HUMMONEY - `Not Light Reading’ (Perspective)

---By Greg Lewin

Two incredibly important investment documents were made available yesterday and I urge all investors to read carefully. One is Berkshire Hathaway’s annual report, and the other is Mary Meeker’s “USA Inc.,” which can be found at www.kpcb.com/usainc. As a general rule I believe Warren Buffet and his partner Charlie Munger have dispensed more investment wisdom than all other investment commentators combined.

However, it seems in my estimation that as Berkshire’s assets have grown so too has Mr. Buffett’s ownership bias. Throughout the recent recession his public commentary has been decidedly optimistic, closer in form to cheerleading than the critical analysis we have grown accustomed to.  In his latest report to shareholders he bases his optimism on “human potential,” a quality not easily subject to measurement, yet forming the basis for his new and increased investments in the United States.  Obviously he is of the opinion that we are in procession of a uniquely large sum of this potential versus our foreign competitors. Later, as he begins to explain to the readers how he approaches investing his capital he spends time reviewing his calculation of intrinsic value, his 3 part process for investment selection, of which the third part consists, in a single word, management. We will explore this later after we review our second document, “USA Inc.”

Mary Meeker is a Wall Street trained internet analyst who built a considerable reputation during the boom years for the internet stocks. She is now a partner at a prominent private equity firm. In her current capacity she wrote an outstanding piece on our federal government’s financial position. Her approach is unique and thoughtful. In this 266-page document she attempts to take public data and evaluate our federal government in much the same way as a security analyst might evaluate a public company, examining revenues and expenses, assets and liabilities, both on and off the government’s balance sheet, in an effort to determine the fundamental worth of the US as if it were a publicly traded company. I will try to summarize some of her key financial conclusions for “USA Inc.”:

1 -   “Cash flow is deep in the red (by almost $1.3 trillion last year, or $11,000 per household) and USA Inc.’s net worth is $45 trillion in the red and deteriorating.”

2 - “Entitlement expenses amount to $16,000 per household per year, and entitlement spending far outstrips funding, by more than $1 trillion in 2010. More than 35% of the US population receives entitlement dollars or is on the government payroll.”  Note: this analysis excludes state and local government workers, who account for 15% of national employment, and large unfunded deficits and entitlements.

3 – “As a percentage of GDP, the federal government’s public debt has doubled over the last 30 years, to 53% of GDP,” including underfunded entitlements and other liabilities, “. . . gross federal debt accounted for 94% of GDP in 2010. The public debt to GDP ratio is likely to triple to 146% over the next 20 years, per CBO . . . By 2037, cumulative deficits from Social Security could add another $11.6 trillion to public debt.”

4 – “Last year’s interest bill would have been 155% (or $290 billion) higher if rates had been at their 30-year average of 6% (vs. 2% in 2010). As debt levels rise and interest rates normalize, net interest payments could grow 20% or more annually.”

5 – “By 2025, entitlements plus net interest payments will absorb all - yes, all – of USA Inc.’s revenue, per CBO.”

6 – “The low personal savings rates of average Americans – 3% of  disposable income . . .  limit flexibility, at least in the early years of any reform.”

7 – “The ‘management team’ has created incentives to spend on healthcare, housing and current consumption. At the margin, investing in productive capital, education and technology – the very tools needed to compete in the global marketplace – has stagnated.”

In conclusion she remarks, “With these trends, USA Inc. will not be immune to the sudden crises that have afflicted others with similar unfunded liabilities, leverage and productivity trends. The sovereign credit card issues in Europe suggest what might lie ahead for USA Inc. shareholders – and our children. In effect, USA Inc. is maxing out its credit card. It has fallen into a pattern of spending more than it earns and is issuing debt at nearly every turn . . . Past generations of Americans have responded to major challenges with collective sacrifice and hard work. Will ours also rise to the occasion?”

As investors we are challenged to integrate the wisdom and analysis presented in these informative documents. In my opinion the central thought behind Ms. Meeker’s facts and Mr. Buffet’s optimism is an assessment of the quality of management. In this case can one invest in a subsidiary of USA Inc., a corporation domiciled in the US who must pay taxes, employ workers and support their families, if the parent company, USA Inc., is managed by executives (our political branch) who have a terrible track record of financial performance? Furthermore, is the very structure of the organization of the company (our government) designed to allow for the very radical decisions necessary to succeed? Are incentives in place which allow for long term thinking at the expense of the short term? And have the shareholders (US citizens) put themselves in the type of position to endure short term consequences? Until some of these questions can be answered with far less speculation it would seem wise to focus a little more on the facts and a little less on the potential.

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.

HUMMONEY - Increasing Risk Through Diversification (Perspective)

by Greg Lewin

I have been a professional investor since 1982 and I thought it may be useful to pass along an early observation which greatly influenced my thinking. I was reading an article by an economist from MIT published in the early 1980’s which examined theories of stock market diversification. He concluded that when holding a diversified selection of 10 stocks you achieved over 90% of the benefits of portfolio diversification. Additionally, as you grew the number of stocks held beyond 10, those benefits diminished rapidly. A second important insight provided by this particular study helped reorient my thinking. The author then went on to point out that another fundamental characteristic of a diversification portfolio is that it will perform increasingly like the underlying asset it was designed around. Therefore, a portfolio of 10 diversified stocks will be highly correlated to the actions of the stock market itself. In other words, with 10 or more large stocks in hand you will act and feel a lot like the market in general.  

Now this influences some very fundamental thinking when managing financial assets. First, diversification is most probably the primary tool advertised by financial advisors to manage risk. So given what we just learned, if I, for example, were to postulate that the stock market was to decline 50% would you be managing your risk if you were essentially mimicking the stock market? I think the answer is clear. Diversification across asset classes - a house, gold, bonds, commodities, art, stocks, etc. - is much more relevant as a risk management tool versus diversification within the stock market. Although I will offer that over the years the correlation among asset classes is increasing super fast and thus this form of diversification may also prove less valuable in reducing risk.

My position is not to totally squash this concept, rather, to put it in better context when analyzing advice and strategies. First of all, I would like to think my advisors have thought things through rather than just regurgitating finance 101, when in fact this could lead to some pretty sobering consequences if markets fall. Second, it should help explain why most money managers perform similarly to the overall stock market, but trail miserably when fees, expenses and taxes are included. Diversification can actually be a bit of a ball and chain. However, I believe many advisors and money managers intentionally use diversification strategies to ensure they never really deviate from the crowd. This has always been a reliable way to keep your job. I am just not sure why it should help you keep your client? We may now know why such luminaries as Warren Buffet have been the biggest advocates of undiversified portfolio thinking.   

The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.    

HUMMONEY - The Crisis of our Confidence (Perspective)

--By Greg Lewin

 “Nothing is more dangerous than an idea, when it is the only one you have.”   Emile August Chartier

As the financial crisis unfolded and policy actions were chosen the mission was clear: increase economic activity, repair the housing market and get people back to work. Step One involved the transfer of many of the troubled assets (bad decisions) from the balance sheets of the banks to the balance sheets of the federal government. Step Two was to institute a series of stimulus measures which included numerous tax incentives and some make work projects. Step Three, called QE2, involves a two part process ultimately leading to the injection of money into the stock and commodity markets to create what is called the wealth effect in the hope of stimulating spending and therefore growth. We have written about these subjects in the past and encourage your review should you wish more detail. Although this story has been broadly reviewed, we suggest one important subtlety has often been overlooked - the use of leverage as a deliberate policy choice.

In Step One assets flowed from the banks to the government, thereby deleveraging the banks. Now as assets are flowing back to the banks in Step Three, in the form of cash, the banks are once again free to employ the leverage they were unable to use when burdened with troubled assets. Federal Reserve policies have essentially lowered interest rates to zero, forcing investors, including banks, to seek returns in more speculative assets, such as stocks and commodities, rather than fixed return instruments like bonds.  The basic business model of all banks is the liberal use of leverage, which has generally ranged from 10 to 30 times their capital bases.  So now after capital was recycled from the banks (who were burdened with troubled loans that could not sustain more leverage) to the government and back again to the banks essentially in the form of cash, the banks are able to back the deployment of this cash into the stock and commodity markets with their customary leverage.  As if by magic, leveraged capital is thrust back into the markets without repairing any of the problematic assets that were the genesis of our problems.  It should become a little clearer why the markets have exhibited such consistent strength since the inception of QE2. We have once again employed our traditional weapons of leverage and speculation to address our financial problems.

But the magic does not stop there.  The market operatives can apply a special sauce to effectively increase their leverage on market behavior to create the results they desire. One of the fascinating features of financial markets is the power of the marginal dollar. What does this mean? Let’s use the stock of IBM as an example. IBM has a market capitalization of over $200 billion and trades approximately 4 million shares per day. At a price of $160 per share that suggests 4x160 or $640 million of stock trades on an average day, or 0.032% of the total value of the company.  Yet consider how often you see IBM change well over 1% and on occasion as much as 5%.  This impact on the overall value of this gigantic fixture of American business is as much as 30 to 150 times greater than the proportional value of the shares traded. How can this happen? It is beyond rare that any single piece of information that could possibly arise on a given day could alter the destiny of such a large and great company to this degree. Because the vast majority of shares do not trade on any given day or for that matter series of days, the point being made is that marginally traded shares have incredible power over the fundamental value ascribed to businesses of any scale. Let me assure you our 30 to 150 times example gives us ample room to support our assertion should we be referencing days of unusually large volume. And this is by no means fictional value. The price of one’s shares can impact the cost of raising capital, the ease of recruiting and retaining employees and the ease of gathering new business as a strong stock price influences the perceptions of customers regarding the health and vitality of an institution. To further add to this brew I can also share that the way the Fed advertises when it injects cash in the system allows sophisticated traders to create the vast portion of the stock price move for the day in very small windows of activity. So often this marginal dollar impact is not a matter of the daily shares but a few minutes of the day’s volume and shares making this marginal dollar effect that much more powerful. As a final point let’s add one last twist. What if instead of just buying stocks and commodities our new speculative dollars go into futures contracts, each of which represent hundreds of shares of the underlying assets being traded?

Well you get the point.  Our government has once again figured out a clever way of using financial markets to try to repair fundamental problems. You might argue that no one seems to get hurt and maybe it will help us get out of this mess. If we are lucky that may be the case, but a lot of us were taught that you usually don’t get something for nothing, and this is where the laws of unintended consequences sometimes raise their head, otherwise known as Black Swans. In this case, one could argue that is exactly what we are beginning to see, because along with QE2 we have seen the enormous spike in commodities prices across the board from agriculture to energy. And it is these very spikes in costs which have pressured the costs of living around the world that may have been a catalyst to the activities we are now seeing spread across the Middle East. So my caution remains, beware when you have one idea, especially one which has such a dubious record of success. 

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.

HUMMONEY - Seduced by Language (Perspective)

- by Greg Lewin

We so often get in the habit of being channeled by the media into narrow-band thinking. Language enters the mainstream and from it commentary and analysis evolves.  Take a recent contribution to our investing lexicon: de-risking. 

What does that mean and where did it come from? Does it imply that we know what represents risk at all times, therefore, we always have the antidote handy? Does it mean that we should actively seek risk in and of itself at times? Quite frankly, I’m pretty sure it means that when you charge fees this high in the financial industry for investing, and you don’t know what to do you better come up with a far slicker name than `I’m selling stocks and putting it in cash’. But the danger of this new nomenclature is that it creates a new normative around which investment discussion begins, and the surest way to come to a poor conclusion is to start with a faulty or misleading premise.

Another widely misused term in investing is - value. It is often used to not only support its presence but to rail against its absence. The notion of value is often reduced to small themes such as simple financial ratios, to define its boundaries and to divide those who have it from those who don’t.  It is in fact the simplicity of these arguments that form the core of the danger for investors.

Value: (def.) attributed or relative worth, merit or usefulness. To start, the definition as presented by Random House seems neither specific nor narrow.  So let’s try to dissect how Wall Street wants us to proceed. Value investing tries to suggest a pattern of stock selection which identifies that which is mispriced relative to worth. Often this includes stocks selling at low multiples of earnings, book value or sales relative to perceptions of worth in the future. Why should we allow this term to be so narrowly bounded?  If one is a value investor does that imply others are not? Can you tell me the investment strategy that actively dismisses the search for relative worth?  So the question is, what is value?

To define what is currently of value one must best identify future worth. So let’s say you are an amazing biologist and know enough about the science of a particular disease to predict the worth of a particular company’s science in the cure of a serious disease. Might that highly priced stock nevertheless still be a potential value? In this case, although the financial metrics of a stock may appear rich they in fact could be attractive and therefore it is fair to argue this particular investor to be a value investor.

It is my contention that all investors are value investors.  In fact it would be insane to presume they were not. It is a simple matter of how they see the future and how their investment will be valued as events unfold. Now even if this argument were accepted, the “true” value investor would argue against its broad application, seeking defense in the thought that true value investors limit their risk. So now we must ask, how can one measure risk?  I presume risk control is what is necessary when things go wrong.  For example, investors with Bernie Madoff did not forecast theft when evaluating risk and therefore predictions of value turned out a bit askew.  So if by definition things are not as planned how can you begin to redefine worth?

I would contend that value is not a style or class of investments, but rather an ongoing process, one which actively monitors and analyzes facts in the context of a well organized plan. But the real intent of this article is to shake investors from conventions created by the misuse of language. Language can effect perceptions which then impacts behavior which ultimately leads to risk. The investment puzzle is complex enough. Try to detach yourself from the noise created by the media and Wall Street to find the best path for your investment success.     

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.

HUMMONEY - Short Term Mindedness (Perspective)

photo courtesy Washington Times- by Greg Lewin

Since Ben Bernanke, the Chairman of the US Federal Reserve Board, announced his new program of Quantitative Easing at the Jackson Hole Economic Symposium in late August 2010 called QE2, the stock market has had a dramatic change of fortunes, turning a 2010 January – August  loss of 5% into a roaring 18% gain.  Now it is true that it can be misleading to attribute specific moves in the markets to any single event, but in this case the correlations look extremely strong and in fact can be traced to daily interventions conducted by the Fed in the markets that have led, by some measures, to a rally of unprecedented strength, length and consistency. Therefore, it behooves us as investors to examine this program and its merits a little more closely.

QE2 is a rather simple policy that effectively exchanges higher yielding assets held by banks and replaces them with lower yielding assets. So the Federal Reserve takes on the obligation of an interest paying obligation and the bank now must look for another way to create returns lost. The catch is that in the process the Fed in effect has created a low to no interest rate environment and the only place for investors to locate returns is by accepting higher levels of risk than those often found in fixed rate instruments. If we examine the overall picture of economic health since the inception of this program we see little uniform relief. Many measures have continued to deteriorate such as employment and housing and others such as real GDP (when stripped of government stimulus) and credit have at best stagnated. Therefore, by definition, if fundamentals are little changed and investors are accepting more risk by exchanging fixed rate investments for equity investments they are in effect speculating and this is never healthy.

The original quantitative easing program which began in the heart of the financial crisis was a $1.7 trillion program focused on bringing stability to the free falling mortgage-linked debt markets and thereby aiding the banking system. In contrast, QE2 had been launched with the hope of stimulating growth. But close examination may raise important questions about the impact of this growth.  For the 2 clear areas of economic growth we have seen over the past 6 months have been the price of stocks and the prices of commodities and these 2 asset classes lead to very different and troubling outcomes.

Since we know that 10% of American families control approximately 90% of investible assets, stock market gains are clearly concentrated in the hands of the few. Assuming these are the families least likely to be suffering the stress of the financial crises, it can be assumed that this incremental capital is likely saved or spent on highly discretionary purchases, not necessarily the investments necessary to drive employment and business formation. However, if we look at the other alleged by- products of the Fed’s promotion of speculation, investments in commodities have led to steep rises in commodity prices such as gasoline, home heating fuel, agricultural products and a whole host of metals. Different than stock price appreciation we know that these price increases directly and disproportionally impacts those already in stress.

So we seem to be walking down a path we have walked before. As we review earlier policies of financial intervention, complaints were loud and clear that the banks got relief that they used to rebuild their health and wealth (bonuses) while the individual and small business owners floundered. And now much of the same (albeit with slightly different actors) seems to be taking place. When does the failure of these policies to address the real issues of employment, growth and inequality begin to stress the economic platform on which we all dependent?

Long term investing is predicated on a sound alignment of fundamental progress and stock price movement. Therefore investors must judge whether the policies driving our stock market movements are worthy and sustaining.              

 ---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.