Capital Market Dysfunctionality

More from a recent article in The New Yorker. Some thoughts from the man who set up the Paul Woolley Centre for the Study of Capital Market Dysfunctionality at the London School of Economics:

On Allocating Capital

Was the financial industry doing what it was supposed to be doing? Was it allocating capital to its most productive uses?

At first, like most economists, he believed that trading drove market prices to levels justified by economic fundamentals...The dotcom bubble of the late nineteen-nineties changed his opinion.

Markets are "Grossly Inefficient"

Financial markets, far from being efficient, as most economists and policymakers at the time believed, were grossly inefficient. "And once you recognize that markets are inefficient a lot of things change."

Rent Capture

"Rent capture causes the misallocation of labor and capital, transfers substantial wealth to bankers and financiers, and, at worst, induces systemic failure. Both impose social costs on their own, but in combination they create a perfect storm of wealth destruction."

Size of the Financial Sector

I asked Woolley how big he thought the financial sector should be. "About a half or a third of its current size," he replied.

Check out the entire article in The New Yorker.

Adam

Related post:
The Banking Power Utility

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Buffett's Business Principles: Berkshire Shareholder Letter Highlights

Many of the business principles that Berkshire Hathaway (BRKa) is built upon are useful for the individual investor. In 1983, the number of Berkshire shareholders had increased from 1900 to 2900 (mostly the result of merging with Blue Chip Stamps), so Warren Buffett took some time to summarize these principles for the benefit of the new owners.

From that year's shareholder letter:

• Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we also are, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but, instead, view the company as a conduit through which our shareholders own the assets. 

• In line with this owner-orientation, our directors are all major shareholders of Berkshire Hathaway. In the case of at least four of the five, over 50% of family net worth is represented by holdings of Berkshire. We eat our own cooking. 

• Our long-term economic goal (subject to some qualifications mentioned later) is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. We are certain that the rate of per-share progress will diminish in the future - a greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation. 

• Our preference would be to reach this goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation. 

• Because of this two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them. 

• Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains. 

• We rarely use much debt and, when we do, we attempt to structure it on a long-term fixed rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, depositors, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. 

• A managerial "wish list" will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market. 

• We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely. 

• We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance - not only mergers or public stock offerings, but stock for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company - and that is what the issuance of shares amounts to - on a basis inconsistent with the value of the entire enterprise.

• You should be fully aware of one attitude Charlie and I share that hurts our financial performance: regardless of price, we have no interest at all in selling any good businesses that Berkshire owns, and are very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling - the advocates will be sincere - but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in it. 

• We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private. 

• Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore, we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say "no comment" on other occasions, the no-comments become confirmation.

The business principles of Berkshire are unique among major corporations.

It's tough, if not impossible, to find businesses to invest in that operates along similar lines. The next best is thing is to invest in those that who operate with as many of the above principles front of mind as possible.

Adam

Long BRKb
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Edison on Gold: Fictitious Value & Superstition

From this New York Times article:

"All of the wealth in the world, according to our present standards, may be rendered worthless, by the discovery that gold can be made synthetically."
---
"That is one way to do it - make it so plentiful that it drowns its fictitious value and drowns the superstition of the people along with it." - Thomas Edison

New York Times article - 1921
---
Here are some related posts that may be of some interest:
---
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold

Gold is not a productive asset.

A good business certainly is.

To me, it makes sense to own productive assets with the long haul in mind. This, of course, includes partial ownership of a good business via common stocks.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Favorite Rationalizations: Berkshire Shareholder Letter Highlights

Warren Buffett, in the 1982 Berkshire Hathaway (BRKa) shareholder letter, said the following about how management and directors often will rationalize issuing stock to purchase another company:

(a) "The company we're buying is going to be worth a lot more in the future." (Presumably so is the interest in the old business that is being traded away; future prospects are implicit in the business valuation process. If 2X is issued for X, the imbalance still exists when both parts double in business value.)

(b) "We have to grow." (Who, it might be asked, is the "we"? For present shareholders, the reality is that all existing businesses shrink when shares are issued. Were Berkshire to issue shares tomorrow for an acquisition, Berkshire would own everything that it now owns plus the new business, but your interest in such hard-to-match businesses as See's Candy Shops, National Indemnity, etc. would automatically be reduced. If (1) your family owns a 120-acre farm and (2) you invite a neighbor with 60 acres of comparable land to merge his farm into an equal partnership - with you to be managing partner, then (3) your managerial domain will have grown to 180 acres but you will have permanently shrunk by 25% your family's ownership interest in both acreage and crops. Managers who want to expand their domain at the expense of owners might better consider a career in government.)

(c) "Our stock is undervalued and we've minimized its use in this deal - but we need to give the selling shareholders 51% in stock and 49% in cash so that certain of those shareholders can get the tax-free exchange they want." (This argument acknowledges that it is beneficial to the acquirer to hold down the issuance of shares, and we like that. But if it hurts the old owners to utilize shares on a 100% basis, it very likely hurts on a 51% basis. After all, a man is not charmed if a spaniel defaces his lawn, just because it's a spaniel and not a St. Bernard. And the wishes of sellers can't be the determinant of the best interests of the buyer - what would happen if, heaven forbid, the seller insisted that as a condition of merger the CEO of the acquirer be replaced?)

Later in the letter Buffett goes on to say...

Managers and directors might sharpen their thinking by asking themselves if they would sell 100% of their business on the same basis they are being asked to sell part of it. And if it isn’t smart to sell all on such a basis, they should ask themselves why it is smart to sell a portion. A cumulation of small managerial stupidities will produce a major stupidity - not a major triumph. (Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly-small disadvantageous capital transactions.)

A good relatively recent example of this is Kraft's purchase of Cadbury.

Adam

Long BRKb

Related posts:

Buffett on Kraft-Cadbury Deal

Bankers & Barbers
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

The Banking Power Utility

Some excerpts from an article in The New Yorker:

"When the banking system behaves the way it is supposed to...it is akin to a power utility, distributing money (power) to where it is needed..."

The banking "power utility" should be, as it has in the past, funding new and existing industries.

"The other important role of the banking industry, historically, has been to finance the growth of vital industries..."

Unfortunately, these days, there's just too much reliance on trading.

For example, investment banking (advising businesses and raising capital for them) was less than 15% of Morgan Stanley's revenue during the first nine months of this year, sales/trading was more like 36% of revenue (and an even greater percentage of earnings).

"Goldman Sachs is even more reliant on trading. Between July and September of this year, trading accounted for sixty-three per cent of its revenue, and corporate finance just thirteen per cent."

So these businesses have changed "from businesses whose profits rose and fell with the capital-raising needs of their clients into immense trading houses whose fortunes depend on their ability to exploit day-to-day movements in the markets."

Is the amount of speculation built into the current system a good thing?

Lord Adair Turner doesn't seem to think so. According to the article he describes "much of what happens on Wall Street and in other financial centers as 'socially useless activity'".

Some is speculation is necessary, and maybe even desirable, but the proportion matters. A petrol engine needs, at least, roughly the right amount of air and fuel but, at some point, more of either in the mix will subtract from system performance. It is about optimization. A similar thing likely applies to the financial system. In other words, eventually more liquidity isn't such a wonderful thing. Worse yet, at least in some cases, is that some of the current activity amounts to little more than pure gambling. Speculation and gambling may seem like similar activities but they are far from the same thing.

A better balance sure seems needed. Far too much energy goes into what is, for the most part, socially not very useful (or, at least, economically mostly useless) in lieu of financing vital industries (the intelligent allocation and formation of capital) and otherwise providing the "power utility" function.

Check out the full article in The New Yorker.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Shaq Still Dominates around Basket (of fries)

From an article in The Onion:

Celtics coach Doc Rivers said the 7-foot-1 center showed remarkable passion, screaming at opponents and throwing elbows in order to clear out the area in front of the basket of fries.

According to Rivers...

"Some people say that he's slowed down over the years, but he showed some real lateral quickness when he was defending his basket. He must have snagged about a dozen fries that I thought were out of his reach."

"He sent a clear message to the league tonight," Rivers added. "If you get close to that basket of fries, Shaq can still make you pay."

Check out the entire article.

Adam

Ackman's 3Q 2010 Letter

Some comments on Kraft and ADP from Bill Ackman in his latest letter:

Kraft 
We continue to like the "new Kraft" for its underappreciated international growth opportunities, as Kraft leverages Cadbury's well-established distribution network particularly in emerging markets. We also believe the company will significantly improve its profit margins, which are among the lowest of its peers. 

Thus far, our thesis appears to be on track. Year to date, base Kraft EBIT margins (excluding corporate expense) are up from 14.8% to 15.4%. We believe margins will continue to increase in the coming quarters, particularly as the company delivers its expected $750 million of cost savings from the combined Kraft/Cadbury operations. 

From a valuation perspective, based on the attractiveness of the categories in which Kraft participates, and its strong and growing emerging market presence, we think the stock is inexpensive at roughly 11x 2012 earnings.  

ADP 
The opportunity to acquire ADP at a discount to intrinsic value arose as ADP's earnings and cash flow weakened with the economy. Retention rates and new business bookings declined substantially as recession-related pressures drove some ADP customers into liquidation, led to headcount reductions, and otherwise delayed new business. Lower average client fund balances coupled with low interest rates also contributed to weakness in ADP's earnings. 

Later he added...

...ADP continues to wisely deploy capital in high-return acquisitions, substantial share repurchases, and dividends. Over the past five years, the company has repurchased more than 20% of its stock, made a number of intelligent acquisitions of complementary product offerings, while divesting non-core operations through sale or spinoff. 

Check out the full letter.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Berners-Lee: Facebook Could Fragment Web

In an essay published this morning in Scientific American, world wide web founder Tim Berners-Lee is critical of the most successful social networking sites. In the essay, Berners-Lee accuses Facebook of creating a "closed silo of content" that risks fragmenting the web.

Excerpt from an article on the new Berners-Lee essay:

Facebook, LinkedIn and other social networking sites represent "one of several threats" to the future of the world wide web, its founder, Sir Tim Berners-Lee has warned.

Some of the web's "most successful inhabitants", such as Facebook and large telecoms companies, have begun to "chip away" at its founding principles, Berners-Lee wrote in a Scientific American journal essay published today.

Social networking sites that do not allow users to extract the information they put into them is a "problem" that could mean the web is "broken into fragmented islands", he said.

Google accused Facebook earlier this month of leaving its 600 million users in a "data dead end" with their contact details and personal information "effectively trapped".

Although Facebook recently began allowing users to download profile information including status updates and photos, the world's most popular social network has been roundly criticised for leaving users' network of contacts "walled" inside its own site.

Berners-Lee warned that such a "closed silo of content" risked leaving the web "fragmented".

"The web evolved into a powerful, ubiquitous tool because it was built on egalitarian principles," he said. "The web as we know it, however, is being threatened in different ways. Some of its most successful inhabitants have begun to chip away at its principles."

He added: "The more you enter, the more you become locked in. Your social networking site becomes a central platform – a closed silo of content, and one that does not give you full control over your information in it."

"The more this kind of architecture gains widespread use, the more the web becomes fragmented, and the less we enjoy a single, universal information space."

We are just shy of the 20 year anniversary of the world wide web. It went live in December of 1990 on Berners-Lee's desktop.

Adam

related article

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Munger on Buying Gold

From this article:

"I don't have the slightest interest in gold. I like understanding what works and what doesn't in human systems. To me that's not optional; that's a moral obligation. If you're capable of understanding the world, you have a moral obligation to become rational. And I don't see how you become rational hoarding gold. Even if it works, you're a jerk." - Charlie Munger
--
Some related posts on gold that may be of interest.
--
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Grantham: Gold is "Last Refuge of the Desperate"
-Why Buffett's Not a Big Fan of Gold

A good business -- whether owned fully or partially -- is a productive asset.

Gold is not.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Buffett, Unplugged

Some excerpts from a Wall Street Journal article from roughly five years back.

The article describes Buffett's approach to buying businesses and has a few other interesting insights.

Buffett offers to buy Forest River, a recreational vehicle maker, with the idea that the founder, Peter Liegl, would remain in charge.

So what happened?

The deal was closed a week later during a 20-minute meeting.

Buffett told the founder not to expect to hear from him much.

Here's what the founder said:

"It was easier to sell my business than to renew my driver's license." 

Later the article describes Buffett's daily routine. Apparently, it hasn't changed much over the years.

He says he spends the better part of most workdays thinking and reading. He fields a handful of phone calls, and on most days, he confers with the chiefs of a few Berkshire subsidiaries. He seldom holds meetings. "There isn't much going on here," he says of his office on a typical day. 

The article also points out there is no computer in his office though he does keep the financial news on.

He keeps no calculator on his desk, preferring to do most calculations in his head. "I deplore false precision in math," he says, explaining that he does not need exact numbers for most investment decisions.

Check out the full Wall Street Journal article.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.