1. Black box finance. In our latest letter, we described how financials led the market for the first quarter and yet, we reminded clients that we don’t own any depository financials.  We wrote:

“As we hinted in our first page introduction, we are not particularly bullish on depository financials (i.e. banks).  The community banks have too much capacity, significantly limiting growth.  The large ‘money-center’ banks are subject to vast new legislation by the name of Dodd-Frank that we believe will significantly reduce their returns relative to historical trends.  In addition, the big banks are essentially black boxes.  They may trade below stated book value, but does anyone, including the CEOs and CFOs of these immensely complex institutions with their myriad derivative positions, really know what book value is?”

If yesterday’s revelation by JPMorgan CEO Jamie Dimon regarding unforeseen trading losses in their risk management group is not enough empirical evidence to close the case on our point, we don’t know what is.

With highly levered banks, the black box could include positions that completely wipe out equity holders.  This thinking on “money-center” banks is not new – we’ve continually emphasized it in both written and oral communications with clients for several years.  All investors need to cope with uncertainty but our primary objective is to protect capital, so if there is a meaningful possibility of total loss we will pass. This framework is a hallmark of our investment process. We participate when the range of possible outcomes are all positive, or (for very small positions) when the probability weighted expected outcome is very high.  Potential returns between 6% and 12% (see Excelon), are acceptable.  Potentially being wiped out is not.

2. Jamie Dimon. Jamie Dimon remains an impressive leader.  Frank, tough, and seemingly fair, he has built a career and a bank by methodically putting one foot in front of the other, taking the long view, and (for the most part) acting conservatively.  There is a positive potential outcome of this event.  If this causes Mr. Dimon to recognize the vast gulf between a 2 trillion dollar bank’s operations and his ability to monitor and control these operations, this event will guide the direction he takes the bank.  JPMorgan would become a better institution.  In addition, there is some chance that his approach to this issue will further enhance his stature as a banker and a leader.  His frank mea culpa yesterday was a start in this direction.

3. Ben Bernanke. The primary culprit here does not receive a JPMorgan paycheck nor work in Manhattan (or London).  Rather, his check is signed by Uncle Sam and his office is at 20^th & Constitution Avenue in Washington, DC.  While it is still unclear exactly what positions JPMorgan held and holds in its CIO office, financial repression a la Ben Bernanke is likely the root cause of JPMorgan’s current mess.  The “London Whale’s” trading activity was just a natural reaction by a profit seeking financial institution to zero interest rates.  Bernanke dangled the bait and the whale took it.  The Federal Reserve has stated that a primary goal of their financial repression is for investors to “step out on the risk curve” (i.e. microscopic Treasury bill yields force investors to take risk to increase their yield; moving to longer durations, corporate credits, equity, leveraged derivatives, etc.).  Like all central planners before them, this Federal Reserve ignores the law of unintended consequences at citizens’ peril.

The information contained herein should not be construed as personalized investment advice.  Past performance is no guarantee of future results.  There is no guarantee that the views and opinions expressed in this blog will come to pass.  Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors.  Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

At a current price in the mid $38s, we think Excelon Corporation (EXC) provides investors a steadily growing 5.4% dividend yield with a “free call option” on rising power prices.

With the just completed acquisition of Constellation Energy, EXC became the largest power retailer in the United States.  At $38.50 and a dividend of $2.09, the stock trades with a 5.4% current yield.  The dividend is well covered with estimated trough 2012 earnings of $3/share (a payout ratio of 70%).

EXC is essentially two distinct businesses.  The first is a regulated utility that earns a fixed return.  The second is a merchant power generator that sells power on the open market.  EXC’s power generation is primarily nuclear.  With current power prices near multi-year lows, we expect one third of 2012’s earnings (and half of EBITDA) to come from the regulated utility side of the business.  This is a very stable, slow growth business.  The regulated utility will likely earn a 10% return on equity (set by regulators) and grow earnings at 5% a year through growing its “rate base” (i.e. property, plant, and equipment).

Absent any improvement in power prices, we would expect to earn a 6-12% annualized total return on our EXC investment.  Current market expectations for future power prices and the extent to which EXC “locks in” their future selling prices will determine where in the 6-12% range our returns fall.  If future power price expectations were to match today’s low levels, our return would be closer to 6%.  If EXC were to “lock in” their sales at today’s future price expectations (the market expects prices will be higher next year and the year after), we would earn closer to 12%.  Either way, this is a significantly better return than we expect from the S&P 500 from the current, 1400 level.  We would also expect the business to be less volatile than the overall US economy and the stock’s price level to be less volatile than the S&P 500.  EXC fits several of the “high-quality” business dynamics we described in our fourth quarter 2011 quarterly letter.  But that is not the end of the story.

Power prices are near multi-year lows primarily because natural gas prices are at multi-year lows.  Natural gas provides the majority of peak usage power in the US and thus determines domestic power prices.  When demand for power increases above a certain threshold, natural gas power plants come online and provide power.  Nuclear is one of the lowest cost sources of power and thus when power prices increase, EXC’s margins expand.

Natural gas prices are at multi-year lows because of the recent shale gas revolution.  In the mid to late 2000s, entrepreneurs and engineers discovered technology and techniques to extract significant quantities of gas from sources that were never accessible before (cost effectively).  This has led to a massive increase in natural gas supply as lessees were required to drill in order to hold leases (even if the drilling was not economical).

Commodity prices typically trade at their marginal cost of production.  Reasonable estimates of all in cash costs for natural gas are closer to $6/mmBTU than the current $2.50/mmBTU spot price.  We believe there are three primary drivers that will lead to higher natural gas prices over the next few years:

1. As leases become established, uneconomical drilling will likely stop.
2. When new Environmental Protection Agency (EPA) rules go into place in 2015, a large number of old coal-based power plants will become uneconomic and thus come offline.  This will increase demand for natural gas.
3. When the economy begins to recover (albeit very slowly by our analysis), a rise in industrial production will also increase the demand for natural gas.

Increased power prices could easily lead to $5/share earnings for EXC and a stock price of $50-60/share.

Outlook:  long EXC.

The information contained herein should not be construed as personalized investment advice.  Past performance is no guarantee of future results.  There is no guarantee that the views and opinions expressed in this blog will come to pass.  Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors.  Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.

I recently had a “shopping” experience that has caused me to really question the economics of big box retailers.  Like many men when it comes to shopping I am more of a hunter than a gatherer.  When I need something I find my prey, I hunt it down and metaphorically kill it.  I do not spend any time looking around for other bargains or do much comparison shopping.  Until now.

With the advent of the internet, comparison shopping that once took hours can now be accomplished in minutes, from the comfort of your home or office.  My recent experience involved the purchase of a cordless phone system for my home.  Specifically we needed a two-line cordless phone system that would support multiple handsets.  I found myself at Staples for another reason, and the phone display in the store triggered me to recall our need and take a look.  A sales associate quickly approached me and asked about my needs.  Of the two options I was considering he gave his opinion and helped me make my choice.  In the process I was thinking I should check on Amazon to see what the price differential was, but I decided to buy first and then check.  In this day and age how much different could it be?  Everyone on the planet is aware of online commerce, right? Retailers have their own online capabilities, and are certainly aware of the price competition.  I decided that if it was $10-15 difference the convenience of the store would be worth it.  I also had 14 days to return the items.  Boy was I wrong.

The items I purchased from Staples for $230 ended up costing me $168 on Amazon.  Part of the difference was taxes, most of it was price.  As an Amazon Prime member shipping was free, so you might add some small shipping cost to compare apples-to- apples.  No matter how you slice it the difference is dramatic.  My cost was $62 less on Amazon for the identical items.  Put another way, the cost at Staples was 37% higher than Amazon.  No contest.  The items were returned to Staples before noon the next day.

The full impact of the shift to e-commerce has not yet been felt.  As time goes on, the first place people will look for items will be the internet, rather than as an alternative.  Granted, the online experience is not appropriate for all types of purchases.  If you are uncertain about size or fit, returning items can add to the cost and be a hassle.  But ultimately the lower cost will erode the already thin profit margins of big retailers.  Big box retailers will require less floor space and possibly fewer locations.  Retail real estate will need to adapt.  Investors need to consider this with every potential purchase.

*This discussion should not be construed as a recommendation to buy or sell Staples or Amazon.

November 23, 2011

Dear Client,

We recently changed your account’s core money market (i.e. “cash”) fund to a US Treasury money market (symbol FDUXX).[1] Our reason for doing so is rooted in safety and prudence but also in the belief that when we do take risk, we must be adequately compensated.

Money market funds’ exposure to short-term European debt is significant. The Wall Street Journal reported in June the largest US money market funds held roughly $1 trillion of debt issued by European banks. The low interest rate environment has squeezed money market funds’ ability to cover their management fees and expenses, encouraging them to “reach for yield.” Unfortunately, this reach for yield has not accrued to investors as evidenced by the uniform yield profiles across money market funds regardless of composition. This results in an asymmetric distribution of risk and reward for investors.

ZIRP[2] has artificially depressed interest rates and changed the economics of operating money market funds. While these instruments have never been large profit centers for the companies that offer them, they were largely self-sustained. With yields at record lows however, they have instead become a cost center as funds are unable to cover their expenses and fees. Funds are mitigating this, albeit marginally, by seeking higher returns while not passing through the incremental yield to investors. To illustrate this, below we provide information as of 10/31/11 for the Fidelity US Treasury Fund and the Fidelity Cash Reserves Fund. The latter is Fidelity’s largest money market fund.

Fund Name (Symbol)	7 Day SEC Yield (%) With Subsidy[3]	7 Day SEC Yield (%) Without Subsidy
Fidelity Cash Reserves (FDRXX)	.01	-0.03
Fidelity US Treasury Fund (FDUXX)	.01	-0.61

Source: Fidelity Investments

The second column shows both funds offer the same return: 0.01%. The holdings of the funds however, are different. FDUXX is invested, as of 10/31/11, entirely in US Treasury securities or repurchase agreements for those securities. FDRXX on the other hand holds a variety of non-US Treasury securities including certificates of deposit and commercial paper issued by European banks, among others. Given the current environment, we believe that US Treasury securities are “safer” than European debt, be it sovereign or corporate.[4] The question then becomes, why would FDRXX, which invests in higher yielding debt, offer the same return as FDUXX which invests entirely in US government debt? The third column shows the yield that investors would have obtained in the absence of subsidies. The lower the value, the more money the fund company has to spend in order to make investors whole.[5] By investing in higher yielding paper, FDRXX lowers the cost to the fund sponsor to preserve $1 NAV per share. This works out for the fund sponsor but not for the investor who still receives the same paltry yield the US Treasury fund offers although with higher risk.

To be clear, we are not sounding the alarm bells and calling for financial Armageddon. However, a fundamental cornerstone of our investment process is taking calculated risks that we are compensated for. This is simply not the case here, where investors are undertaking greater risk yet receiving the same return offered by a US Treasury money market.

As always, if you have any thoughts regarding the above ideas or your specific portfolio that you would like to discuss, please feel free to call us at 1-888-GREY-OWL.

Sincerely,

GREY OWL CAPITAL MANAGEMENT, LLC

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[1] The symbol for the Treasury fund is FDUXX.

[2] Zero Interest Rate Policy

[3] SEC 7 Day Yield is the average income return over the previous seven days, assuming the rate stays the same for one year and that dividends are reinvested. It is the Fund’s total income net of expenses, divided by the total number of outstanding shares. This yield does not include capital gains or losses. Yield without Subsidy is the Class’s SEC 7 Day Yield without applicable waivers or reimbursements, stated as of month-end. Waivers and/or reimbursements may be discontinued any time. All yields are historical and will fluctuate.

[4] “Safer” in this context means lower credit risk. Because these funds hold very short maturity paper, there is al very little “interest rate” risk should US interest rates normalize.

[5] A negative yield would result in the fund’s NAV dipping below $1/share causing it to “break the buck.”

The S&P 500 peaked this year on May 2^nd at 1371 (intraday).  The current selloff began on July 7^th just slightly lower at 1356 (again, intraday).  From the close on July 7^th through today’s close (August 8^th), the S&P 500 (as measured by the SPDR S&P 500 ETF)(1) was down 17.20% on a total return basis to 1119.

While the media has recently been filled with stories fomenting panic (about the European debt crisis, the recent US debt-ceiling political argument, and now S&P’s lowering of the US’s credit rating) and suggesting all sorts of portfolio strategies, the time to prepare for increased volatility and lower equity prices was long ago.  These crises did not appear out of thin air and are not really crises in and of themselves.  Rather, they are symptoms of underlying issues that have been building for some time, in plain sight.  The Fed was trying to trick investors with zero percent interest rates into ignoring the problems, but eventually that had to give.

We have long been advocating portfolios built primarily around higher quality investments and reserving some cash or “dry powder” for a time when securities would likely sell at better values.  Our rationale was based on the following:

• Broad equity market valuations were and are too high.  We discussed a basic methodology for valuing broad markets in detail in our fourth quarter 2009 letter when the S&P 500 was also in the mid-1100s.
• Developed market sovereign debt has reached unsustainable levels relative to GDP which will likely lead to increased volatility and inflation (though deflation is a potential too).  We discussed the issues of sovereign risk in our first quarter 2010 letter.
• The US economy has been supported by fiscal and monetary stimulus and will atrophy when the steroids are eventually removed.  Our first quarter 2011 letter tells this story in pictures.

While the last month is merely a short battle in a long war, we are pleased that our typical equity (or “risk”) account’s losses  were limited to 10.65%(2) during this period; only 62% of the S&P 500’s 17.20% loss.  An important element to increasing long-term compounded growth is to minimize drawdowns.  Our equity portfolios have behaved as designed.

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1. The SPDR S&P 500 ETF (“SPY ETF”) is used for comparing performance on a relative basis. There are significant differences between the SPY ETF and our accounts, which do not invest in all or necessarily any of the securities that comprise the SPY ETF.

2.  This is an intra-month estimate reflective of one account invested in our model and is not representative of all clients. While clients were invested in the same securities, this performance does not reflect a composite return.The return presented is net of all adviser fees and includes the reinvestment of dividends and income. Clients may also incur other transactions costs such as brokerage commissions, custodial costs, and other expenses. For the most recent performance, please visit www.greyowlcapital.com or call us at 703-459-9400.

THE RETURN SHOWN REPRESENTS PAST PERFORMANCE AND IS NO GUARANTEE OF FUTURE RESULTS. NO CURRENT OR PROSPECTIVE CLIENT SHOULD ASSUME THAT FUTURE PERFORMANCE RESULTS WILL BE PROFITABLE OR EQUAL THE PERFORMANCE PRESENTED HEREIN.

Microsoft (MSFT) is as out of favor as out of favor can get.  Apple adds “i” to the word “Cloud,” talks about it at a developer conference, and Steve Jobs is on the front page of the Financial Times.  Microsoft releases the fastest selling operating system of all time (Windows 7) and then the fastest selling consumer device in history (the Kinect) and newspaper editors and investors alike just yawn.  Microsoft can’t innovate, Steve Ballmer inherited a great company but hasn’t really done anything to move it forward, and he allocates capital poorly with dumb acquisitions (Skype) and silly R&D projects (Kin One and Kin Two).

Despite this, or perhaps because of it, we think Microsoft is a spectacular investment opportunity.  We have owned Microsoft for several years, trading around the position multiple times.  Today it is one of our largest positions.  We articulated our thesis at length in a recent quarterly letter.  In this brief post, we want to take a look at the claim that Mr. Ballmer has been a poor allocator of capital.

Last week, David Einhorn presented his investment thesis for Microsoft at the Ira Sohn Conference.  He was bullish on the stock.  He said it is very cheap on both an absolute basis and relative to the market and yet the business is outperforming the average S&P 500 company by a wide margin.  Mr. Einhorn believes Microsoft is cheap for a reason.  He argued that the number of poor capital allocation decisions on the part of Steve Ballmer has overwhelmed the superior operating performance and good decisions that have been made.

It seems clear that Steve Ballmer IS an “overhang” on the stock as Mr. Einhorn phrased it.  The stock would likely appreciate if he was to move on.  However, the question of whether Mr. Ballmer truly is a poor capital allocator seems less obvious to us.  Remember, it isn’t his fault that the market irrationally bid the stock up to a PE of 70 right when he took over as CEO.  So, you can’t judge him on stock performance alone.  In addition, we think that the sheer size of Microsoft can cause confusion.  Skype may or may not turn out to be a good acquisition.  If it is a mistake, the $8.5B price would seem to make it a big one.  But, it is only 4.5 months of free cash flow to Microsoft.  What has Mr. Ballmer done with the rest of Microsoft’s cash?

From a base of $10.5B in 2000, Microsoft grew free cash flow (i.e. operating cash flow less capital expenses) to $22B in 2010.  This is a CAGR (compound annual growth rate) of 7.7%.  The total free cash flow generated over this ten year period was $155B.  During that same period, Microsoft returned to shareholders $142B in cash via dividends and stock buybacks.  In other words, Microsoft returned 92% of all the cash they generated to shareholders!

Let’s now use this information to perform a brief thought exercise.  Today, you can purchase Microsoft stock for $24/share or you can buy the entire company for $203B.  Imagine you were to buy the entire company today.  Next, imagine that Microsoft were to grow free cash flow at the same rate for the next ten years that it did for the previous ten years.  This means the firm would generate $360B in free cash flow over the next ten years.  Given the firm’s historical need to retain very little capital, further imagine that 92% of all cash generated was returned to shareholders.  Let’s assume it is all in the form of share buybacks so we don’t need to worry about taxes.  At this point you would have received 1.6x your money back AND you would still own the entire business that is Microsoft:  whatever it is that becomes of a cloud development platform (Azure), software as a service (Office 365 and Dynamic CRM), home entertainment (XBox, Kinect, XBox Live), etc., etc.  Hmm… maybe Mr. Ballmer has presided over some innovation.

If those are the available investment dynamics, one could certainly do much worse.  Perhaps that is exactly Mr. Einhorn’s point.  If you buy Microsoft today, you likely get the above investment dynamics.  You also get a free call option on Mr. Ballmer’s departure.

 

The information contained herein should not be construed as personalized investment advice.  Past performance is no guarantee of future results.  There is no guarantee that the views and opinions expressed in this blog will come to pass.  Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors.  Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.

A recent Wall Street Journal article highlights the macro-driven nature of today’s stock market.  In it, long-time value investors lament the current environment where stocks appear to trade in unison based on unemployment data or European bank stress test results.  If stocks are driven by macro factors instead of individual company fundamentals, stock pickers can’t get an edge.  Market strategist James Bianco of Bianco Research asserts “stock picking is a dead art form.”  Macro hedge-funds are opening at a rate equivalent to that of traditional stock funds and the big asset management firms are even launching macro mutual funds.

We think stock-picking is very much alive.  In fact, we recently wrote a 20-page investment guide that details a bottom-up approach for today’s environment.  Call us contrarian, but we couldn’t think of a better sign than this article that fundamentally-driven, bottom-up stock-picking is likely to make a comeback sooner rather than later.  Didn’t the commodity bubble burst right around the time that the asset management firms were rolling out a new commodity fund or ETF every week?  Moreover, didn’t “the death of equities” cover stories in the early 1980s signal the start of a 20+ year bull market for stocks?

The Wall Street Journal article presents data that shows the correlation of stocks in the S&P 500 between 2000 and 2006 was 27% – quite a bit of disparity indicating undervalued stocks could appreciate and overvalued stocks could depreciate as opposed to trading up or down in unison.  The article also points out that correlation spiked to 80% during the credit crisis and again more recently during the European sovereign debt scare.  As these issues petered out, correlations never dipped below 40% and today hover around the mid 60s.  However, the article does not point out the length of time over which the correlations were measured – days, weeks, months?

The time period over which the correlation is measured is critical.  “Time arbitrage” has proven to be a very effective investment strategy.  Who cares if individual stocks are correlated over days and weeks when your investment horizon is years?  Glenn Tongue (one of the Ts in T2 Partners along with Whitney Tilson) highlights this fact in a recent appearance on Yahoo! Finance.  Like us, the partners at T2 believe buy-and-hold stock picking is far from dead.  Mr. Tongue also makes a critical point about matching the duration of the investment strategy and the investors.  This is why we work very hard to ensure our investors understand our process before they become clients.

Don’t misunderstand our view.  We agree the data shows a significant increase in correlation between individual stocks (and we witness this as we watch the market and our individual names on a daily basis).  We also agree that the macro backdrop driving the market will remain for some time.  The over-leveraged PIIGS, US federal and local governments, and the US consumer will likely take years to adjust to sustainable levels.  In addition, the massive government intervention in fiscal and monetary policy does not appear to be subsiding with Bernanke and company preparing for QE2’s maiden cruise.  (We have discussed these issues at length in several of our recent quarterly letters.)  The market will certainly react to macro factors over short time periods, but that doesn’t mean significantly undervalued stocks or significantly overvalued stocks won’t gravitate toward fair value over a longer period of time.

In our recently published investment guide titled How to Prosper in Volatile and Range-Bound Markets we detail the strategy we are employing to deal with the current environment.  We believe a concentrated portfolio will be more likely to outperform – a few deeply discounted names that are returning capital to investors (via share repurchases or dividends) and that also have a catalyst can outperform even if the majority of the market moves in unison.  In addition, the flexibility of corporations to deal with macro shocks (be they slower growth, inflation, government regulation) means equities have a better chance of outperforming government bonds, currencies, or commodities (areas macro funds are more likely to play in).  Finally, we think valuation-based timing will be more important than it has been for traditional stock pickers.  While Japan’s macro-driven market now trades at close to a quarter of its peak value 20 years ago the market experienced four rallies and five sell-offs of greater than 30% over that period.  That type of volatility creates terrific opportunities for value investors to increase exposure as the macro shock of the day creates fear and to pare exposure as the fear fades away.

For a more detailed overview of our approach, you can download our full 20-page investment guide here:  www.greyowlcapital.com

While the increasing role of transfer payments to shore up personal income and stabilize consumer spending has long been recognized by the more circumspect economic observers throughout the recent recession and “recovery,” the observation has now gone main stream.  Last week, the USA Today ran an article titled Private pay shrinks to historic lows as gov’t payouts rise.

Those questioning the veracity of the term “recovery” as it applies to the current economic situation in the United States (or at least those who question the strength and sustainability of said recovery) point to the fact that absent transfer payments, real personal income is stuck at a trough level.

Why is the source of personal income important?  Earned income (from wages or investment yield) allows people to save, invest, and consume.  The government can also redistribute a portion of this income to others who are not working so that they too can save, invest, and consume.   Absent sufficient tax receipts, the government can borrow money in order to make transfer payments.  However, the government can only borrow and transfer for so long.  Eventually there needs to be real productive work that can be taxed in order to pay back the debt.

The USA Today article does a great job of presenting the facts and then presenting opinions on the implications of the facts, overtly mentioning the political orientation of the person opining.    Talk about fair and balanced.

Paul Van De Water, an economist at the liberal (the USA Today’s word choice, not mine) Center on Budget and Policy Priorities, argues that the system is working as designed – “stimulating growth and helping people in need.”  If that is the case, one would expect to be able to look at a historic chart of transfer payments and see them increase during recessions and decrease afterward.  80 years of data show that about half of the time, this is true.  However, the same 80-year chart shows a secular increase in the percentage of personal income coming from transfer payments and a mirror-image, secular decline in the percentage of personal income coming from wages.

The rapid rise in gross public debt shows that the latest increase in transfer payments is not being funded from tax dollars, but rather from borrowing.  It will need to be paid back.

Keen-eyed readers will note that the current level of gross public debt is not unprecedented.  A similar debt spike occurred in the 1940s as the government borrowed money to fund our efforts in WWII.  However, some of this spending built infrastructure and manufacturing assets that were later retooled from war use to productive commercial use.  One can’t say the same of transfer payments that mostly fund consumption.  Perhaps more importantly, the gross public debt in the late 1940s was near an exhaustive accounting of public debt.  Today, there is an order of magnitude more debt ($100T) held “off balance sheet” in the form of “unfunded liabilities” for future promised transfer payments.

It is unclear if we have reached a tipping point, but we know for sure we grow closer by the day.  Uncertainty abounds – investors must remain nimble.

On Monday, a bipartisan group of 130 members of the U.S. House of Representatives sent a letter to Treasury Secretary Timothy Geithner and Commerce Secretary Gary Locke urging the agencies to use “all available resources” to end what they view as damaging currency manipulation by China.  The full text of the letter can be found here:  http://wallstreetpit.com/19954-china-manipulates-its-currency-say-130-congressmen

The letter states “By pegging the renminbi (RMB) to the U.S. dollar at a fixed exchange rate, China unfairly subsidizes its exports and disadvantages foreign imports”.   True, but who do they think is benefiting from the subsidy?  The congressmen are overlooking the fact that by allowing Chinese manufacturers to sell goods for less it allows American consumers to BUY goods for lower prices.  It is the U.S. consumer that is ultimately receiving the subsidy, not Chinese manufacturing companies.  Be careful what you wish for: a higher RMB/USD exchange rate would lead to higher real costs for all U.S. consumers.

These Congressmen are playing up to concerned workers, while ignoring the fact that every single one of their constituents that purchases goods made in China benefits from this subsidy.  The letter states that “China’s exchange-rate misalignment threatens the stability of the global financial system by contributing to rampant Chinese inflation and accumulation of foreign reserves.”  Where do they think the inflation will go if not to China?  It would stay here, is where.  In 2009, the U.S. trade deficit with China was $226 billion.  Personal consumption expenditures were a bit over $10 Trillion.  So, the trade deficit with China was 2.2% of personal consumption.  If the RMB were to appreciate by 20%, it would amount to an increase in costs of $45 Billion or .4% of personal consumption.  This back-of-the-envelope calculation indicates that a 20% increase in the RMB would increase consumer price inflation by roughly .4%.   Be careful what you wish for: a higher RMB/USD exchange rate would lead to higher inflation in the U.S.

The direct assertion of the letter is that if the U.S. places tariffs and regulations on China then the goods being manufactured there will be manufactured in the U.S. and put unemployed workers back to work.  In reality the U.S. and China are not the only place where commerce can flow.  In all likelihood, restricting the flow of goods from China will lead to those goods coming in from other lower cost countries like India, Mexico, or Malaysia.  Are we then going to place tariffs and restrictions on imports from EVERY country in an effort to reduce unemployment?  This might be popular with the press, but it would  act like a large tax on consumers.

The final unintended consequence of pushing the Chinese to revalue their currency relates to the large “accumulation of foreign reserves” by the Chinese.  China has used $889 Billion of their reserves to purchase U.S. Treasury obligations, making them the largest foreign holder of our debt.  This is up from $739 Billion just one year ago.  In the absence of China’s willingness to acquire our excessive debt, the United States would have to pay higher interest rates to attract other lenders.  Be careful what you wish for: a higher RMB/USD exchange rate would lead to higher risk-free interest rates, which impacts rates for almost every borrower.

In summary, strong-arming China to revalue their currency, while perhaps politically popular, would have several adverse unintended consequences: higher real costs, higher inflation, and higher interest rates.  We say, let the Chinese continue to peg the RMB to the U.S. dollar.  On balance it is considerably more helpful than hurtful to the U.S. at China’s expense.  Be careful what you wish for.

This past Saturday, Warren Buffett released Berkshire Hathaway’s 2009 annual report and his annual letter to Berkshire shareholders.*  The last Friday in February has become like Christmas Eve for value investors the world over.  A night of tossing and turning is followed by a mad rush to the computer to download the latest version at 8am on Saturday morning.  And then, maybe 30 minutes later, melancholy as we all realize that Mr. Buffett won’t write to us again for 365 days.  As admirers of Mr. Buffett, frequent shareholders, and practitioners of the “value” approach to investing, you could count us among the sleep deprived on February 27^th.

Given Berkshire’s recent (and massive) acquisition of Burlington Northern Santa Fe, Mr. Buffett chose to make this year’s letter a primer on the various Berkshire business lines, as well as his value-oriented approach to investing.  Here are a few thoughts on areas we found particularly interesting:

• Berkshire’s stated book value was $84,487 / share (page 3).  Investments totaled $59,034mm with a cost basis of $34,646.  If one were to mark these investment to market and then subtract 20% for capital gains taxes (estimate of federal and state), Berkshire’s book value is just over $97,000 / share.  As of the close on March 2, 2010, the stock traded at $121,740 or 1.26x “adjusted” book value.
• Mr. Buffett has always shunned excessive leverage and talked about its many risks.  He often admits that during good times the company’s equity might underperform more leveraged entities.  “Sleeping well at night” is the reason he usually provides for this strategy.  True enough, but 2008 demonstrated that over a full cycle, low leverage entities such as Berkshire can outperform because they are able to provide liquidity precisely when no one else can and in doing so receive outsized compensation.  As he writes on page 4 of the letter, “When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant.  At the very peak of the crisis, we poured $15.5 billion into a business world that could otherwise look only to the federal government for help.”
• The 17^th century philosopher Frederic Bastiat spoke of “what is seen and what is not seen” in regards to the unintended consequences of laws on the economic sphere.  Mr. Buffett recognizes similar risks in over handed management and thus promotes an organizational approach at Berkshire that is as laissez-faire as the political approach recommended by Bastiat.  On page 5, Mr. Buffett states, “We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy.”
• In the Insurance section beginning on page 6, Mr. Buffett states the two critical aspects of the insurance business:  1) fairly unique in business, insurance operates on a “collect-now, pay-later model” and thus requires “negative” working capital – called “float” and  2) because enough people have recognized how favorable these economics are, the insurance industry as a whole operates at an underwriting loss.  Berkshire offers shareholders a unique proposition:  the firm has demonstrated an ability to invest the “float” in a very profitable way AND because of the superior managers and compensation structure the Berkshire insurance companies operate under, the firm has consistently operated at an underwriting profit.
• In the Utilities section, which begins on page 8, Mr. Buffett provides insight into why Berkshire is now willing to own such capital-intensive business when in the past they avoided them.  Two explanations are given:  1) today, Berkshire is so big that Mr. Buffett has no choice but to look at opportunities he would have passed on before and 2) given the regulated nature of utilities, Mr. Buffett seems to believe that he is trading some investment upside for greater certainty.  This makes sense to us.  Other investors and financial writers (including Whitney Tilson) have articulated a third possibility:  because Berkshire pays a “negative” rate on its borrowings (i.e. “float”) investments that would be unprofitable for others can be profitable for them.
• The housing market makes its way into the letter on page 12 in the Finance and Financial Products section.  Given the lowest-in-fifty-years 2009 housing start number, Mr. Buffett believes that “within a year or so residential housing problems should largely be behind us.”  While he is correct in stating that 2009’s 554k starts is well below the 1.2mm annual housing formation number, we think his optimism might be a bit premature.  The recession has probably lowered the annual housing formation number and published inventory numbers are too low when bank “real estate owned” is considered.
• Mr. Buffett then discusses the structural problems at Clayton Homes that are a result of the government’s housing finance policy.  The government artificially lowers the interest rate for conventional mortgages.  Therefore, when financing is considered, a traditional home can be cheaper than the manufactured houses sold by Clayton.  Mr. Buffett doesn’t say this but this is another example of Bastiat’s “not seen.”  It also reminds us that in the current climate, government interference must be a part of the investment calculus.
• Berkshire is unlikely to experience the damaging impact of “group think.”  In describing Berkshire’s derivative contracts, Mr. Buffett (on pages 15 and 16) assures shareholders that these contracts neither expose Berkshire to extreme leverage nor to counterparty risk.  “If Berkshire ever gets in trouble, it will be my fault.  It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.”
• Mr. Buffett concludes the financial section with a well-deserved excoriation of financial company CEOs and directors.  However, regarding his defense of investors against the “bail-out” claim, we offer one final quibble with Mr. Buffett.  He states, “Collectively, they [shareholders of the largest financial institutions] have lost more than $500 billion in just the four largest financial fiascos of the last two years.  To say these owners have been “bailed-out” is to make a mockery of the term.”  If he is using the term “owners” very explicitly, then, with the exception of Bear Stearns shareholders, perhaps he is correct.  However, he leaves out the fact that bond holders of these same insolvent institutions, who knowingly assumed the risk of capital loss, were in fact bailed out to the tune of hundreds of billions of dollars and made whole by taxpayers.

That wraps up the highlights as we see them.  However, the whole letter is well worth reading and it is available here:  http://www.berkshirehathaway.com/letters/2009ltr.pdf

*This discussion should not be construed as a recommendation to buy or sell Berkshire Hathaway.