F Wall Street

Profiting from Fear

Joe Ponzio — Mon, 28 Sep 2009 22:27:00 -0600

I often tell clients and investors: "If I can find one or two opportunities a quarter, I'm ecstatic." As we close out the third quarter of 2009 in a few days, I'd like to share with you some of the investments we've made. As I mentioned in this post, I simply don't have the time to maintain an F Wall Street portfolio, but that doesn't mean I haven't been investing!

We'll start with a position taken on July 27, 2009 — Volt Information Sciences. It's the company to which I alluded in this article, and then mentioned in this comment. Below is the text of an e-mail I sent to clients shortly after I bought the stock. After the text of the e-mail, I'll provide some thoughts.

Dear Joe,

Today we invested in Volt Information Sciences Inc. (NYSE:VOL, "Volt"), a provider of staffing services and telecommunications and information solutions throughout the U.S. and Europe. Odds are, you've never heard of Volt, and a quick look at the business' performance might leave you scratching your head over this one; so, let me explain.

Remember: We always want you to be as comfortable with your portfolio as we are.

Volt is a very "ordinary" business — thin profit margins in good times, and a very average return on equity under normal conditions. (Average return on equity for American businesses is around 12%.) Over the past ten years, Volt's revenues have been steadily increasing and earnings, while volatile, have also risen over time. Still, it's not the next Google.

What is it about Volt that attracts us? Ben Graham and "net-net."

Net-net: Defined

A "net" is a stock that is trading for less than its "net liquidation value" — its break-up value. You may also know these as the low "price to book" or "below liquidation value" stocks discussed in many value investing books. A "net-net" is a stock that is trading for less than its "net working capital less long-term liabilities" — basically, a company that has so much in cash, accounts receivable, and other "current assets" that it could pay off all of its liabilities (short- and long-term), and still be liquidated for less than its trading value, assuming its properties, equipment, and other long-term assets were completely worthless.

Ben Graham — the father of value investing — discussed these in both The Intelligent Investor and Security Analysis, and Buffett reportedly spent his early years at his partnerships investing primarily in net-nets.

The math behind net-nets is simple, and we'll illustrate it with our recent investment in Volt.

Volt as a Net-net

Volt's market capitalization — the price at which we could theoretically purchase the entire company — is about $163 million. The company reported (May 3, 2009) $633.8 million in current assets, which include cash-on-hand, accounts receivable, inventories, and other cash expected over the next twelve months. The company also reported $61.2 million in property, plants and equipment, and another $111.5 million in various other long-term assets, both tangible and intangible.

The sum of the company's liabilities, both short- and long-term, was $411.2 million.

Temporarily ignoring the roughly $173 million of long-term assets (properties, goodwill, etc.), the company could quickly be wound up in the next year for $633.8 (current assets) minus $411.2 (total liabilities), or $222.6 million — roughly 25% more than the market capitalization — and that's assuming that the properties, equipment, and all other long-term assets are totally worthless.

Worth More Dead Than Alive?

If Volt shut down today and liquidated in an orderly fashion, we would likely earn more money — probably 15% or so more — than we paid today. And though the market seems to be pricing Volt as if it's going out of business, we see no reason that it should.

In its fiscal years ending October 29, 2006 and October 28, 2007, the company's operations generated more than $33 million of owner earnings. For the fiscal year ended November 2, 2008 — a tough year for all businesses — operations generated nearly $24 million of owner earnings. The first six months of this fiscal year which ended on May 3, 2009, the company had negative owner earnings of -$3.8 million — a small sum when compared to its financial and cash position. Its short-term liabilities are well covered and the company has virtually no long-term debt.

Though its earnings have fallen significantly and turned negative over the past two years, this hasn't caused a rapid cash burn. Furthermore, the company has recorded $14.4 million in impairment and restructuring costs so far this year — costs that are not likely to occur over a long period of time.

Through the worst part of this recession (the first two quarters of this year; still, I wouldn't break out the bubbly as anything can and does usually happen), the company's cash burn rate was such that it could reasonably operate under those extreme conditions for more than ten years.

The Margin of Safety

Our margin of safety on this purchase appears to be two-fold:

if the company goes out of business, we should get back more than we paid in an orderly liquidation. (Again — we don't believe there is any risk of it going out of business.)
if the company returns to a more "normal" state of operations, its intrinsic value should be more than double what we paid.

We plan to exit Volt at the sooner of:

two years,
a 100% gain, or
a material change in the business that would no longer make its then market price attractive.

A Note on Today's Price Action

If you bring up today's chart on Volt, you'll see that it spiked in early trading on no news. That was us, and it speaks to the ridiculousness of the markets and why prices mean very little.

We placed a large order for Volt relative to its regular trading volume. Though the market maker tried to sneak us in, the market's speculators — seeing the aggressive buying — also jumped in to ride the Volt trend of the day. Ultimately, I expect them to be disappointed as our early, aggressive buying dried up when the order was filled, and now they are sitting on short-term, trend-trading holdings that they will likely dump at any price, causing Volt to drop and forcing them to take a loss.

That is the nature of the day-to-day markets. The actions of one large investor can affect the actions of dozens or hundreds of smaller investors; and, while every approaches the same stocks with different intentions (long-term holdings vs. short-term trading; 2% daily gains vs. 100% multi-year gains), they all act together to create wild volatility and unpredictable daily price changes.

By not taking our cues/instructions from price changes, we can be much more patient in our approach and have results that may not correlate with the overall markets.

As always, if you have any questions, please let us know.

Joe Ponzio

End e-mail

Going Where the Panic Is

In March of this year, I presented to MBA students at Howard University in Washington D.C. I modified Buffett's "Be greedy when others are fearful" by summing up my investment strategy as:

The time to invest is when you find an asset surrounded by fear, where the risks of that asset are grossly overestimated.

When it comes to investing, the first question you must seek to answer is: What can I lose? It's not a question that is answered with absolute precision; but, it can be answered to a certain degree. In this case, the market seemed overly fearful of Volt — an employment company in the midst of rising unemployment — and priced it below liquidation value.

What could I lose? If the company were liquidated in an orderly fashion, I'd expect to earn about 15%. If it survived as an ongoing concern, I'd look for a 100% or so gain. As Mohnish Pabrai put it: Heads I win; tails I don't lose much or win a little. (By the way, Pabrai's was a great annual meeting; and, though I'll write about it soon, Miguel Barbosa at Simoleon Sense posted some notes here as well.)

Could I lose in other ways? Sure! The price could have fallen 50% from our purchase price, and then never recovered because the market never went on to realize Volt's value. The economy could have been brought back to the brink and we could have entered a full-blown depression, wiping out Volt in the process. So...yes — there is always a way to lose money. Still, the key is trying to minimize those risks by investing in companies with:

an "edge" that virtually ensures higher profits for many years to come, and/or
a balance sheet with quality assets and manageable liabilities.

Then...you have to pay such an attractive price that the risks of losing money are minimal at best.

They won't all be like Volt — moving almost straight up from the point of purchase. In fact, more times than not, they'll be more disappointing than not because you'll never know when the fear will pass and the party will start. They'll be volatile; they'll be ugly. Then again...that's what makes them so beautifully attractive.

(Why didn't I buy it at $4 back in March? It wasn't on my radar!)

Looking Back at Mistakes

It's always good to go back over past investments and see what worked and what didn't. If you can sort through your past holdings and ignore the "lucky" ones, you'll probably begin to find that your mistakes (and my mistakes) led to losses because the companies in which we invested didn't have a strong enough edge or didn't offer a solid enough financial base, and we paid too much money for too little quality.

Investing is all about looking into the future; so, it's impossible to know for certain whether or not today's purchases will be long-term winners. Still, you'll be amazed at how much risk you can mitigate and how satisfactory your results will be if you simply focus on paying cheap prices for good assets surrounded by fear, where the risks to those assets are grossly overestimated.

Other Purchases

We also invested in three other companies in this quarter, and I'll get to those in a future post. Four companies purchased in three months — now you see why I haven't been around! Thanks for your patience with my absence!

A Prequel to F Wall Street

Joe Ponzio — Thu, 03 Sep 2009 10:26:00 -0600

I wanted to write a quick post about an interview I recently did with Miguel Barbosa of Simoleon Sense. Miguel's is a great blog that covers a number of aspects of financial behavior and psychology.

You can find part 1 here, and part 2 of the interview here. It shouldn't surprise you that it's in two parts: The interview was conducted through e-mail and, in my long-winded fashion, came out to seven or eight pages typed. As a comparison, my posts are usually between three and five; so, brew some coffee!

I titled this post as such in reference to a Twitter comment made by Jae Jun (@Jae_Jun) over at Old School Value in response to the interview:

@JoePonzio @SimoleonSense Actually it's a great prequel to F Wall Street

Enjoy!

Understanding the True Profit Margin

Joe Ponzio — Fri, 07 Aug 2009 17:27:00 -0600

On the heels of yesterday's article, I received an e-mail from a friend this afternoon asking me about my thoughts on inventory turns and profit margins. To paraphrase: The math doesn't work right, as the inventory turns don't affect the profit margins each year.

I didn't do a good job of explaining it properly; so, let's look at the "true" profit margin of a company.

The Low Cost Business

We all know that it's better to have a low-cost business than a high-cost business. Companies with relatively small capital expenditures and fat profit margins should be chosen over those with high capital expenditures and thin margins, assuming all other things are equal.

If you can find good companies that generate tons of cash on a relatively small amount of invested capital, and you can buy those companies at a discount to their intrinsic value, you'll probably find that your long-term investment results are quite satisfactory.

Profit Margin on One Inventory Turn

So...we turn to two businesses, each of which has a thin profit margin, to see how inventory turns can give us some insight into the economics of the company. Let's first look at the economics of the business from a single sale perspective to show that they're the same:

(Note: The number of "inventory turns" refers to the number of times a company must replenish its inventory throughout the year. If Walgreens orders one case of Coca-Cola each month, and sells one case each month, it will have "turned" its Coca-Cola inventory twelve times that year.)

	Company A	Company B
Revenue	$ 100	$ 100
Cost of goods sold	98	98
Other expenses and taxes	—	—
Net income / Cash flow	$ 2	$ 2
Profit margin	2%	2%

In this case, both businesses earned $2 on $100 of revenue. Their profit margins were 2% ($2 divided by $100). Fortunately, they lived in the land of Tina's Family Therapy; so, no taxes or any other costs.

Both companies invested $98 in inventory (cost of goods sold), sold it for $100, and made a $2 profit. Simple enough.

Conventional wisdom would say that both businesses should be avoided. We're supposed to look for businesses with wonderful economics, and a 2% profit margin is anything but "wonderful." Then again, we're all about being non-conventional around here.

Profit Margin on Multiple Inventory Turns

Same companies, but factoring one year of inventory turns into the mix:

	Company A	Company B
Inventory turns	12	2
Revenue	$ 1,200	$ 200
Cost of goods sold	1,176	196
Other expenses and taxes	—	—
Net income / Cash flow	$ 24	$ 4
Profit margin	2%	2%

Right off the bat, these companies may still look similar. Though Company A has greater sales and revenues than Company B, they both boast 2% profit margins and seemingly terrible economics.

Then again, these are businesses, not just numbers on a piece of paper. And the business of Company A is far superior to that of Company B from an owner's perspective.

What Each Business Invested to Earn Their Income

Let's first look at Company B. To generate $4 in income, it invested $196 in inventory (cost of goods sold), right? Wrong. Because it had two inventory turns, it invested $98 in inventory to generate $100 in sales, took the profit from that, reinvested the $98 in more inventory, and then turned another sale.

Essentially, Company B invested the same $98 twice to earn $4. Already see where this is going?

Company A invested $98 in inventory to earn $2, but was able to reinvest that $98 eleven more times to generate a total of $24.

Both companies invested $98 to earn $2, but Company A was able to reinvest it faster, thus generating six times more than Company B.

The "true" profit margin of Company A was not 2%, but 24%. The "true" profit margin of Company B was not 2%, but 4%. Here's how it works:

True Profit Margins...as Bonds

Think of the true profit margin as a bond with a fixed interest rate. Would you rather have a bond paying 24% or a bond paying 4%? The answer is clear.

Company A and Company B both invested $98 into their business through the purchase of inventory. In essence, each purchased a $98 bond (the inventory), and that bond generates a certain amount of profit ($2). Except that Company A's "bond" pays that $2 monthly while Company B's "bond" pays $2 every six months.

Which company has better economics? They both have terrible profit margins from an accounting standpoint, but then again — accounting numbers are for the IRS. Business owners and investors follow the cash.

Which Company Will Grow Faster?

It's pretty clear in the above example that Company A will have a better chance to grow faster than Company B. It generates more in sales, and it generates more cash. Let's level the playing field. Instead of selling products for $100, Company B is selling higher priced goods. It buys products for $588 and sells them for $600. Both companies have the same revenues, cost of goods, net income, and profit margins:

	Company A	Company B
Inventory turns	12	2
Revenue	$ 1,200	$ 1,200
Cost of goods sold	1,176	1,176
Other expenses and taxes	—	—
Net income / Cash flow	$ 24	$ 24
Profit margin	2%	2%

So...which is the better investment?

Though it looks like we've leveled the playing field, we really haven't. These are two very different businesses. To understand this, we have to work backwards.

How will Company A and Company B generate additional cash? With no other expenses, they each have three choices:

raise the price of their products (e.g., from $100 to $105, from $600 to $630),
lower their cost of inventory (e.g., find cheaper inventory at, say, $90 and $500), or
sell more of their products.

If they can't raise prices and they can't find any cheaper suppliers, their only option is to sell more of their product. While that is great in theory, it ain't so simple in the real world. Unless they have some magic formula for making cash appear out of thin air, how will they purchase additional inventory so that they can sell more of their finished product?

Assuming neither has cash in the bank or access to outside financing, they have one of two choices:

require payment upfront, and then use the customer's money to purchase inventory, or
save up enough cash to purchase more inventory, using the funds of the business.

Some businesses can do the former; but, let's assume that these two companies are retailers, and that their customers aren't paying for clothes today, but willing to take delivery in sixty days. To get more inventory which will lead to more sales, the company's must use the funds of the business.

But wait — neither company has cash in the bank! Okay — how long will it take before the companies can expand? That is...which company will grow faster?

	Company A	Company B
Profits	$ 24	$ 24
Cost to purchase more inventory	$ 98	$588
Years until company can handle double sales volume	4.1	24.5

In 4.1 years, Company A will have saved $98 from its $24 of profits — enough to purchase another unit of inventory. With two units of inventory both being sold concurrently, the company is generating twice as much cash.

It will take Company B 24.5 years to save up $588, if saving just $24 per year. As such, Company B will have to wait 24.5 years before it can double its cash flow.

Again — which company has the better economics: the one that can double every four years or the one that doubles every 25?

The Race is Over Before it Begins

If we fast forward and look at these two companies in 25 years, assuming that each tried to beef up their inventory at the end of the year (not 0.1 years into year 4), Company B has finally purchased another unit of inventory and will begin generating $48 a year in excess cash. Company A, on the other hand, has 465 units of inventory and is generating $11,160 in excess cash.

And while Company B has finally beefed up sales to $2,400 ($600 times 2 inventory turns times 2 units of inventory), Company A is generating $558,000 in sales — 233 times the amount of sales!

High Profit Margin/Low Turnover

Finally, consider this: A high profit margin business may have a very low "true" profit margin, and may be a candidate to avoid. When comparing a 2% profit margin business to a 10% profit margin business, many investors automatically assume that the 10% business is better.

That's not necessarily true.

Everything else being equal, the 10% margin business with one inventory turn is no better or worse than the 2% margin business with five turns a year.

I apologize for any confusion I caused in this post.

Questions and Concepts in Value Investing

Joe Ponzio — Fri, 07 Aug 2009 01:09:00 -0600

It's been quite a while since I've written an article, and for that...I'm sorry! The past few weeks have had me extremely busy — reading, researching, and ripping apart companies. We've made a few investments this quarter, but I haven't had time to write about any of them here. Sadly, F Wall Street's portfolio has gone from largely ignored to entirely ignored.

Of course, I couldn't ask for more out of a lazy man's portfolio. Being some 17% in cash brings me no joy; but, this portfolio has continued to outperform the S&P 500 Total Return Index (the S&P 500 with dividends reinvested) by 19.7% a year, growing 4.2% annually versus the S&P 500's -15.5% annual return. That said, the F Wall Street portfolio is going bye-bye. Though I will continue to write about investing and individual companies, I can't maintain the portfolio in real-time (or even somewhat real-time).

Still, this "value investing" stuff works. And though we've only been going two years, if you don't believe by now that buying good businesses on the cheap and ignoring the markets is the way to go, it will probably never sit right with you. As Buffett says: You either quickly get the concept of buying $0.50 dollars, or you never do. Let's jump into some interesting questions from visitors, and concepts in intelligent investing.

Did You Miss The Recent Rally?

Two of the great things about intelligent investing are:

you never "miss the boat" because there's always going to be another boat, and
your results, though volatile, will be largely independent of the market's returns.

Think about that for a second. If you're lamenting the fact that you weren't fully invested in March and you missed the rally — that you "missed your chance" — think about who is promoting that idea, and then remember back not only to March, but to the dot-com bubble, burst, and recovery.

When the markets are flying high, they say that you have to get in — you're missing the action. When the markets are at their lows, you should "keep some powder dry" because they're going lower. Then, a massive recovery comes and everyone says, "We told you to buy! You missed the action!"

Interestingly enough, it's the same people that scream, "Get in! Stay in cash! We told you to get in!" They don't put a guy like me on television because I' not fast and actionable.

Reporter: Joe, what should investors do today?
Joe: Buy assets for less than they're worth.
Reporter: But the markets are [up/down] 40% in the last year, and you said that a year ago!
Joe: Yep.
Reporter: Thanks for another scintillating interview.

I won't name names, but it's all garbage. When I talk about Rose in the book, I mention some of the crazy markets she saw — up 40% in a year, down 50% in a year. Rose never concerned herself with the markets. She never timed anything. She paid good prices for good businesses, and ended up a wealthy woman.

But It's Different This Time!

Bull.

The "September Event" that occurred after Lehman Weekend was different that anything we've seen in 80 years. But that's behind us now (it was behind us a while ago). And even still — had the world economy stopped completely, had everything collapsed, your money market, your stocks, your gold ETFs — all worthless. Even those gold bars they're selling on television — they'd only be as good as the ammo you have to protect them.

If you're still looking for the end of capitalism and wondering how to profit from it, get in the ammo business. Otherwise, keep looking for good businesses at cheap prices.

At this point, the economy is still ugly. Unemployment is still rising. Foreclosures. Volatility. Inflation or deflation — take your pick. Rates will go up in the future, putting added pressure on stocks. These things — all of these things — we've been through them before, in varying degrees.

It's not different, it's just scarier because the internet and the media throw it in our faces more often than they could twenty years ago. And our next crisis, whenever that may be, will seem even more dire and hopeless because we'll have more information from more sources, adding to the fear and confusion.

Is everything we're seeing now unprecendented? Yes. But it doesn't change the game. It's not "different."

The markets work. Definitely not on a daily basis. Sometimes not even on a yearly basis. But over the long run, an asset purchased on the cheap will usually work out just fine regardless of whether or not we "retest the lows" or hit Dow 10,000 before the end of the year.

Questions from Visitors

Jason asked about the value of goodwill and intangibles. When figuring out "invested capital," you should ignore the cost of intangibles and goodwill as you try to determine what the business can earn regardless of what management does with the excess cash. For example, Johnson and Johnson makes a lot of acquisitions; but, you shouldn't bet your retirement on the hope that they'll continue to make acquisitions to grow. In determining CROIC, you want to know what the business can earn from its operations as a healthcare company, or retailer, or whatever.

A prime example — and I hate to keep picking on these guys — is Lucent. Lucent doesn't seem to have a very good business; so, they constantly try to grow through acquisitions. What happens when the financing runs out and they can't make any acquisitions for a while? You're stuck with Lucent's business, and whatever returns they'll generate on the existing capital.

ajay asked a few questions. Question 1: Do we include X, Y and Z in shareholder equity, and is it the same as net worth, book value, etc.? Shareholder Equity is all of the assets minus all of the liabilities. There is a difference between Shareholder Equity and book value in that book value is often considered the tangible book value — the net value of the tangible assets minus all of the liabilities. Book value excludes certain accounting "assets" such as goodwill or the value of trademarks. That distinction is critical when investing in break-ups, bankruptcies, and net-nets. (More on net-nets in another post.)

He also brought up Pfizer, a topic discussed recently at a book signing I did. Is it a good investment? My two cents on pharmaceutical companies is that they're generally only as good as the drugs coming out of their pipeline. They have to invest massive amounts in research and development, and often seek growth through acquisitions. Every product they make generally has a very limited revenue stream, as opposed to a Coca-Cola. If you can predict the value of their pipeline, you can invest in a pharmaceutical company...but you have to have a thesis on the pipeline, just as you have to have a thesis on where oil is going before you buy a company that makes money on oil.

Joie asked about whether or not goodwill should be included in shareholder equity, and the answer is: it depends. If the goodwill is truly valuable, then it should be included. If not, ditch some or all of it. When I wrote about Adobe Systems, I talked about their goodwill from their purchase of Macromedia. The goodwill was the difference between the purchase price of Macromedia and the value of its actual, tangible assets. I felt that Macromedia was so integrated in Adobe's business that the goodwill carried was much too high relative to the ongoing, resale value of Macromedia in the event of a sale; so, I reduced the goodwill somewhat.

Joie also asked about capital expenditures. Some companies break down their capital expenditures for you so you can easily deduce which ones are required and which are temporary; some don't, and you have to use some math and logic to work it out. (See this post on Wal-Mart.) When looking through annual reports, look at the notes to the financial statements. And don't be afraid to skip it if it's too hard to figure out!

Ari Greenberg also asked about capital expenditures, but more specifically: Does depreciation equal maintenance capital expenditures. Answer: No. Over the course of the business' lifetime, depreciation will equal capital expenditures because that's how the accounting works. Depreciation allows a company to spread out an expense over a certain period of time, and that depreciation works out to the purchase price minus the sale or scrap price of that asset. There will also be costs in upgrading the equipment, maintaining it, etc. which may be significant. The fact that the accounting regulations allow the company to write off a piece of equipment over a number of years doesn't mean that the ongoing expense of maintaining, upgrading, and repairing that equipment can be ignored — and that's the number you want to figure out as well.

Avishek asked about moats and Morningstar. The "moat" you want is that key ingredient that virtually ensures that the business will be profitable in the future. I wouldn't rely on anyone but my own research, because most people get it wrong which is why you have the opportunity to buy a great asset on the cheap. If you're not comfortable reading annual reports and identifying moats, you can learn over time by continuing to look and read. Start with big companies and work down the line. And on that note: It won't all be in the annual report. Avishek mentioned "switching costs." You don't necessarily learn that in the company's filings, but in learning about the industry, how it works, and who the customers are.

Finally, Ron asked why I thought that Harley Davidson had high capital expenditures versus a Wal-Mart. Make sure you check out this post about Wal-Mart to understand the growth vs. maintenance capital expenditures. HOG, like most auto manufacturers, airlines, and heavy steel/iron operators, have to rely on massive, old, clunky machines to build their products. These machines require constant maintenance, upgrades, and repairs. This leads to large capital expenditures. Wal-Mart, on the other hand, merely needs to buy a building and set up shop. The massive jumps in capital expenditures over the past few years was largely due to growth capex (including expansion into China) and, perhaps moreso, due to their revamping and building out of their massive distribution center — a cost that isn't likely to occur indefinitely in the future. When looking at two similar businesses at similar prices, you'll likely be better off with the company that doesn't have to spend huge amounts just to keep the doors open.

That leads me to the second part of his question: What is a good inventory turn rate to profit margin? It depends on what you consider a good profit margin. A business with one inventory turn a year and a 20% profit margin is no better or worse (at least from a profit margin standpoint) than a company with two turns and a 10% margin, or four turns and a five percent margin. Don't rule out a company solely because of profit margins. Wal-Mart's margin is about 3.5%, but it is wildly profitable because it turns its inventory seven or eight times a year, for a "true" profit margin of 26% or so.

Think of it this way: If you buy a rock for $100 and sell it for $102, you've made one inventory turn and a 2% profit margin. If you're doing that once a year, close up shop because your shareholders are better served if you stop buying rocks and invest solely in U.S. Treasuries. But, if you're buying and selling these rocks twice a month — twenty four times a year — you're laying out $100 to earn $48 a year. Though your profit margin would still be 2%, your "true" margin would be 48%. That's one heck of a business.

And of course, don't take it all at face value. Two companies with "true" profit margins of 40% won't necessarily grow rapidly. The one that has to lay out more in capital expenditures is going to grow more slowly (all else being equal).

Keep On Trucking

There are values out there. I recently purchased a stock around $7.80, even though it was up some 92% from its March low. Think we've "come too far too fast"? I don't know. What if we fell too far to fast?

There is no way to know what the markets will do next week or next month. The nice thing is: So long as you keep investing intelligently, you'll never have to worry about it.

Selling DBB Because I'm a Bonehead

Joe Ponzio — Thu, 18 Jun 2009 20:26:00 -0600

As I mentioned in this post, I got rid of DBB — the base metals ETF. Admittedly, I'm hanging my head in shame — not because we lost money (actually, we made money) but because I made a stupid judgment mistake that cost us opportunity. (Fortunately, there's a lesson in here.)

My mistake was not in my evaluation of the commodities or reasoning for buying them. The mistake was that I bought an investment that grouped the three together instead of buying a virtual certainty.

In buying DBB, I decided that the three base metals in DBB — copper, zinc, and aluminum — would all move more or less together. Producers were scaling back and still the prices of these commodities crashed. I figured that, when the world realized it wasn't coming to an end, all three of these would move back up together.

Well...I was wrong.

Copper did exactly what I expected; zinc started its run up; aluminum disappointed. If I had held these commodities individually, I would have sold copper, held aluminum, and considered dumping zinc. Instead, I bought them together and had a "group" decision.

My Dilemma

With copper at a fair price, I had a choice — hang on to DBB and hope that zinc and aluminum returned to more rational levels, all while hoping that copper bubbled up or, at the very least, didn't fall much, or sell.

Personally, I don't think that hope is a very intelligent investment strategy; so, I sold.

My "Whoops" Cost Us Opportunity

On April 4th, we bought the three commodities together through DBB. We earned roughly 11.6% in two months — a great return in and of itself. Here's where I screwed up: in the absence of a pure aluminum or pure zinc ETF, I bought them together with copper through DBB. (I could have purchase a pure copper ETF in JJC.) Instead of buying just JJC, knowing that copper was cheap and that it would move up at some point, I bought the three metals knowing they were cheap and that they would move up at some point. Unfortunately, I tried to get greedy, they didn't all move up together at the same pace, and we missed an opportunity.

What was the real opportunity cost? If I had not gotten creative and simply purchased the copper ETF, accepting that I would miss the boat on aluminum and zinc, we would have earned JJC's 17.7% return.

The Base Metals Lesson

Considering the markets over the past two years, it's odd that someone might say, "Well, we made money, but here's where we screwed up." Still...we made money, but here's where we screwed up:

Creative is stupid. (Just ask the folks at Lehman, AIG, Merrill, Bear Stearns, etc.)

When you have a great idea, you should zero in and make meaningful bets. Keep it simple and don't allow too many variables into the equation. And that's one main premise of the book — bet on virtual certainties.

The virtual certainty was that copper, aluminum, and zinc would all rise in price. The variable that I introduced into the equation was that they'd all rise contemporaneously.

And that cost us an opportunity.

Good Ideas are Rare. Bet Big, but Bet Smart.

Good investment ideas are rare. I'd be ecstatic to find one a quarter. In this quarterly or annual search for a great investment opportunity, you'll make some bonehead moves. Sometimes you'll lose money. That sucks, but you can always make more back.

It's the lost opportunities that can kill your returns.

With DBB, I can fall back on Buffett's "I would rather be vaguely right than precisely wrong" and sleep peacefully tonight. Still, the next time you see prices out of whack, stick to the simple investment that is virtually certain to work out well with as few variables as possible and maybe you won't have to admit to the world that you're a bonehead too.

Is Buy and Hold Dead? Performance Update.

Joe Ponzio — Tue, 02 Jun 2009 14:46:00 -0600

I can't believe that it has been nearly two years since F Wall Street was originally launched on June 25, 2007. And what a two years it has been!

Since our launch, we saw the S&P 500 climb to an all-time high in October of 2007, only to watch it plummet nearly 58% to a level first seen in May of 1996. Some of the causes of the drop were highly predictable. Some of the events, such as the September 2008 disaster, were completely unpredictable. And through it all, we were largely, if not entirely, invested in individual stocks.

Let's see how we did.

Portfolio Performance

If you recall, I started the F Wall Street portfolio with $100,000, and compare it to the Diamond Trust Series (DIA) — an ETF that tracks the Dow — and the Vanguard S&P 500 index fund (VFINX). I compare to these two funds because investors can't invest directly in an index; so, these are two of the broad "index-type" investments.

In the roughly two years since F Wall Street was launched, $100,000 in the F Wall Street portfolio grew to $103,224 (+3.2%) while $100,000 invested in the DIA and VFINX fell to $68,246 (-31.8%) and $63,225 (-36.8%), respectively. On an annualized basis, we have outperformed the better of the two investments (the DIA) by 19.6% per year.

What's In Our Portfolio?

The portfolio snapshot below is as of yesterday's close. This morning, I sold DBB because it didn't work out as planned. I will discuss it in a later post.

Thoughts on Our Portfolio and Performance

Had I been able to spend more time and energy on the blog, I am certain that our results would have been much better. As the markets plummeted, I found myself with less and less time to post, as is indicated by my lack of activity here over the past year. I first mentioned this problem in March of 2008 in this post:

When the markets were flying high, I had all the time in the world to write posts for an hour or two a day. Trying to maintain that pace in this market would be detrimental to our future returns.

It is important to remember that I am not a professional blogger, living off advertising revenue and blogging for dollars. Nor am I a professional author, living off book royalties. (Trust me — there's no money in writing books unless you're Steven King.)

Some opportunities that were missed in the F Wall Street portfolio:

Graham Corporation, which was discussed ex post facto and never included in our results.
The InBev acquisition of Anheuser-Busch workout which, at one point, offered a substantial premium.
As I mentioned in this interview on First Business and back in November to my friend Barry Pasikov, Managing Partner at Hazelton Capital Partners, Sears Holding Company was an amazing opportunity in November, when it was trading at just $30 and less.
And, of course, Wells Fargo which, in February, fell to just $7.80 a share. In response to Dan's question whether or not WFC was a screaming buy, I responded: "Screaming," but didn't have the time to post more about it.

These investments would have had a significant impact on our results. The total impact of these investments, as of June 1, 2009, would have added another 33% or so to our returns, broken down as follows:

about 2.5% from Graham, in which a 5% investment would have doubled,
about 0.5% from the InBev workout, in which a 10% investment would have grown about 5%,
10% from Sears Holding Company, in which a 10% investment would have doubled, and
20% from Wells Fargo, in which an additional 10% investment would have tripled.

And that's net of some of my more boneheaded moves, like overpaying for American Eagle or getting my butt kicked in the Landry's workout-gone-bad.

The point here is not that I'm backward looking or playing with the numbers, but that the market presented investors with some amazing opportunities over the past year, if, of course, you were looking at the business and not the media or stock markets.

On a relative basis, I'm bubbling over with joy at how we continue to outperform the markets and at the amount of safety our portfolio enjoys. On an absolute basis, I am upset that I didn't have more time to discuss some of these amazing opportunities in greater detail and include them in the F Wall Street portfolio.

Still, we own some wonderful businesses at great prices. While my primary responsibility is to manage money for our clients, I will continue to run the F Wall Street portfolio on this part-time basis because, as I discuss in the book, casual investors can invest conservatively, confidently, and at satisfactory rates of return without taking a lot of risks. This portfolio will continue to be run "casually," unlike the portfolios we manage at The Meridian Business Group.

Thoughts on Diversification and Buy-and-Hold

Clearly, and once again proven over time, broad diversification just doesn't cut it. Having extremely small positions (1% of the portfolio, or broadly diversified mutual funds) doesn't allow your best ideas to have a meaningful impact on your returns. And though the losses have a greater impact (and we've had a few), a 5% loss in the portfolio due to a 50% loss on a 10% position is not impossible to overcome, so long as you can remove emotion and media hype from the equation and focus on making smart business decisions.

The number of positions an investor should hold is inversely correlated to the predictability and discount one receives in any investment. You could put your entire net worth into a single U.S. Government bond, and never diversify outside of that one bond because you have absolute certainty and predictability. Conversely, if you're going to invest in a highly speculative, debt-laden, poorly run company, you wouldn't want to risk too much of your savings.

That, of course, is one of the problems with mutual funds, and particularly index funds. Both the DIA and VFINX held General Motors as it fell from $90 to bankrupt and worthless over the past ten years. From a value standpoint, it was as worthless at $90 as it is today; however, if you have to own a GM (like when you invest in index funds), you certainly want it to be a very small portion of your portfolio.

This, of course, leads us to the constantly-asked-and-wrongly-answered question: Is buy-and-hold investing dead? The short answer is an emphatic "no."

Whether stocks are rising, falling, or hanging flat, Wall Street wants you to believe that "it's a trader's market." When the markets are rising, it's a trader's market because easy profits are aplenty. When the markets are falling, it's a trader's market because you need to be nimble and liquid. When the markets are flat, it's a trader's market because "buy and hold ain't working" and you have to do something to make money.

The truth is that it's always a trader's market on Wall Street because Wall Street gets paid when you're buying and selling. The broker handling the F Wall Street portfolio couldn't buy an iPhone with the money he would have made from us.

Buy-and-hold is a poor strategy if you're buying anything at any price, and holding it no matter what. If, however, you are buying great businesses at great prices, the overwhelming majority of active traders won't be able to match your results over the long-term.

I had written the following to clients a few weeks back about this exact topic. Though it's not an exact comparison, I think you'll get the gist of it:

Warren Buffett has built his fortune on buy-and-hold investing. His company, Berkshire Hathaway, is not only larger than every brokerage firm in the United States (many of which are much older than Berkshire Hathaway), but it is larger than Goldman Sachs, Morgan Stanley, State Street, Citigroup, Charles Schwab, and E*TRADE combined. (Based on market capitalization at the close of business on May 7, 2009.)

A Final Thought, On Volatility

It's easy to look at our results and think that the ride was smooth. All you see in the above chart is three points in time, and a straight line joining each of them. The truth is that the results were volatile, and we suffered wide swings in the prices of each of our investments.

There is no way to control the daily swings of the markets or any individual position. Then again, there is no need to worry about it if:

You hold great investments at great prices, and
You have no intention of selling that day.

When the markets pounded Wells Fargo down to $7.80 per share, we were down 67% from our initial purchase at $23.41. We invested again at $16.63, but that only gave us an even larger loss on a dollar-basis, and we were still down 63% in a matter of days.

It's easy to sweat over the market action if you need to sell, or if you don't fully understand your reason for buying. Even my own brother, whom will remain nameless but trusts me implicitly (I have four, so don't try to guess), commented on the unrealized loss and was tempted to swear off stocks completely until we had more clarity in the markets.

The truth is that stock prices, on a daily, monthly, and even quarterly basis, are quite silly. Buffett and Munger commented on this at the annual meeting, I discuss it in detail here on the site and in the book, but I'll reiterate it: A major key to the success of one's investment program is having the right emotional make-up to handle the market's ridiculousness.

As I stated in this post, most people don't have the emotional constitution for investing in stocks. With the markets down nearly 40% from their October 2007 highs, people that were plowing money into stocks two years ago are now sitting on cash and looking for bonds. It's not just individual investors — many pensions, mutual funds, and other institutions operate with this backwards mentality that investing should be done when prices are high and may go higher, instead of when prices are low, even if they go lower.

Over the long-term, the markets work very well; but, your investment results will depend on how much time you can put into your investing and how well you suppress your emotions while focusing on making smart business decisions.

The results of the F Wall Street portfolio will not do as well as I'd like going forward (that is, very high, non-conventionalist returns) due to my lack of time for blogging; so, I'll focus on trying to make smart business decisions when I can post here.

(Of course, we'll keep on trucking at the firm!)

Two Interviews

Joe Ponzio — Mon, 18 May 2009 16:39:00 -0600

If you're more into video and audio than reading my long-winded blog posts, below are two interviews I did recently.

For my video lovers, here's a link to a TV interview I did on First Business. It aired nationally on Wednesday morning.

Below is another clip from WBBM's Noon Business Hour from May 12, 2009.

Leaving For Omaha; Berkshire Updates

Joe Ponzio — Fri, 01 May 2009 10:51:00 -0600

I'm heading out to Omaha for the Berkshire Hathaway annual meeting. Though I'm still trying to figure out Twitter, I'll do my best to post updates on my Twitter page here.

If you're going to be in Omaha, drop me a line via e-mail and we'll meet up.

How to Value a Commodity

Joe Ponzio — Mon, 27 Apr 2009 09:40:00 -0600

There is no discounted cash flow method for commodities. They don't pay dividends or bear interest rates; they don't generate cash. Long-term investing in commodities is all about finding opportunities where supply and demand are out of balance and the price is low relative to where it "should" be on an inflation adjusted basis.

With no external forces acting on a commodity price (ie., supply and demand are in balance and the currency doesn't change), commodities prices would move in lockstep with inflation. A 3% increase in inflation would result in a 3% increase in commodities prices.

Of course, this is the real world; so, supply and demand aren't always in balance, currencies fluctuate, and speculators push prices up and down regardless of supply, demand, inflation, and currency fluctuations. And that messes with prices.

The Inflation-Adjusted Price of Copper

To get a good handle on what the price of copper should be, we need to look at the inflation-adjusted price throughout history. In 1946, the US Government lifted their temporary, war-time fix on the price of copper; so, that will be our starting point.

From 1946 through 2008, inflation in the United States averaged 4.07%. If we look at the average annual price of copper in those years, and adjust those prices for inflation, we can look at how the price of copper has changed over the past six decades and get a handle on where it should be in a perfectly balanced world.

The above chart is very telling as to how copper has performed during periods of high inflation, particularly in the early portions of those periods before supply could ramp up to meet demand. (All those juicy, higher prices invited more competition and more mining, calming rising prices.) Ignoring everything else, copper's best returns were during periods of high inflation. When inflation was in check, the commodity performed poorly (relative to other investment options.)

This chart shows the inflation-adjusted price of copper during those times. You can easily spot the points in history when the price of copper got way ahead of where it "should" have been (green line) on an inflation-adjusted basis. (Remember: Copper doesn't get better or worse; it is just there, growing at the rate of inflation if supply and demand are in balance.)

You can also spot times when investing in copper made sense. When it dipped below its inflation adjusted price (the green line, about $2.27 in today's dollars), copper would have been a good investment.

How do the numbers play out?

The Results of Investing In Copper

Let's take a rational approach to investing in copper. Before we buy, we need our purchase to meet a few conditions:

The price is below its inflation-adjusted average at that time (ie., it's cheap);
Supply is falling versus demand (ie., net production, including imports and exports, is less than the previous year's net production).

And, of course, we sell when the price returns to a more rational, inflation-adjusted level, ignoring any really compelling reason to hang on. One such reason, for example, would be that we expect high inflation which would naturally serve to increase the inflation-adjusted "normal" price and give us a higher selling point; but, we'll just do this blindly for now.

Keep in mind: This is not about speculating where copper will be in a few days or months. Rather, it's an investment based on the laws of economics.

So, we're buying in 1957, 1958, 1960, 1961, and 1965. Then, we sell in 1969, when the price gets back to "normal." (We don't speculate that a bubble would develop and then try to ride it up. We make cold, rational business decisions.)

Of course, we're using annual figures here; but, you would have been able to dance in and out a little more if you were watching the price more closely.

	Purchase Price of Copper	Sale Price of Copper	Gain (Loss) (Cumulative)	Annualized Return	Dow Jones Annualized Return
1957	$0.2999	$0.4743	58%	4%	5%
1958	$0.2613	$0.4743	82%	6%	5%
1960	$0.3216	$0.4743	47%	4%	4%
1961	$0.3014	$0.4743	57%	6%	3%
1965	$0.3235	$0.4743	47%	10%	-1%

You would have bought copper again in 1978, only to sell a year later:

	Purchase Price of Copper	Sale Price of Copper	Gain (Loss) (Cumulative)	Annualized Return	Dow Jones Annualized Return
1978	$0.6653	$0.9275	39%	39%	4%

And again in 1984 and 1985, selling in 1988:

	Purchase Price of Copper	Sale Price of Copper	Gain (Loss) (Cumulative)	Annualized Return	Dow Jones Annualized Return
1984	$0.6877	$1.2266	78%	16%	15%
1985	$0.6885	$1.2266	78%	21%	16%

And so on, buying in 1993 and selling in 1995, and then buying in 1999, 2000, 2002, 2003, and 2004, and selling all of those lots in 2006.

Buying Copper Today

Notice that the results were not based on massive, macro calls. That's not to say that you couldn't do better — or worse — by timing your purchases and sales based on macro events. (Like Buffett's belief that oil is due for a massive increase — a belief that led him into, and quickly out of, ConocoPhillips, and that he has repeated in a number of interviews.)

Instead, these purchases and sales were made based on the ordinary course of economics. When prices were low and supply and demand were out of whack, you would buy, expecting that prices would go up to rebalance supply and demand. When prices were high, you found other opportunities in other investments.

Today, prices are low and supply and demand are out of whack. Production has slowed, meaning that, when demand comes back, supply will likely trail it for a while. In addition, when we first bought DBB, copper was around $1.87, about 20% below its inflation-adjusted average.

We have a good margin of safety against macro events. If we have deflationary pressure for some time, I don't expect that to rage at 20%; so, we're still in cheap. When inflation hits, today's $2.27 inflation-adjusted "normal" price target would rise, offering a chance for even greater gains.

And, of course, production is low based on current demand and the expected demand of any recovery (and recovery will come); so, the price would be expected to rise as (a) demand increases, or (b) demand holds steady but production continues to fall.

It Could Go Lower

In every investment you hold, you must have expectations. I expect copper to be $2.27 plus future adjustments for inflation. In that case, it could easily drop from today's levels. It wouldn't bother me a bit because my data and reasoning tell me that, at some point in the future, supply and demand will have to work towards balance again.

The same is true with all of the stocks we hold. When Wells Fargo dropped below $9 a share, a leap of faith was required. Our data and reasoning said (says) that Wells Fargo is worth considerably more than $20 a share, and a helluva lot more than $8.70. The leap of faith required was (is) that the US Government wouldn't universally nationalize all banks, profitable or not.

The important thing when investing, whether in commodities or stocks, is ignoring the "in between." You know — the noise and market action that rips you one way or the other while you patiently wait for the fear surrounding your asset to lift and a more rational price to show through.

If you could buy a one-year treasury today for $800, knowing that, one year from now, you'd get back $1,000, would you really care if the markets pushed the price of that bond to $700? $500? $100?

Though stocks and commodities aren't guaranteed like US Bonds, that's exactly how we should be thinking about the daily market action. So long as the US Government isn't going to default on its one-year bonds, you could feel very comfortable with a 70% quotational loss. So long as your businesses are performing as expected, or so long as supply and demand are out of whack, quotational losses shouldn't bother you one bit.

What Affects Commodities Prices

Joe Ponzio — Mon, 27 Apr 2009 09:30:00 -0600

In general, there are four main factors that affect commodities prices:

Supply & Demand
Inventories & Stocks
Currency
Inflation

Let's go down the list to best understand their harmony. We'll start in a tiny, isolated town of farmers and families.

Supply and Demand in Commodities

If supply and demand are in perfect balance (assuming no other factors affect the price), commodities prices would go nowhere. Take corn for example. If the demand for corn was exactly one ear each day, and a farmer could grow exactly one ear every day, supply and demand would be in balance and the price would not change.

With no external factors on this transaction, the farmer of the corn could not raise or lower his price because he must sell one ear each day or he loses money. (The cost of growing the corn.) By raising the price, he would drive the purchaser away to another farmer at a lower price. By lowering the price, he would increase demand for his corn. Still, he wouldn't be able to meet that demand; so, buyers would go back to the other farmers and the price would not change.

We're making huge, unreal assumptions about how the real world works because nothing in economics is devoid of external forces; but, you get the idea. If supply and demand are in balance and there are no external factors, prices can't change.

Inventories and Stocks

Let's assume that supply and demand are not in balance. Instead, there's a draught (thanks Alan ☺) drought this year and half the farmers can't grow corn. The demand is still strong — the people have to eat. Supply and production are short — half of what it should be. And because nobody stocked up on corn, creating reserves for this very scenario, prices rise to drive demand down.

Ten years later, another draught hits. This time, however, the town was prepared. Half the farmers can't grow corn; but, those farmers had built silos and stocked them for emergencies. Though production has temporarily shut down, the supply is fine for the amount of demand. Inventories begin to fall; but, nobody is worried because the draught is a temporary problem. Prices don't change.

Of course, if production remains offline for too long, inventories will begin to fall to alarming levels. In that case, prices will rise to quell demand and preserve inventories until production can ramp up again.

Currency

We'll now expand our scenario. Rather than having a single, self-sufficient town, we have three countries — Import (the "Eaters"), Export (the "Producers"), and Investment (the "Investors"). All three countries have different currencies.

Sometimes, Investors believe that Export offers the greatest investment opportunities; so, the people of Investment convert their money into Export currency, driving the value of that currency higher. In Export, the Producers don't really notice, except that they have a little more coin in their pocket. Why? Let's explain.

When the people of Investment keep their currency at home, Import and Export are not affected. With supply, demand, and stocks in perfect balance, prices never change. The exchange rate between the two countries is one Import dollar for one Export dollar.

Enter the Investors, putting their money into the country of Export. When that happens, the currency of Export begins to rise against that of Import (and that of Investment). Without getting too technical, it comes down to supply and demand. As more people want Export currency and less people want the other two, the Export currency rises against the other two (or, the other two fall against that of Export).

Now that corn price has to change, not because supply and demand are out of balance, but because the farmer from Export still wants one Export dollar for an ear of corn but the folks in Import can't convert $1 Import into $1 Export because of the currency fluctuation. Instead, the conversion is now at, say, $1.50 Import to $1.00 Export, and for the people of Import, the price of corn (commodities) just went up 50%.

Ouch.

And Then There's Inflation

Now, let's assume that the world is perfect. Supply and demand are in balance, inventories are perfectly managed, and currencies never fluctuate. But, inflation chugs along at 3% a year. How will that affect the price of commodities?

If you said that they'd go up at 3% a year, give yourself a balloon — you now understand how commodities work. The corn farmer has to raise his prices 3% a year because his cost of living — electricity, fertilizer — is going up by 3% a year. People can pay that increase without feeling it because everything (including their incomes) is going up 3% a year.

This Is All Too Macro For Me

I know — Buffett says that investors should ignore the macro stuff. That's all well and good; but, this is one area in which Buffett's actions don't match up precisely with his words. Buffett doesn't ignore the macro stuff or commodities. In fact, he tends to have very strong opinions on both, and takes actions based on those opinions.

Take, for example, his 1997 purchase of silver. World mine production of sliver was 16,500 metric tons. World consumption was 857 million troy ounces. A quick math conversion (32,500 troy ounces = 1 metric ton) tells you that, in 1997, the world was producing 16,500 metric tons while demand for the metal was 25,163 metric tons. Warehouse stocks were being depleted, down about 40% through 1997.

More recently, look at his comments on ConocoPhillips. He bought assuming that oil would continue to rise. Regardless of what oil actually did, look at Buffett's thinking. A large part of his investment thesis on COP was a macro, commodity prediction. How large? Large enough that it drove him to take action on (sell) COP when the price of oil collapsed.

Buffett may tell people to ignore "the macro stuff" so that they don't overthink their investments because people could get blasted in commodities or overthink minor macro events. Still, you can't invest in a company whose profits are tied to an underlying commodity without some thesis on where that commodity is headed.

Why Base Metals?

The perfect storm for rising commodities prices would be:

A disruption in production with increasing demand, and
Low or diminishing inventories without adequate production to replenish them, and
A falling currency, and
Rising inflation

All of this leads up to the decision to invest in zinc, copper, and aluminum through an investment in DBB. Walking through all three would be much too long a post; so, we'll look at copper and then you can look at aluminum and zinc, applying the same logic.

And it's important to remember two things:

I have no idea when the pricing shift will take place (ie., this isn't a short-term swing or momentum trade); and,
We have very small positions in each metal (roughly 3.3% of the portfolio in each).

Why Copper?

I'll spare you my long-winded definition. From the CRB Commodity Yearbook:

Copper is one of the most widely used industrial metals because it is an excellent conductor of electricity, has strong corrosion-resistance properties, and is very ductile. It is also used to produce the alloys of brass (a copper-zinc alloy) and bronze (a copper-tin alloy), both of which are far harder and stronger than pure copper. Electrical uses of copper account for about 75% of total copper usage, and building construction is the single largest market (the average US home contains 400 pounds of copper). Copper is biostatic, meaning that bacteria will not grow on its surface, and it is therefore used in air-conditioning systems, food processing surfaces, and doorknobs to prevent the spread of disease.

In short, it's used almost everywhere. Compare that to gold, for example, which is hardly used any more but in some electronics, a few dental fillings, jewelry, and as a filler for underground vaults. Gold demand is nothing like what it was decades ago, when gold backed currencies and it had a much more practical application across the board.

Supply, Demand, and Production

It doesn't take a genius to figure out that production at virtually all levels of the economy has slowed. In metals, this means that mines have been shut down, employees have been laid off to slow the supply line (as demand had dried up), and operations along the line — from smelting to delivery — have been interrupted and scaled back.

This, of course, caused the crash in many commodities prices. While demand was slowing, supply was not slowing as quickly. Ultimately, supply exceeded demand, inventories began to rise, and prices began their freefall. To stop the drop, which would be a self-fulfilling prophecy of further maiming the industry (if prices dropped too much for too long, there would be no industry because there would be no profits — no producer makes money if copper is selling for $0.10), supply was intentionally interrupted and plants, facilities, and mines were taken offline, workers were fired, etc.

It's a lot easier to disrupt production than bring it back online. Think of it this way: You operate a copper mine with, say, 1,000 employees. Every day, they're digging, transporting, etc. Things are going swimmingly.

Along comes a global credit crisis. You can barely finance your receivables because credit has dried up. Demand for your product is waning. So, you take your mine offline to wait it out. On Friday, you fire everyone, shut down the power, and lock the security gates. Mine closed.

(Okay — maybe it takes a little longer than that.)

A year passes, and you decide to get your mine back online. Now you have a dilemma. You can't just flip a switch. It's fairly easy to walk out of a mine; it takes some careful planning, security checks, hiring, paperwork, financing, and more to get the mine back online. To put 1,000 people to work (or back to work) can't usually be accomplished in a matter of days. And the longer you're shut down, the longer it will take to get back online.

Need to see it in action? Take a look at Freeport-McMoRan's December 2008 press release concerning their planned interruption of copper production.

So, condition 1 is partially met — we've had a disruption in production.

Inventories and Demand

Throughout the second half of 2008, production was still in full force (more or less) while demand was falling (due in large part to the real estate crisis). Hoping it was somewhat of a temporary condition, producers didn't scale back operations much. By the end of 2008, it was clear that the slowdown was not a temporary hiccup in the economy; so, steps were taken to cut supply.

During this time, copper inventories were on the rise. It's simple math — if supply is high and demand is low, inventories (stock, warehouses) grow. Nobody's buying the stuff so it has to be stored somewhere.

In January of 2009, daily copper inventory levels (stocks) grew 44%, according to the London Metal Exchange (LME), from 342,000 to 491,000 (metric tons). By February 24, 2009, LME warehouse data showed almost 549,000 metric tons of copper in inventories, up roughly 60% from the beginning of the year.

Let's put this into perspective so that the above chart isn't taken out of context. Inventories were extremely low in the last five years, which helped push the price up as demand increased. At today's levels, inventories are still 25% or so below the average levels of 1999-2003, and are right around the LME levels of late 1993 and early 1994.

By the end of March 2009, the world began to draw down on inventories. Though demand isn't what it was two years ago, it still exists. With production interrupted, copper end-users began drawing down on inventories because the interrupted supply couldn't (can't) meet current demand.

(Of course, demand will change up or down based on how the world economy plays out.)

So, we have conditions 1 and 2: A disruption in production with increasing demand, and diminishing inventories without adequate production to replenish them.

A Falling Currency

Prior to the real estate boom which caused us to import copper as fast as possible, roughly 80% of the copper used in the United States was produced in the United States. In the grand scheme of things, the US is, or can be, somewhat self-sufficient when it comes to copper. In addition, copper prices are quoted in US dollars.

Because of those two factors, a rising or falling US dollar shouldn't have too much of an impact on the price of copper in the US. And that's a good thing, because I don't have a strong opinion on which way the dollar is headed. Some people insist that it's going lower — much lower. But to them, I ask: Against what? Currencies rise and fall against other currencies, and, quite frankly, I don't know where an investor would want to put money right now other than in US dollars in some fashion.

I don't know if we have condition 3 or not, but I don't think it would have a major impact on US investors owning copper in US dollars.

Finally, There's The Inflation Factor

Why will we have inflation? Though nothing is certain, one thing history has shown is that you can not increase your available money supply without some inflation. The more you increase it, the harder inflation hits.

That's why the fed plays so many games with interest rates — to keep inflation in check. When the printing presses are running and inflation rears its head, the fed raises rates to "tighten up" the money supply, making it less attractive to spend wildly and enticing foreign investors to take some of that supply in the form of investment. On the other hand, when the presses are slow, rates can be lowered and money can become "loose" because the money supply isn't increasing all that fast.

Right now, we have the printing presses on overdrive and very low interest rates — a condition that usually results in high inflation. It happened during World War II and again in the 1970s.

This would give us condition 4 for commodities — dramatically rising inflation.

During World War II, the price of copper was frozen at $0.11. No surprise there — we couldn't afford to have price manipulation while the world was engaged in a global war. World War II was very inflationary. So, in 1946, when the price of copper was no longer fixed, it began its climb to a higher, inflation-adjusted rate. Over the next ten years, copper would rise some 400%.

In the mid-1960s, just as inflation was coming back with a vengeance, copper was trading around $0.34. Over the next fifteen years, rising interest rates and rampant inflation caused stocks to do virtually nothing; but, copper prices rose more than 300%.

This wasn't all due to inflation; but, inflation helped fuel the fire.

Why would inflation help commodities? Commodities are "fixed assets" with no interest-bearing or cash flow value. If you recall from Part I of this article, in a world with no external forces on them, commodities prices would grow at the same rate as inflation.

People generally believe that gold is a hedge against inflation. They're partially right. In fact, gold, along with real estate, commodities, and other "hard assets" are all hedges against inflation (if purchased at the right price) because the cost to produce or extract the hard assets rises with inflation; so, the cost to sell them must also rise with inflation.

That's not to say that prices are always rational. In fact, they can get ridiculous, as we saw at the tail end of the commodities bubble of 2007 and 2008. And, that's not to say that commodities at any price are necessarily good hedges against inflation, just as individual stocks at great prices can beat the pants off of commodities, inflation or not.

Like with stocks, you have to pick your spot in commodities.

Continue to Part III of this article.

Investing in Commodities; Base Metals

Joe Ponzio — Mon, 27 Apr 2009 09:20:00 -0600

Mention the word "commodities" and one of three images usually pops into mind. Some people immediately think of Trading Places, of Louis Winthorpe and Billy Ray Valentine cornering the orange juice market and issuing a false crop report to the Duke Brothers, leaving the Dukes high, dry, and utterly broke. (The story has a happy ending. The Duke Brothers make a comeback in Coming to America.)

Others maintain a lovely blank stare.

And then there are those that immediately think of pork bellies, and know a guy who knows a guy who knew a guy that lost everything trading pork bellies.

The truth is that commodities don't have to be — in fact, shouldn't be — scary. Especially if you have a long-term perspective on things. Sadly, they're merely misunderstood. To add to their elusiveness, most brokers and financial advisors aren't licensed to buy and sell commodities; so, Wall Street has a bias against commodities.

I don't plan to change everyone's opinion on commodities; but, this 3-part article should shed some light on what goes into long-term investing in commodities.

Understanding Commodities

I won't get too detailed on defining the term "commodity." Suffice it to say that commodities are items like corn, wheat, copper, oil — items that are substantially the same no matter who produces them. (See more traded commodities.) Whether it comes from Chile or Saint Vincent and the Grenadines, copper is copper.

If you were to invest directly into commodities, you would be buying futures contracts — basically, you'd be securing a price on a commodity at some point in the future. For example, copper trades in 25,000 pound "units." The September 2009 futures contract on copper is right around $2.00. If you needed 25,000 lbs of copper in September, and you were worried that the price of copper would be higher than it is today (right around $2.00), you could buy a future on copper.

Come September, no matter where copper was trading, you would get 25,000 pounds of copper for $2.00 a pound.

You can see how that would be beneficial to a business owner that needed to plan his or her future cash flows.

As an investor, you probably wouldn't want 25,000 pounds of copper delivered to your door. Fortunately, there is a commodities market in which you could sell your contract to another investor, a speculator, or the business owner/end user. If the price of copper was substantially higher, your futures contract would be more valuable. If the price of copper was lower, your futures contract would be worth less.

Once you see it in action and when you learn some of the lingo (backwardation, contango, spot, etc.), you begin to realize that the commodities market is not some mysterious craps table requiring an iron constitution and a propensity for gambling.

In fact, it's a lot like learning about investing in stocks. To many, the stock market is nothing more than a casino. To some that bother to look beyond daily price swings and headlines, the stock market is a place to value, buy, and sell businesses. The commodities market is a place to value, buy, and sell commodities.

Volatility and Leverage in Commodities

Commodities tend to be more volatile than the general stock markets, and certainly more volatile than large-cap stocks. This volatility should come as no surprise — in 2005, the New York Stock Exchange alone had more daily volume in stocks than the entire world experienced in annual futures volume.

Of course commodities will be volatile, just as thinly traded or small market cap stocks would be volatile compared to their highly liquid, mega cap peers.

Then there's the "pork belly" factor. The guy who knew a guy who lost everything. Odds are, that "guy" lost everything because he was trading with the maximum allowed leverage. In the stock market, you can buy on margin, but you're typically limited to as much as 50% margin. If you've got a $100,000 brokerage account, you can typically buy up to $150,000 in stocks. With commodities, leverage is a whole different ballgame.

If you've got $100,000 to trade in commodities, you can buy up to $2 million worth of futures contracts. That's right — 20-to-1 leverage. With that kind of leverage, and considering how volatile commodities can be, you have to be right. At 20-to-1 leverage, a 5% drop wipes you out entirely. (Just ask the banks!)

Still, You Don't Have to Be Psychotic

Then again, you don't have to be an insane gambler to invest in commodities. The fact that you can leverage yourself 20-to-1 doesn't mean you have to — or should. You can pay cash and relax.

And, so long as your data and reasoning are right, you needn't fret a bit over the volatility. If your data and reasoning tells you that, for example, oil will be at $80 a barrel by the summer of 2010, and you bought it at $40, why should you care if it goes to $30...or, $20...or, $60?

Just as you can day-trade the heck out of stocks, you can trade commodities like a psycho. But, there is another approach to commodities. Take a step back, put them into five- and ten-year timeframes, and they begin to make sense.

It's the same when we look at stocks, not as prices streaming across a computer screen, but as pieces of businesses.

Then, keep in mind: When it comes to intelligent investing, the goal is to figure out what will happen. You'll never peg the "when;" so, figure out the "whats" and then put your money into your best ideas.

Click here to continue to Part II of this article.

Some Laws Can/'/t Be Broken: Supply and Demand

Joe Ponzio — Sun, 05 Apr 2009 19:58:00 -0600

I appreciate your patience with the lack of posts here on F Wall Street. As you may have noticed from this comment, I had the honor of being invited to speak to the MBA students at Howard University in Washington DC on March 13th. I'm working on getting the video from that speech (about an hour long) and will post it here when I have it.

One of the topics I covered was basic economics. More specifically, the two laws of economics that can't be broken, and that are paramount to investment success and thinking about investing:

Supply and demand can get out of whack for a long time; but, they always work towards balance over the long-term; and,
Whomever controls the prices gets the money.

You don't have to be an economic guru to understand these laws. Still, not understanding them could be disastrous to your portfolio. Today, we'll look at the first point and I'll cover the second in a subsequent article (in less than a month — promise).

Supply and Demand: Everyday Life

When it comes to money, the markets, business, economics...everything works on supply and demand. Rather than digressing into a bunch of wild tangents, theoretical rants, and deep discussions on economics, I'll give you the world's greatest example of supply and demand, and how these two laws affect pricing: eBay.

Even if you haven't used it before, you know eBay — the auction website that allows you to turn the garbage in your garage into cash, or to find hidden gems on the cheap. Just recently, I purchased a brand new copy of the 2006 CRB Commodity Yearbook as my kids turned my last one into a coloring book. I could have purchased it new from the Commodity Research Bureau for $100. Instead, I bought it on eBay for $11.65.

Why could I buy a $100 book and CD on eBay for just $11.65? Supply and demand. Very few people are interested in buying a copy of the 2006 CRB Commodity Yearbook (little demand) so the price is low to entice otherwise disinterested buyers to enter the market.

Supply and Demand: The Stock Markets

Supply and demand is easy to understand, and you see it every day in the stock markets. When you buy a stock, you are buying it from someone else. When you sell, you sell to someone else. Supply and demand determines which way prices go.

If there are more shares wanted for purchase than are immediately available from sellers, the price goes up. In this case, there is a lot of demand (interested buyers) but very little supply (few sellers). By raising the price of the stock, one of two things will happen to bring supply and demand back into balance:

Interested buyers become less interested in buying at the higher prices, thereby reducing demand to meet the short supply; and/or,
Otherwise disinterested sellers become more interested in selling at the higher prices, thereby increasing the supply of for-sale shares to meet the demand.

The opposite is true when more shares are tendered for sale than there are interested buyers — sellers become less interested in selling at lower prices, and buyers become more interested in buying at lower prices.

Supply and demand can get extremely out of whack for a while, which ultimately moves stock prices up and down very rapidly. We saw it happen recently with the bank stocks — Bank of America, Citigroup, Wells Fargo, and others. There was an overabundance of sellers — traditional sellers, fire-sale sellers, short sellers, naked short sellers — all trying to dump their or sell short these stocks. There was very little demand to buy these shares; so, the prices fell fast and hard to try and reduce seller interest and increase buyer demand.

This was driven primarily by media sensationalism, as I pointed out in this comment as Wells Fargo crossed below $9 and every news channel was promising universal bank nationalization.

Here we are six weeks later — universal bank nationalization is off the table (I don't believe it was even on the table), things are proving to be ugly, though still better than full-blown, 1930s-style depression, and the demand for stocks outgrew the supply, pushing the markets back up.

Supply and Demand: Understanding it at eBay

Here's how eBay works: A user posts an item for sale and sets a starting (and possibly a minimum) price. Then, visitors bid on that item. Each bid is higher than the last until supply and demand get into balance. That is — until the price reaches a level to where the demand for that one item and that high price is exactly one.

When that happens, the item goes to the highest bidder.

Now, the price can be much less than what the seller hoped to get for his item; or, the item can sell for much more than what the seller had hoped to get. It happens. But...there a lesson in there: Supply and demand determine prices; hope is not an investment strategy.

The Elasticity of Supply and Demand

In a perfect world, supply and demand would be in perfect balance, prices would always be efficient, and I'd have a little more hair. Unfortunately (especially for me), the world is not perfect. Supply and demand get out of whack from time to time, which ultimately presents investors with the opportunity to profit greatly, earn anemic returns, or lose substantially.

You need not look further than the dot-com bubble. In the early part of the 1990s, demand for technology companies was growing somewhat faster than the supply of great businesses. Prices increased.

By the late 1990s, the demand for tech was so high that speculators couldn't buy them fast enough. It didn't matter whether or not the company made money — what the business was like. The supply of stocks was short relative to the demand, and prices had to rise...for a while.

By the early 2000s, a bubble had formed — supply and demand were grossly out of whack and something had to give. Supply and demand, over the long-term, will always try to find their balance. To do so in tech stocks, prices hit a critical mass high, drying up the demand and, and prices began to fall, flooding the markets with supply.

The Unbreakable Rubber Band

Of course, supply and demand don't get out of whack only to end at a balance. Instead, think of it as a rubber band — stretching out as they get out of whack, and then snapping back. The more you stretch it, the harder it will snap back.

When you let that rubber band snap back, it doesn't usually end up as a perfect circle. Instead, it looks more like a limp noodle — partially or totally devoid of slack at all ends. Where a taut rubber band has a ton of demand (pressure) on it and very little supply (addition room to stretch), a limp rubber band has no demand and very little supply.

Except in economics, the rubber band can't break. Demand can dry up when a product or service becomes obsolete, in which case the rubber band goes away. Otherwise, the rubber band will over stretch and over shrink as supply and demand try to find balance.

How Supply and Demand Affect Prices and Profits

Why is it that some companies can increase prices with inflation while others are doomed to bad economics? Supply and demand.

Coca-Cola is the only company in the world that can supply the world's thirst for Coke, Sprite, Minute Maid, A&W Root Beer, and more than 2,700 other products. If you want a Coke, a Pepsi won't cut it (for many people; and, the opposite is true as well). That's why these businesses have been able to increase the prices of their products over time.

On the opposite end of the spectrum you'll find the Freeport McMoRans of the world — mining companies that have virtually no pricing power. Their profits are tied to the values of the commodities they extract and sell, as the chart below shows. Their costs are substantially fixed (though they can control costs by adding or reducing staff, starting or stopping mining operations, etc.); so, these companies will perform well (from a business standpoint) when commodities prices are high and will perform poorly when commodities prices are low.

Freeport McMoRan (FCX) can't arbitrarily raise the price of its products because its customers don't generally care if they're doing business with FCX — they care about getting rock bottom prices on copper.

Speaking of supply, demand and commodities companies, Stan & Mel asked an interesting question:

Why is there nothing about oil companies or oil service companies on your site. These seem to have been big money makers for investors over time. Is it because these are difficult industries to follow?

Why Buy The Company When You Can Buy The Commodity?

Exxon Mobile. Freeport McMoRan. Alcoa. Though they may have various business lines and plans to keep them afloat when commodities prices are ridiculously low, they all share a basic characteristic: their profits and growth are highly dependant on the price of the underlying commodities in which they deal.

So, before buying an oil company, or an agricultural company, or any commodity-based company, you must first ask and answer the critical supply and demand question. Is the demand for the underlying commodity greater than the current supply? If so, how long before the supply can meet the demand? (A mining company can't wish its way to new mines — it has to locate the commodity, build out the mines, extract it, etc. This process can take many years.)

Finally, is the price of the commodity low relative to the supply and demand characteristics? In 2008, oil nearing $150 was the peak of a bubble, as was copper at $4.

Then, you have to ask yourself the truly critical question: Do I buy the companies...or the commodities? If you know that the current and near-term potential supply is extremely short relative to the demand, and you know that the price is relatively low, then you have the "what" of your equation: The price of the commodity — oil, copper, aluminum, wheat, whatever — has to go up over time (or demand has to fall sharply) until supply and demand get back in balance.

In that case, if you think oil is cheap, why buy Exxon (XOM)? Buy oil! If you think that copper is cheap, why buy FCX? Buy copper! Why let the executives or securities laws or corporate tax laws screw up your investment if you don't have to? Unless, of course, the company is a more attractive versus the commodity.

If I think oil is going to $70 a barrel, I'd rather buy the commodity at $52 than XOM at $70. At $70 a barrel, the commodity is worth $70 while XOM might only be worth $85 — the difference between a 35% return in oil versus a 14% return in XOM.

That said, in the same scenario, I'd take XOM over oil if I could get XOM at, say, $50.

Aren't Commodities Risky?

That depends on how you approach them. Day-trading commodities is risky, as is day-trading stocks. With commodities, the risk can be magnified by insane amounts of leverage, moreso than is allowed with owning stocks.

If you're a long-term investor, and if you have a good idea of what will happen even though you don't know when it will happen, owning commodities is no more or less risky than owning stocks. Remember: volatility is not risk. Risk is in the strategy, not the security.

I'm not suggesting you open a futures trading account. Instead, if you see supply and demand out of whack in a commodity, look for an exchange traded fund (ETF) that deals in that commodity. You can buy and sell it like a stock, but don't have to worry about having a different account, settling your futures on a daily basis, backwardation and contango (generally, if you're a long-term investor), and the myriad of other commodities headaches that scare and confound inexperienced futures traders.

F Wall Street Adds DBB

Yesterday, I added 694 shares (10%) of The PowerShares DB Base Metals Fund (DBB) to the F Wall Street portfolio. An investment in DBB is a passive investment in aluminum, zinc, and copper. I'll get more in depth about the whys of aluminum, zinc, and copper in another post; but, here's the rationale: If I think that copper prices are going to rise 50%, why buy FCX — a company that would generate a 20% profit margin on those 50% higher prices? Why not take the 50% for myself?

Obviously, my investment in DBB says this: I believe that demand for aluminum, zinc, and copper will be much higher than the current and near-term supply capabilities. My 10% investment is not a 10% investment in each of these metals; rather, the metals are split evenly in thirds. My investment, therefore, is a 3.33% investment in each of the three metals.

Back To The Law That Can't Be Broken

When supply and demand are out of whack, prices change — in stocks, in commodities, on eBay. In the short-term, this can lead to massive bubbles and gut wrenching bursts. In the long-term, however, supply and demand will always try to work towards a balance, and the best way to balance them is by raising or lowering prices.

There is no better way to entice people to increase supply and to contemporaneously reduce demand (ie, help bring supply and demand back into balance) than by increasing the price of the item in demand. This is a law that can't be broken.

If you have a grasp on the supply and demand characteristics of your investments, and if you understand the second unbreakable law (whomever controls the prices gets the money), you'll have almost everything you need to figure out what will happen.

What would you do differently if you knew precisely what would happen, even though you didn't know when it would happen?

Why This Won/'/t Be Like 1929

Joe Ponzio — Sun, 08 Mar 2009 14:30:00 -0600

Let me continue this economic discussion, though I also have to get back to a few other topics as well. There is a lot of chatter as to whether we are in a recession or depression. Since November of 2007, Wall Street has been calling bottoms to this market, first setting their sights on Dow 13,000, and then incrementally lowering their targets by 1,000 points as time marched on.

Optimism and pessimism have no place in investing. Let's look at the economy from a realistic perspective to see why this recession will be nothing like the Great Depression.

The Consumer Who Spent Too Much

Let's face it: The United States has a consumer-driven economy. Some will have you believe that this is exactly why we are headed for a depression. "You can't rely on the consumer! It's fake growth! You have to manufacture! You have to produce!"

In theory, that makes a lot of sense. How long can an economy prosper, if at all, if it primarily relies on consumers and consumer spending?

If we are to believe that an economy can't rely primarily on consumers and consumer spending, the entire US economy's growth has been a sham. Not just recent growth, but the majority of growth for the past seventy years.

See, since 1929 (the earliest GDP data available at the BEA), consumer spending has made up 65.8% of GDP, on average. That is, we have always been a consumer-driven economy.

	1930s	1940s	1950s	1960s	1970s	1980s	1990s	2000s
Consumer Spending, as %age of GDP	77.0%	60.6%	62.6%	61.8%	62.4%	64.3%	67.0%	70.0%
Personal Savings as %age of Disposable Income	3.0%	14.0%	8.0%	8.3%	9.6%	9.1%	5.2%	1.6%

Over the past two decades, the problem with the US consumer is that (s)he started spending a bit too much. Ours is not a country of debt-laden, useless, broke slobs. In fact, by merely saving an extra 8% to 10% of her paycheck, Jane American can be financially stronger than she's ever been in the past (save the 1940s World War II era).

Her portfolio may be in shambles. Still, no matter how bad things seem, it's never too late to make some intelligent decisions and get back on track.

In doing so, Jane is not "destroying" America or putting the economy into a downward spiral. (Think of how the media rejoiced yesterday when the consumer surprised the market with spending.)

"Impossible!" naysayers scream. "Unemployment is 8.1% and rising!"

Right, which means that employment is 91.9% which means that 91.9% of our consumer-driven economy can start saving more. And if unemployment rises to 15%, then 85% of Americans can focus on spending a little less and saving a little more.

It's Happening Now

In the fourth quarter of 2008, personal saving exploded — from 0.4% a year earlier to 3.2%, a hell of a jump in just one year. In fact, at no other point in the past fifty years have Americans increased their savings as a percentage of disposable income as quickly as they have in the past year.

In addition, nonmortgage interest payments started plummeting, down 13% from a year earlier. In the past fifty years, the amount of nonmortgage interest paid by consumers has never dropped so quickly. In fact, from 1948 to 1987 — pretty damn good years in this country— this number never fell.

This has little to do with low interest rates. We know that credit card companies have dramatically increased rates over the past two years. So...people are saving more and paying off debt.

And these numbers are skewed as the savings rate is even greater. Clearly (and sadly) the unemployed can not save; so, they don't contribute to the top line figures (gross wages), and they detract from the bottom line figures (the unemployed are generally not net savers while they are unemployed).

If you look beyond the numbers, 91.9% of American consumers have, in the aggregate, been paying off debt and saving more and more in recent months. The American consumer spent $240 billion less last quarter than in the previous quarter.

(This, in turn, helps bank balance sheets as well which ultimately helps get us out of the crisis. As consumers save and get healthier, banks also get healthier.)

Forget GDP for a second. It's dropping. It will continue to drop for a while. The key to a healthy consumer-based economy is not higher GDP — that can be accomplished through nothing more than inflation, if needed. The real key to a healthy consumer-based economy is, well, a healthy consumer.

But We Don't Manufacture Anything! Trade Deficits!

I know it's easy to think that. Many of us, especially those of us that are online, reading investment websites, are in cities working service jobs. We also know that the US is a net importer — we've been running a trade deficit for years. Some people attribute that deficit to a lack of manufacturing in this county; others say that it's due to our insatiable demand for foreign goods.

Is manufacturing and production dead in this country? Hardly. In 1929, for each citizen in the United States, we exported about $44 in goods and services. By 2008, that number had grown to more than $4,200 per person. As a percentage of GDP, exports have grown from about 4% in the 1930s to more than 7% in the 2000s.

Both per person and as a percentage of GDP, we manufacture and export more in this country than at any other time in the past seventy years. (Want to fix the trade deficit? I'm not one for "protectionism;" but, if we all just chose to spend $98 per month more on American than foreign goods, our trade deficit is gone.)

In fact, after taking into account inflation, we now produce and export fifteen times more than we did in 1950. Do we produce stuff in this country? More and more each year. So, before we jump to the conclusion that we have no manufacturing outflows from this country, or that the US is a black hole, sucking down foreign goods and services and giving nothing back to the world, consider this: As a percentage of GDP, the amount of goods we exported and the amount of services we exported in 2007 and 2008 were higher than they have ever been since 1929.

In addition, our trade deficit isn't impossible to overcome. In fact, ours has been shrinking since its 2006 peak. As it shrinks, GDP and our economy grows as a net trade deficit reduces GDP while a net surplus would add to GDP.

When Businesses Cut Back, Look Out

Over the past seventy years, "private investment" has averaged about 15% of GDP. This isn't investing in the sense of stocks and bonds; rather, it's the spending that businesses do on equipment, plants, etc. Business investors call these "capital expenditures."

In every recession, businesses cut their spending on these items as they anticipate lower revenues which will lead to a strained ability to generate cash. The chart below shows Private Investment as a percentage of GDP since 1950, with the grey areas being periods of recession.

To preserve cash, these businesses also lay off workers. In essence, they shrink in real terms...for a while.

To quote Buffett on deferring capital expenditures:

...though dentists correctly claim that if you ignore your teeth they'll go away, the same is not true for [capital expenditures].

Eventually, these businesses will have to repair or replace equipment, and otherwise ramp up spending. That doesn't happen, of course, until we've swung from "panic and fear" to "I'm glad that's over."

In every economy, businesses, in the aggregate, swing like a pendulum — hiring and spending when times are good, and firing and preserving cash when times are bad. In addition to business spending, part of this "private investment" component to GDP is residential spending — spending by households on, well, houses.

If we take residential spending out of the picture for a second, here's a chart of "private investment" as a percentage of GDP.

Remove Real Estate? But It Is Real Estate, Stupid!

Real estate spending has slowed. Then again, residential real estate spending falls in every recession, and even a few times when we're not in a recession. Here's the chart:

We know that foreclosures are still rising; but, let's think logically about this for a second: In the mid-2000s, we had rampant real estate speculation. People had two, three, four homes/condos. Everyone with a pickup truck was a "developer," their mothers were real estate agents, and their fathers were mortgage brokers. (Just like when everyone was a day-trader in the late 1990s and early 2000s.)

When home prices started falling, the first to get hit were the speculators. A mechanic with four condos waiting to be flipped was in no better position if he only held three; so, speculators like this had no choice but to flood the market with inventory — being foreclosed on two, three, four properties at a time. Other careless speculators would also walk away from their "investments" as soon as they knew they couldn't flip them for a profit.

In that sort of environment, we would expect foreclosures to surge initially, especially in the "hottest" real estate markets — places like Nevada, California, Arizona, and Florida. It should come as no surprise, then, that these states have the highest foreclosure rates.

Making up just 21% of this country's population, these four states have 53% of the country's foreclosures. Though rising unemployment will add to these figures, the overwhelming majority of gainfully employed people will not walk away from their homes simply because others have. And, while the media focuses on the people struggling to modify their mortgages on underwater homes, let's keep in mind the tens of millions of people that didn't buy homes in 2005 through 2007.

(People are using scare tactics as though everyone in this country, or even the majority of people, bought overpriced homes in 2006, are now underwater, and will soon leave the banks to foot the bill on every mortgage they hold.)

Because of that, even though we're seeing rising unemployment, foreclosures in these four states rose 46% over the past year while foreclosures in the remaining 46 states fell, in the aggregate, by 2%.

(These statistics reflect foreclosure filings, default notices, auction sale notices, and bank repossessions.)

Then Versus Now

You can't compare today to the Great Depression. In 1930, GDP fell 12%. By the end of 1933, GDP had fallen more than 45% from its 1929 levels, and unemployment was wildly out of control.

What changed in 1933 and 1934 that would turn the economy around?

I hate to say it...Government Spending.

Gasp. Government Spending.

The fourth component of GDP (after consumer spending, private investment, and net imports/exports) is government spending. The government is not a stimulative factor to the economy; rather, it is an employer and spender of last resort. When businesses are firing and cutting back on private investment, the government typically ramps up its hiring and spending to keep the consumer afloat until businesses can get back on track for growth.

By 1941, prior to World War II, the US economy was already larger and stronger than it was in 1929. Unemployment had fallen to less than 10%, GDP had more than doubled from its 1933 bottom, and businesses, which had previously cut private investment from $16 billion in 1929 to just $1.7 billion in 1933, were back on track spending $18 billion in 1941.

Without World War II, our recovery would have continued to be gradual. From an economic standpoint, World War II put our economic recovery on steroids. The butcher, the baker, and the bread maker sprinted back to the US.

But This Spending Is Different! It's Too Much!

In 1929, non-defense federal spending was just 0.77% of GDP. During the first three years of the Depression, the government did nothing to help curb the decay, actually paring back spending while Americans were losing jobs. Enter Roosevelt, the New Deal, and deficit government spending. (Roosevelt took the country off the gold standard to fund the recovery. Imagine what the headlines were back then!)

Roosevelt more than quadrupled non-defense federal spending to where it would ultimately become more than 5% of GDP in 1936. In essence, Roosevelt and the US Government filled the void when businesses couldn't or wouldn't put people to work. By 1942, unemployment was back below 5%, private investment was back on track, having grown tenfold since the 1932 low, and the consumer was healthy again.

One could argue that today's proposed spending is too much. I'm not going to speak to the fundamental policy changes they're proposing; but, I'll tell you this: When Joe American loses his job and can't find work, he'll gladly help the government build the high speed train from New York to LA so that he can put food on his table.

So long as Joe is getting a paycheck, we won't have a depression.

But Higher Taxes Kill Growth!

So the government is proposing higher taxes, and that stunts economic growth, right? After all, who in their right mind would ever start a business or grow their business if Uncle Sam is taking a bigger piece of the pie?

Yet from its 1933 low to pre-war 1941, the economy grew 125%, roughly 10% per year (faster than China today), while taxes on the "rich" went from 25% in 1929 to 81%, with the lowest bracket going from 0.375% to 10%, all while businesses were being launched, business spending was on the rise, and unemployment was dropping.

Though lower taxes might encourage growth, higher taxes don't kill growth. They provide critical funding for the spender and employer of last resort at a time when businesses are ratcheting down their spending and work force. (This is not a political or partisan statement, but a matter of history.)

And let's not forget — our country did pretty darn well and a lot of businesses were started and grew from 1940 through 1986, a time during which the top tax bracket was never below 50% (and sometimes as high as 92%).

I'm not one for higher taxes; but, ours are extremely low compared to the historical average.

The Stock Market, Then and Now

A lot of people look at the stock market as a sign of our economic health, the same way that they view daily stock prices as a sign of a company's health. A year into the Great Depression, stocks had fallen at a pace similar to what we've seen over the past eighteen months. Stock prices, however, are not a sign of the economy.

The 90% stock market plunge of the Great Depression was insane. Then again, from top to bottom, GDP — the US economy — fell 45% from 1929 through 1933. Their market effectively crashed in October; our market started crashing in October. They had a banking crisis; we have a banking crisis. Theirs was global in scope; ours is global in scope.

Those are about the only similarities one can draw.

By this time in the Great Depression, unemployment was nearing 20%. Today it's 8.1%. First year Depression GDP had fallen 12%; ours grew 3% in the first year of this crisis. Depression-era government did nothing to stop the fall in the first three years; ours is trying to stop the bleeding and to, in time, create jobs to keep the consumer healthy and offset business losses.

I can promise you this: The inflation that follows as a result of today's actions is certainly better than the hard times of the Depression. Nobody would dare say that the high inflation of the late 1970s and early 1980s was anything like the utter despair of the early 1930s.

Those Toxic Assets & Credit Flow

Let me end with the garbage that started this in the first place: Frozen credit and level 3 "assets." Let's start with Buffett on these level 3 derivatives in his 2002 Letter to Shareholders:

In banking, the recognition of a "linkage" problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a "chain reaction" threat exists within an industry, it pays to minimize links of any kind.

With so many banks, brokers, insurance companies, pensions, and hedge funds tied together in a derivative cesspool, the failure of any one of these large institutions would pose a systematic risk. Lehman failed, and the system froze. (Hence the bailouts, to prevent further problems and "minimize links of any kind.")

We're all mad as hell, and rightfully so. Still, it's not the end of the world.

The economy is shrinking somewhat, but certainly not as fast as the Depression. In addition, we have the backstops in place (government spending) to keep us afloat if businesses continue to contract. Though we're engaging in deficit spending, we're issuing bonds at 2%.

At 2%, the government should borrow as much as it can, reinvest it in America at 5% or 6% GDP growth, and thank the world for providing the funding. This is good debt, assuming our leaders don't waste it all studying pig farts.

People are saving more and paying off debt, which directly strengthens bank balance sheets. Though credit locked up in October of 2008, it has gradually started flowing again (see the TED Spread) which means that businesses and individuals — healthy businesses and individuals — can conduct business or manage their finances.

(The fact that the $18,000-a-year couple still can't get a $700,000 mortgage like they could two years ago is a good thing.)

The stock market is getting to a point where it is predicting the end of capitalism. Some businesses will go away; some will grow stronger. Be realistic for a second: until the government gets into the soft drink business, Coca-Cola is a pretty safe bet. Of course, most people don't belong in stocks in the first place.

Is this the end of capitalism and America? If we ignore the facts and listen to the media, it must be. And I fear it will end the same way America ended during the last six depressions:

Early last week, when the headlines noted that the market's losses had reached the worst levels of any decline since the late- 1930s, some analysts dutifully trotted out new "how low can it go" numbers for the Dow Jones industrial average. Would 6,000 do it? Maybe 5,000? One estimate came in at 777, with a forecast for an accompanying U.S. economic depression. — LA Times, 10/13/2002

No. The nation is in an economic depression. Gramm-Rudman is not going to solve that, and cutting the budget to the bone will only make things worse. We need to return to American System economics, and fast. We need aid from the Asians and Europeans, and the Paris-Berlin-Vienna triangle of industrial production. — Scott Gaulke (D), LA Times, 05/27/1990

Economic depressions may not be a thing of the past, according to some respected economists. The experts cite some striking parallels between 1929 and today, including the overheated stock market, trade imbalances and the rise in protectionism, greater polarization in the distribution of wealth and the prevailing mood of optimism among investors and the general public. — Chicago Tribune, 10/9/1987

Concerned that there's no relief in sight from high interest rates, many Americans believe the country is now in an economic depression. — Washington Post, 7/26/1982

Depression. It is a word to send shivers down the spine of anyone over 50 years old. It evokes dark images of bread lines and bankruptcies, dust bowls and suicides. It is also a word being used by responsible public figures generally liberals for the first time since the nineteenthirties to describe the state of the nation's economy. — NY Times, 3/7/1975

Marshall McLuhan, the intellectual comet from Canada who now resides at Fordham University, startled broadcasting executives here today with a forecast that the United States will have an economic depression "within about five years." — Washington Post, 9/29/1967

Is Peter Full of Schiff on the Economy?

Joe Ponzio — Tue, 03 Mar 2009 15:27:00 -0600

In December of 2007, as Apple was approaching $200 a share, you couldn't say a word about it for fear of backlash from the Apple investment community that insisted it was going to $600 a share. Today, Nouriel Roubini and Peter Schiff are considered gods for predicting the economic turmoil, and anyone discrediting their teachings should be burned at the stake. Well, get the gas and matches, because I have to say that Peter is full of Schiff in his latest article.

A broken clock is still right twice a day. The problem is this: If you look at that clock at that exact "right" moment in time, you should not automatically assume that the clock is always right. Warren Buffett came out recently and said how "dumb" he was in 2008. Should we then assume that Buffett is doomed to be eternally wrong in the future?

The "Credit" Economy

In this March 2nd article on SeekingAlpha, Schiff posits that the government's plan to restore the flow of credit is somehow a plan to entice people to leverage themselves further to the hilt.

Government efforts to simply make credit available, without rebuilding productive capacity or increasing savings, are doomed to destroy what's left of our economy.

True. But then he goes on to explain how a "real economy" works in simple terms:

Suppose there is a very small barter-based economy consisting of only three individuals: a butcher, a baker, and a candlestick maker. If the candlestick maker wants bread or steak, he makes candlesticks and trades. The candlestick maker always wants food, but his demand can only be satisfied if he makes candlesticks, without which he goes hungry. The mere fact that he desires bread and steak is meaningless.

He continues, explaining what would happen if the candlestick maker began borrowing steaks and bread, issuing IOUs, yada yada, until there was a natural disaster that destroyed all the equipment and nobody could produce anything any more. The takeaway lesson: If everyone maxes out their credit cards and a meteor hits Earth and destroys every business and piece of equipment, our economy might have some problems.

(I've got news for you Mr. Schiff: Not everyone is leveraged to the gills.)

Growth in the "Real" World

Let me propose a different scenario to Schiff's doom and gloom economic outlook. We have the same three players above, but we also have a city down the street with ten unemployed, starving citizens. The butcher employs one of these citizens so that he can work a little less. That citizen, now enjoying a paycheck, buys a candle. With increased demand, the candlestick maker hires a citizen, who in turn starts buying bread.

And so on and so forth until all ten citizens are employed.

Credit in the "Real" World

Everything is hunky dory and the three empires — bread, meat, and wax — are expanding into neighboring cities. Demand is through the roof, and the businesses rapidly expand. To fuel this expansion, the three companies put themselves on "credit" — borrowing from each other in the short-term to finance growth. (Example: The candlestick maker needs the fat from the cows to make candles. He'll pay for that fat when he sells the candles.)

Short of a Peter Schiff natural disaster that wipes out the machines needed to make the materials, this system works just fine.

Debt in the "Real" World

The citizens, enjoying their newfound wealth, start spending like crazy — some beyond their means. A few citizens start banks; some start clothing shops. A small portion of them — say, 10% or 20% — borrow too much from the banks to buy from the clothing shops.

It's fine while the system is working; but, along comes a draught. Grains dry up, which puts the baker in a bind. With grass in short supply, cows aren't as fat; so, meat is scarce. Less meat means less material for candle wax.

Not able to produce as much, the "Big Three" employers lay off workers. Some (though not all) of those workers are overextended on their debt; so, they blow off the bank. The bank begins to lose money; so, they stop lending to everyone else.

Unable to borrow money to purchase threads to make 1,000 shirts, the clothing maker now has to make just 400 shirts.

The economy now hits a critical point, at which a decision must be made. Do we let it "work itself out," knowing that we will have real pain and shrinkage at all levels until we find balance, at which point we will have flushed the bad debt out of the system? Or, do we help free up credit so that the rest of the system isn't poisoned by the draught hurting the Big Three?

Finding a Balance

Where Schiff and Roubini have it wrong is in the end result. According to them, everything in the economy is going to zero. We have to reboot the system, which means that we'll all move out of our homes and into the woods to start picking berries and making stone tools until a new butcher, baker, and candlestick maker come along.

During the Great Depression, we couldn't possibly lubricate the system because our currency was tied to the gold that the country had in its coffers. It took a World War and the export of 20%+ of our male "consumers" to bring the butcher, baker, and candlestick maker back.

Today, we can manipulate monetary policy to grease the wheels. Admittedly, we won't see Dow 14,000 for quite some time. Still, without plowing money into the system, the "Greater Depression" would have already been upon us.

People might buy fewer shirts; but, unless you think we're all going to run around naked, the strongest tailors will survive. If they don't, another citizen will step up to seize the opportunity and become tomorrow's employer.

Until we have 100% employment around the world, this is how "real" economies work. We don't live in a limited citizen, fully-employed, this-for-that economy that is being destroyed by an abundance of credit and a series of natural disasters. The problem lies in the non-productive "assets" — an overabundance of "investments" that were believed by many to be assets, but ended up being liabilities.

Pain Today or Pain Tomorrow?

To correct the situation, we have to grease the wheels. I hate it as much as anyone else, but that doesn't change the fact that it needs to be done. Few people believe that we can "sit in the tub" while President Obama takes care of things, as Mr. Schiff suggests.

People will need to make sacrifices — greater than they are now. We need to save more — that goes without saying. For example, the few thousand people that read this article will likely do so on a computer, over somewhat expensive high speed internet, with all the lights on in the room. I'd be willing to bet the TV is on in the background while the cell phone sits quietly, racking up those rollover minutes they pay for but never use.

Before you load up on ammunition and bottled water, realize that today's actions will certainly lead to tomorrow's stagflation or inflation, but the game isn't over. Once panic and fear pushes the pendulum beyond the point of equilibrium, things will start to improve.

Now, the race is on. Who will win? Schiff and Roubini, whom have so convinced people that the end is near that nobody will make changes? (Why should I cancel cable or pay off my debt if everything is going to hell?) Or, the desire for a better tomorrow, at the expense of today's instant gratification? (A vision that a lot of people lost a long time ago.)

Is there more pain ahead? Yes, and probably for a number of years when factoring in the stagflation or inflation that is on the way. Nobody is denying that. Still, to promote a full reboot and going back to a "cash only" society is ridiculous. The problems we face are not due solely to the use of credit; they are due to a massive mispricing of risk at many levels, leveraged by the irresponsible use of credit.

If you want to burn me at the stake, go right ahead. But before you do, consider this: At what point will Roubini and Schiff become bullish on America...on businesses? At what point will they declare that stocks are cheap? If they have their way, you might want to save that match — you'll need it when the power companies shut down and you're foraging the Earth for sustenance.

(For the naysayers that want to immediately jump down my throat without reading this article, keep in mind that Roubini and Schiff were not the only ones to see the writing on the walls — they just have great press agents. While they were booking media appearances and kissing babies, some of us were moving clients largely to cash and/or bonds in 2007 and 2008.)

Buffett May Not Have Sold JNJ

Joe Ponzio — Wed, 18 Feb 2009 11:11:00 -0600

In its recent end-of-quarter filing, Berkshire Hathaway reduced its stake in Johnson & Johnson by 54%. As is often the case, the media automatically assumed that Buffett turned sour on Johnson & Johnson and was dumping the stock. Before you run off and sell 50% of your JNJ stake because Buffett is allegedly dumping his year-and-a-half old investment in the company, let's look at the sale logically.

I'm going to quickly run through the latest filing so that you can ignore the noise going forward. First, let's look at the "reporting entities" in the filing. For Berkshire, there are 21 reporting entities on this filing which means that holdings listed on the 13F-HR include decisions made by...and not made by...Warren Buffett.

If you actually look at the filing, you'll see the list of entities reporting in this filing. Buffett. Blue Chip Stamps. GEICO. Wesco. And a number of other entities, some of which have their own investment managers, portfolios, and decisions.

Later in the filing, where the positions are reported, Column 7 itemizes the "Other Managers" — the entities or people that were involved in making the decision to hold those securities. As Chairman of Berkshire, Buffett is listed on every position. Beyond that, the positions are reported in groups based on who made decisions and/or holds the position.

When Buffett Moves Money, He Moves Money

Rather than immediately assuming that Warren Buffett is shedding his Johnson & Johnson position, let's see the changes to the portfolio based on the "Other Managers" and entities that hold the stock:

What we see here is that National Indemnity, OBH Inc, BH Columbia, and Columbia Insurance reduced their stakes in Johnson & Johnson. Other entities directly controlled by Buffett and Munger — for example, Berkshire Hathaway itself and Wesco Financial and subsidiaries — did not sell a single share of JNJ.

When Buffett is buying or selling stock, he typically does so in bits and pieces through various entities in an attempt to mask his purchases and sales for a while. In this case, large sales were made by a few insurance subsidiaries rather than a "sneaking in or out" move.

Did Buffett Sell Johnson & Johnson?

Maybe. Maybe not. Time will tell as we won't see another 13F-HR for three months. Still, I think it's premature to say that Buffett is dumping Johnson & Johnson based solely on the amount of shares controlled, directly and indirectly, by Berkshire Hathaway, especially when some of the entities he directly controls with little or no outside influence did not sell a single share in the last quarter.

Regardless of what Buffett did or didn't do, buying or selling JNJ based on his 13F-HR or the noise in the media is a poor investment strategy. If you want to do that, buy Berkshire Hathaway stock and put it on the shelf.