In the near future, I’m hoping that I’ll be inspired to put together a side by side example of the owner earnings of two companies.  Good luck and thanks for reading.

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I’d like to start by saying that this situation with BP (BP) is an awful one.  It’s been called the worst ecological disaster in the history of the United States.  This post isn’t about any type of political reform.  I don’t know what should be done, or what should have been done, or what will be done.  A random person off of the street has probably followed the situation more closely than I have, and will have more accurate insight and information.  What I’d like to talk about is whether BP would make an intelligent investment at this point, and going forward.

At least one well known value investor, a fellow named Whitney Tilson, who was notably an early investor in the General Growth Properties (GGP) situation that I’ve talked about ad nauseam on this blog (and I’m probably not finished;).  Before you play the video below, a couple of notes about Tilson.  He’s not always right.  This isn’t an insult, since no investor is, but early on in this situation he went on the record to say that BP wouldn’t need to cut their dividend.  A week later, BP suspended their dividend.  I’m not sure they needed to do so, but under government pressure and the pressure that is public opinion, they did so.  With that in mind, Tilson is a solid value investor that’s done well in his career.  Here’s his case:

This video is from June 9, 2010:

And here’s a written presentation:

Why We’re Long BP

Not everyone is sold on BP, of course. Tilson has inspired at least one article titled, Why Whitney Tilson Is Wrong.  I don’t know who is right and who is wrong, but since Tilson started buying, the stock has taken a significant downturn, hitting $26.85 in after hours trading on Friday.  That’s a 52 week low.  That certainly doesn’t make Tilson wrong.  He’s taking this position with the intention of holding it for an extensive period of time.  But sometimes the difference between being too early and being wrong are impossible to distinguish…especially if in 6 months he could have put the money to work at $19 per share instead of $30 per share.

I have no idea where the stock is going in the short (or long, for that matter) term.  I had a friend buy BP at $42.  In hindsight it’s easy to say that was early.  Another friend of mine bought at around $35.  Mohnish Pabrai is famous for saying that he looks for opportunities with low downside and high uncertainty.  We obviously have the high uncertainty.  Opinions run the gambit from “BP will have to file for bankruptcy,” to “BP will reinstate their dividend next year and return to its highs.”

I tend to agree with Tilson that bankruptcy is unlikely, and even if a bankruptcy occurs, it probably won’t be the typical bankruptcy that wipes out all the equity holders.  But I don’t know.  The stock certainly looks cheap at around 4x trailing earnings.  BP is certainly a company that produces huge positive cash flow.  At this point, though – the uncertainty is overwhelming, and there is still plenty of downside at $26 per share.  We have to deal with regulatory uncertainty, uncertainty as to liabilities, uncertainty as to how this will affect BP’s brand going forward (does their brand matter).

If you’re into being a contrarian, and buying out of favor stocks, I think you’d agree that stocks that are truly out of favor stay out of favor for years.  Tilson makes the point that BP is going to be paying this back, not all at once, but over time, and during that time they will continue to produce lots of cash and earnings.  The inverse of that assertion is that the cloud of this spill will be hanging over their heads for years, chipping away at their earnings and taking cash from shareholders and pouring it into their many liabilities.  The best time to truly be a contrarian is when you’re having difficulty finding people that agree with you.

Warren Buffett is famous for his baseball to investing analogies.  In one of his most famous, he likens investing to an at bat.  Unlike baseball, though, you don’t have to swing.  You can let 3 strikes go by.  You can let 100 strikes go by.  You can wait for the perfect pitch, a pitch that you are extremely confident you can hit.  At this point, BP doesn’t look like that pitch to me.  It looks like a play based on speculation.  The time to make money is certainly when things are at their darkest, and perhaps we’re approaching that point.  I think there’s a good chance that people who invest in BP will be successful.  At this point, however, it won’t be me.  If the price continues to fall, I’ll definitely take another look.  Thanks for reading.*

*On a completely unrelated note, what do you think of the blog’s new look?  It’s the oft used thesis theme.  Should have a couple more subtle changes as I figure out what I’m doing.

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I was reading a Li Lu talk over at the always excellent Street Capitalist, and immediately something jumped out at me.  The talk itself, is, predictably, full of lots of insight into intelligent investing from Lu, one of the best investors in the world.  I encourage you to read it.  That’s not what caught my eye, though.

Professor Bruce Greenwald, (a famous value investor in his own right*) introduced Mr. Lu to the class.  In his introduction, Greenwald stated that,

“Warren Buffett says that when he retires, there are three people he would like to manage his money.  First is Seth Klarman of the Baupost Group, who you will hear from later in the course.  Next is Greg Alexander.  Third is Li Lu.  He happens to manage all of Charlie Munger’s money.  I have a small investment with him and in four years it is up 400%.”

*Greenwald is a professor of finance and teaching in the value investing program at Columbia University.  He’s also author of the excellent book, Value Investing, From Graham to Buffett and Beyond.

Of course Greenwald doesn’t say that these are the people in the running to be the next Chief Investment Officer at Berkshire Hathaway.  He doesn’t know.  Only a few people know those names.  I have no indication that Greenwald would be one of them.  This is good information, though.

Buffett says that these are the people he would trust to manage “his” money.  Most of Buffett’s money is in Berkshire Hathaway.  It may have just been a compliment for the sake of the compliment, I don’t know.  I prefer to believe that we’re being given a series of elaborate clues;)

What We Know About the Candidates

Seth Klarman is one of the best investors in the world.  He’s extremely conservative, keeping large cash positions.  He’s generally pessimistic, and because he keeps large cash reserves, he’s ready to pounce when there’s blood on the streets, so to speak.  He’s also a writer, having written the now out of print Margin of Safety, which now sells for crazy prices on eBay and has become something of a collector’s item among investors.**  I’ve written about Klarman, often, on this site.  I’ve followed him into a couple of trades and I’ve kicked myself a couple of times when I haven’t followed him.  He’s the gold standard of hedge fund managers right now.  He’s the perfect candidate to invest money at Berkshire.  My only question would be whether he would want the job.  He could stay at Baupost, stay a little smaller, and earn better returns.  There are more people out there who can do a good job of managing $1 billion than $100 billion.  He’s already a huge name, with loyal investors.  I’m not sure he would have anything to gain by going to Berkshire.***

**The title of that article is the $700 used book.  You can’t even find it for that anymore.  An updated article would likely be called, the $1200 used book.

***Buffett has expressed in his shareholder letters that all the candidates are relatively young, independently wealthy, and want to come to Berkshire for reasons that have nothing to do with money.

We’ve written about Li Lu here before as well.  He manages the personal wealth of Charlie Munger, Buffet’s 1A in command.  At the meeting, when asked about the use of leverage to boost returns, Charlie boasted that one of the candidates used no leverage and made returns of about 200% last year.  Buffett quipped, “that certainly narrows it down.”  Speculation has led many to believe that the only person they could have been talking about was Li Lu.  Li Lu, like Klarman, is a focused investor, preferring to invest in a few position that he knows very well, rather than many positions that he only knows a little about.  Both are bottom-up investors.  Both are well known.  Lu has had an interesting life and is extraordinarily self-made.  He was famously a leader among the protesters at Tiananmen Square and has lived a very interesting life.****  He’s the kind of guy I would bet on.  It has also been widely reported that Lu was an early investor at BYD and brought Munger and Buffett on board, eventually leading to Berkshire’s investment in the company.

****Read this article for more about Lu’s rags to riches story.

I don’t know anything about Greg Alexander, except that he works for Ruanne, Cunniff and the Sequoia fund.  When Buffett shuttered his original partnerships – this is where he suggested that investors put their money.  Bill Ruane was till alive then, though, and was widely considered to be leading the charge over there.  Alexander has been with the firm since 1985.  If Buffett is that impressed with him, I assume he’s a rare talent.  This is from a 1996 letter to shareholders, written by Bill Ruane:

“Twelve years ago, Greg Alexander joined us out of Yale where, despite his economics degree, it appears that he spent most of his time reading annual reports.  He is highly creative and still spends at least eight hours a day consuming annual reports.  I don’t know anyone who processes more ideas with greater analytical depth and he is excellent at cutting through to the heart of an issue.  He is a master of chewing through immense detail to reach original insights and judgments about our portfolio companies.”

Anyway, I just found this interesting.  Take it for what it is, speculation.  I’ll keep an eye out for more info on Alexander.  Thanks for reading.

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My wife and I live in St. Louis.  For the most part, housing prices in St. Louis have weathered the recession better than the national averages.  A recent article, however, stated that foreclosures here are on the rise, and sales on the decline.  Based on the expiration of the new homebuyer’s credit recently, this is no surprise.  Eventually, home prices must bottom out.  The government’s hope was that by the time the credit expired, the economy would be growing again, creating it’s own demand for housing.  The economy is indeed growing again, albeit not as quickly as it declined.

The point I’d like to make in this post is the relationship between home prices and income.  Home prices should* go up at roughly the same rate incomes do.  Otherwise, home prices in a particular area would have to go down.  Consider this example from the book, Your Money Ratios by Charles Farrell:

“Assume the average homeowner in a region makes $100k, and the average home in the region costs $400k.  Wages tend to grow a little faster than the rate of inflation over the long term.  If inflation runs at 3%, then wages might grow 4% per year.  That keeps the price of housing manageable for a good portion of the population.  Now consider what happens after 30 years if wages grow at 4% but the cost of housing goes up 10% a year.  After 30 years, the average wage in a region would go from $100k to about $324k.  But the cost of the average home would have gone to about $7 million.  Assuming you put down 10% for the home, a $6.3 million mortgage at 6.25% interest would cost $465k per year.  If you are only making $324k, it is going to be hard to carry a $464k annual mortgage expense.”

*Obviously they don’t have to.  Markets aren’t always efficient.  If they were, we’d never have bubbles.

Knowing that it isn’t reasonable for housing prices to grow faster than wages…what can we expect in the future?  Obviously, it depends.  If unemployment stays high for an extended period, signifying low demand for labor, then wages should grow at a very slow rate.  If economic growth picks up, then we can expect housing prices to go up with it.  In any case, it won’t make sense for housing prices to escalate at the levels they were (20%+) before the recession.

I was never on board with the people that claimed “housing prices can only go up.”  It ignores supply and demand.  In markets, prices are set by demand.  Sometimes bubbles form, but eventually they must burst.  You didn’t have to be an economist to see that something was going to happen.  For example:

When I was about to go to law school (back in good ole 2005), my plan was to buy a house.  My hypothesis was that if housing prices would go up 10% per year (“conservative” for the time), I could sell the house at the end of the 3 years and would essentially have lived rent free during that time.  Assume I purchased a house for $150k.  At 10%, compounded, it would be worth about 200k at the end of the 3 year period.  Assume my payment is about $1k per month.  Over that time, I would pay $36k in mortgage payments, at least some portion of which would contribute to the equity I had in the home (equity which I would obviously get back in the event of a sale).  At the end of 3 years, I could walk away having lived rent free and with a small profit.**  Luckily, I told my plan to my uncle, who was (still is) older and wiser.

**After fees and expenses associated with selling, perhaps very small, if any.  The point is, housing would not have been much of a drain on my wallet over that period, if any.

When I told him the plan, he said, it’s a good plan, and an intelligent approach to thinking about the decision, but it assumes that prices will go up…and there’s no guarantee that they will.  That’s not how markets work.  He went on to say that he thought a little bit of a bubble was forming in real estate, and that at some point, a correction would need to occur.  If that happened, you’d only want to be caught holding real estate that you intended to hold for a long time.  Obviously, he ended up being right.  Luckily for me, it was one of the few times in my life that I took his advice.  Instead of buying, I rented a cheap one bedroom for $400 per month.  It worked out better than an out of the money mortgage would have.  That’s the benefit of experience.

I don’t know where housing prices will go in the future.  I don’t know about a sure thing investment that will make you rich beyond belief going forward.  I do know that I’m glad that I lived through this recession and get to benefit from the experience of it.  I know more than I did before the recession.  Let’s face it, over the course of 10 years or so, you’re going to see several recessions.  You’ll see good periods and bad.  It’s important that you keep your head in both environments.  Comparing price growth to wage growth is a good way to do that.

Obviously, there are lots of other things that affect housing prices as well – proximity to work, school districts, neighborhood demographics.  All of these things come back to = supply and demand.***  And none of them change the underlying principle, real estate prices should not outpace wages.  Thanks for reading.

***Interestingly enough, some economists are predicting that there won’t be enough housing supply to meet demand when the economy recovers.  Many homebuilders went out of business with the recession, others have reduced access to credit.  Fewer are investing in new developments because of the downturn.  The theory is, that when the economy recovers, there will be lots of pent up demand from (a) population growth and (b) people living with family members getting back out on their own and into the market.

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"And that's how I struck out Babe Ruth, son."

My father died when I was sixteen years old.  It’s one of those few, unique events, that permanently change your life and how you look at it.  As I write this, 12 years later, it’s still the tragedy of my life.  Most days I don’t think about it.  To this day, though, I can be driving down the road, have that feeling of loss hit me, and I’ll tear up and feel like I’m about to fall to pieces.  Not often.  But occasionally.  If you’ve lost someone that you really loved, you probably know what I’m talking about.

My wife, Rachel, and I spent father’s day in Florida, visiting her father.  He’s a good one.  I’m glad we got to see him.  He was and is a good father, the kind I aspire to be.  He’s patient, and kind, and driven.  He lives for his work and his children.  If I can do half as well I’ll be happy.  When Rachel and I have children (God willing), he’ll make an awesome grandpa.

Anyway, the fact that it was father’s day kind of had me reflecting on my dad.  At least, that was part of it.  Another part is the fact that I’m currently reading Are We Winning by Will Leitch (which has nothing to do with finance or investing, but is excellent nonetheless).  It’s filled with all kinds of anecdotes about baseball and fathers and sons. The biggest part of it, I’d have to say, is a guy named Kevin I met over the weekend.

On Saturday we went to my aunt and uncle’s house for my cousin’s graduation party (congratulations Mel!).  They live in one of those neighborhoods where everyone is friends with pretty much everyone else, and most of the neighborhood was at the party.  Lots of fun, interesting people.  One of the most interesting was this guy, Kevin, a successful salesman.  Very charismatic guy.  Extreme extrovert.  We’re sitting around, sipping beers, and this guy Kevin is cutting up, and he’s got a big crowd.  And he starts doing the best Rodney Dangerfield impression I’ve ever heard, and everyone’s rolling.

As the day wears on and the sun starts to set, we’re still sitting out there, staring at the water, talking about oil spills, business, sales, law, marriage and life.  The crowd has dwindled a little bit, and, not for the first time that day, Kevin starts talking about his dad, who passed away recently.  He’s talking about what a great guy he was, how many people’s lives he touched, and how much he missed him.  I listen intently, but don’t say anything about my own father because (a) I don’t want to interrupt this guy’s flow and (b) I don’t want to get into it (I pride myself in being able to not make everything about me).

Kevin keeps talking and eventually says a line I’ve heard many times, from many people.  It’s some variation of the following:  If I can be half the man my dad was, I’d really be something special.  You didn’t have to be especially insightful to see how proud Kevin was of his dad.  As I heard him talk the night away, with a crowd of people’s attention at his disposal, I couldn’t help but think, that the feeling must have been mutual.

All this got me thinking about my own father.  Sort of a perfect storm, if you will.  I’m not going to start telling stories about my dad.  I have them.  Everyone does.  But I don’t feel like I could capture him.  Not in 1000 words on a personal finance blog, the day after Father’s Day.  None of the stories would be enough.  And I’m not ready to share something on this blog that I can barely talk about at home, anyway;)  But it got me thinking about the things that he was that I’m not, and I’m not sure I can be.  It got me thinking about fatherhood in general, and what a big responsibility it is, and how scary it must be.  There are some things I’m confident I’ll be able to do well.  I could teach someone how to hit a curveball (stay back!), change a tire or value a company.  I worry I won’t be able to teach someone how to be a good, honest person.  I’m not sure I can teach anyone how to be brave.  I don’t know how I’ll teach someone how to be nice to the people that the other kids are mean to.  I don’t know how I’ll be able to do a lot of things.  My dad was up to the task.  So was Kevin’s.  So was Will Leitch’s.  I’m honestly not sure I am.  And I guess that’s what makes our dads so amazing.  So….Happy Father’s Day.  I hope it was a good one.  Thanks for reading.

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I don’t have anything new to say about General Growth Properties (GGP). Simon Property Group (SPG) is sticking to their guns, according to reports, and does not plan to bid on GGP again. The market continues to value the stock below the $15 per share that it is being recapitalized at. Bill Ackman continues to be very long the stock, and to believe that GGP is worth about $15 per share and GGO is worth at least $5 per share – $20 total, or about 42% above the current market price. The GGP stuff starts on page 13 if you’re interested. Good luck.  Hat tip to the always excellent Market Folly.

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Disclosure: Long GGP

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