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.

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.

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.

Unfortunately, in many ways Japan does appear to be a reasonable corollary.  Post World War II, from 1950-1970, Japan’s GDP grew at a real rate of 8.4% annually on a per-capita basis.  It slowed to a still stellar 4.1% rate from 1970-1990.  Then, the bubble burst and from 1990-2004 Japan’s economy grew at an average rate of 1%.  The Japanese market’s slow bleed has led to a -6.4% annualized return over this period.

What happened?  Similar to what we just experienced in the US, the late 1980s in Japan saw monetary inflation that led to tremendous asset price inflation in both residential real estate and equity markets.  The government reaction after the bubble burst was very similar to the US government’s reaction to date.  The Japanese government propped up insolvent banks and built bridges to nowhere.  It redistributed existing wealth rather than allowing creative destruction to work its magic by purging excess and encouraging new development.  While Japan did use monetary policy to combat deflation, it was far less aggressive than the US has been to date and a period of mild price deflation has persisted.

The economic ramification of the analogy are clearly quite negative, but there are several additional insights investors might find useful:

• Valuation matters.  Despite very poor overall stock market returns for the period of -6.4%, our friends at the Applied Finance Group demonstrate here (slide 15) that investors who purchased the “cheapest” quintile of stocks each year were able to achieve a 6% positive return thus beating the “market” by over 12% annually.
• Overvaluation, leverage, and excessive government intervention lead to volatility.  Volatility creates opportunities as the following graph shows with the Japanese market experiencing 5 sell-offs of greater than 30% and 4 rallies of greater than 30% over the twenty year period.
  
• Unlike Japan, the US Federal Reserve has an incentive-caused bias to inflate.  One might conclude that Japan got mild deflation because that is exactly what they wanted.  Japan is a nation of net-savers, while the US is the largest debtor nation.  Savers loath inflation because the value of their bond coupons become less and less valuable.  Debtors love inflation because the value of their debt is less and less.  (Now, before one concludes that the Fed’s aggressive monetary policy will be our saving grace, it is important to remember that real growth is all that matters from the standpoint of wealth and improved living standards and all that inflation achieves is nominal growth with the very negative side-effect of mal-investment.)

In conclusion, we think that while not a perfect analogy (owing to distinct demographic, immigration, and consumer behaviors to name just a few differences), the last twenty years in Japan provide a very useful template to inform current investment decisions in US markets.  We believe a process that is oriented toward value investing, displays the patience to wait for the market to present opportunities, and is mindful of the damaging impact of an unstable currency has the potential to offer both positive absolute and relative returns in even these very challenging conditions.

Mr. Grant continues by pointing out that inhospitable government action does not provide a reasonable argument against a snap-back, as the mid-30s showed four years of close to 10% annual expansion despite Roosevelt’s anti-business activities.  In addition, the combination of government fiscal and monetary stimulus this go-around is 19.5% of GDP compared to the average recessionary government response that has measured just 2.9% of GDP.

Mr. Grant finds himself in good company.  Close to the market trough in April 2009, Ben Inker of GMO published a piece titled “Valuing Equities in an Economic Crisis.”  The crux of this piece is that it is relatively easy to value a broad index given the long-term stability of the economy.  The US economy has always gotten back to its long-term growth trend following recessions, including the Great Depression.  Mr. Inker points out that the 1929 25% fall in real GDP “was a fall in demand relative to potential GDP, not a fall in the economy’s productive capacity, and so the economy eventually got back onto its previous growth trend as if the Depression had never happened.”

These arguments certainly have merit.  Not only do they come from some of the investment world’s preeminent thinkers, they also make logical sense.  However, from an investment process standpoint they highlight a common analytic error:  focusing on experience versus exposure.  (This is the same analytic error that led people to believe that because country-wide housing prices had never fallen on an annual basis, they never would.)

Which leads us to ask the question, what is our exposure if we follow this line of thinking?  Most importantly, these analyses focus on the US economy.  (Mr. Inker does make reference to the rebound of Japan and Germany post WWII, but not much detail is provided and like the US period cited, these were 20th Century industrialized economies.)  Interestingly, Samuel Brittan wrote a piece a couple of weeks ago in the Financial Times saying “Goodbye to the pre-crisis trend line” citing an IMF analysis that included a much broader swath of global recessions.  Mr. Brittan points out that this analysis tells a far different story from Mr. Grant’s and Mr. Inker’s:  “much of the loss of output in a severe recession is permanent and that the economy never gets back to its old trend line.”

In conclusion, while Mr. Grant and Mr. Inker may be proven correct and the US may experience an extraordinarily powerful recovery to match the recent downturn, making a binary investment decision based on that hypothesis does not take into account one’s exposure.  (If looking beyond the US, it does not even appear to take into consideration experience.)  With total US debt still at very high levels and anemic fixed private investment (to name just two systemic issues), betting on a strong economic recovery based solely on the depth of the slump does not appear to us to provide a necessary “margin of safety.”

1. Regarding specific investments where he ignored the macro-picture (i.e. the housing bubble).  “The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture.”  Einhorn goes on to say that this does not mean that individual security selection is irrelevant, but rather that an investment process that combines top-down and bottom-up analysis is best.
2. On why politicians are continuing to kick the can down the road regarding the nation’s fiscal imbalance.  Two basic problems with our government: a) the need to get re-elected (or stay appointed) makes politicians short-term oriented and b) special interests drive the agenda because the benefits of their initiatives are concentrated and the costs are spread out so much that no individual feels too much pain.
3. On the right approach to the economic crisis and an alternative theory for the 1938 double-dip recession.  Einhorn points out that GDP grew 17% in 1934, 11.1% in 1935, and 14.3% in 1936, yet the current powers that be warn that removing stimulus too soon caused a double-dip recession in 1938.  His theory:  “An alternative lesson form the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial.”
4. On the results of the government’s largess.  “I believe that the conventional view that government bonds should be ‘risk free’ and tied to nominal GDP is at risk of changing.  Periodically, high quality corporate bonds have traded at lower yields than sovereign debt.  That could happen again.”

The full speech is worth reading and is available here.

The article goes on to define “good” using several metrics.  One metric is the amount of leverage a firm has – low is good, high is bad.  The higher the leverage, the greater the possibility the firm goes bankrupt and the future cash flows don’t occur.  So,  based on this definition of “good”, a “good” stock should have a higher price and a lower return.  Think about it this way:  A given firm’s equity should have a higher return than the same firm’s debt because (among other reasons) the debt gets paid first and therefore has a higher probability of being paid.  All else being equal, a firm with lower leverage has a smaller chance of bankruptcy than a firm with higher leverage and thus a greater probability of paying the expected cash flows.  Thus, the risk premium should be lower and the expected return lower for a firm with less leverage.  The article highlights empirical evidence that bears this out.

Here is where it gets scary:  When asked about this issue, professional financial advisers gave diametrically opposed answers depending on how the question was asked.  When asked if they required a higher rate of return for a stock with higher leverage, 86.2% of advisers said yes.  When asked if they expected a higher rate of return for a stock with higher leverage, only 12.5% of advisers said yes.  Advisers are clearly prone to many of the same behavioral biases that affect laymen.

Two important conclusions can be drawn from the article:

1. Aspects of the stock market are NOT efficient.  When professionals answer the same question regarding valuation with opposite answers depending on how the question is framed, mis-pricings will abound.
2. When seeking investment advice:  caveat emptor.  As the article states, “avoiding investment mistakes is one of the leading reasons for using the services of financial advisers.  The value added from the advice, however, is compromised if the advisers are subject to the same biases as the individual investors.”

It is mathematically correct that if a 1% position goes to zero the overall portfolio only loses 1% of value, whereas a 5% position could cause a 5% loss of portfolio value.  However, a 100 stock portfolio may only be more diversified than a 20 stock portfolio in the number of company names it holds, as opposed to diversified from true risks.  It comes down to what you are trying to diversify and why.  Imagine recognizing in early 2008 that the financial sector was overvalued and significantly over-leveraged.  If you built a 20 stock portfolio with no financial sector exposure based on this belief, your 20 stock portfolio would have significantly outperformed the 500 stock S&P500 index during 2008.  True risk would have been diversified away.

Thinking about investment diversification based on number of investments alone is a mental crutch and a poor risk-management tool.  One needs to look at a broad spectrum of potential economic factor risks (i.e. risks that can truly impact the intrinsic value of the security you own), as well as market risks and diversify exposure to the most likely and the most potentially harmful.  A few examples of what we would consider relevant risks to diversify are:  capital structure, inflation sensitivity, supplier, consumer, and legislative exposures.

Before we dig deeper into the application of duration to equities other than bonds, we need to take a brief digression for a quick refresher on asset valuation.  In a pure sense, investments are worth the net present value of all of the future cash flows the investment will provide.  The net present value is calculated by discounting each of the individual cash flows back to today using some interest rate.  If my discount rate (or interest rate) is 5% and I am going to get $100 tomorrow, what is that investment worth to me today?  $95.24.  Here’s the math:  $100/((1.00+5%)^1).  So, we can think about duration as the impact of changing the discount rate we use to calculate the net present value of an asset’s future cash flows.

With that background, let’s take a look at how duration applies to equities.  Equity investments have a much longer duration than fixed income investments because there is no set date for a return of principal.  An equity investment’s dividends could continue to grow and pay ad infinitum.  Therefore, equity investments are much more sensitive than fixed income investments to changes in the discount rate (i.e. the interest rate as described above).  Within equities, a stock that pays a very high dividend and whose price implies little growth (e.g. Altria, MO) will have a much lower duration than an equity that pays no dividend and whose price implies substantial growth (e.g. Google, GOOG).

As we articulate in our most recent quarterly letter, we believe the current economic environment has the potential to leave corporate earnings volatile for some time and to increase the volatility of inflation, both of which could lead investors to increase their discount rate.  So, all things being equal we believe equity investments that pay high dividends compared to those that pay no dividends and whose prices imply very high growth will outperform the overall stock market.

To illustrate why the duration on an equity is much higher than that on a bond, let us look at a couple of examples.  First, assume we are talking about a Treasury bond with a 5% coupon and 5 years until the bond matures.  Also, assume that the risk-free interest rate is currently 5%.  As illustrated in the table below, the net present value of that bond is 100.  We get to this value by discounting the bond’s annual coupons and the final return of capital at the risk-free rate.

Basic Bond Example

Now suppose we purchase that bond for 100.  Immediately, new economic news comes out and the risk-free interest rate moves to 6%.  How much is our bond now worth?  The answer is 95.79(1).  The following table illustrates the changes in the value of the discounted cash flows based on the new 6% discount rate, as opposed to the old 5% discount rate.

Bond Example with Increased Interest Rate

Now that we have seen why a change in interest rates changes the value of a bond, we turn to an example of an equity.  Below, we model an equity investment that pays a 2% dividend which we think will grow at 3%.  The risk-free rate is back to 5%, but now we add in a 3% equity risk premium.  The net present value calculation tells us that an investment with these characteristics is worth 63.91.  Notice that the cash flow for the residual value is highlighted.  Unlike a bond, an equity investor is not promised a return of principal.  The residual value of the equity that exists beyond the 5 year period we have chosen to model is just the present value of the future dividend stream that we can expect a new investor to pay.  (The formula for the residual is a perpetuity:  dividend/(discount rate – growth rate).)

Basic Equity Example

Rather than change the risk-free rate, we increase the equity risk premium in the final example below to demonstrate that an equity investment with these characteristics has a duration of almost 25.  A 1% increase in the equity risk premium changes the net present value of the investment to 48.03.  (48.03 is 25% below 63.91.)  Notice how sensitive the value of an equity investment can be to the discount rate.  Valuing an equity investment is a very imprecise process which is why it is important to have a very large margin of safety (i.e. an undervalued asset) before making an investment.

Equity Example with Increased Risk Premium

In conclusion, we believe the concept of duration is just as relevant when thinking about equity investments as it is when thinking about interest rate risk and fixed income investments.  For a more detailed analysis of the impact inflation has had on the equity risk premium, review Ed Easterling’s work here.  For further reading on equity duration, both Ben Inker of GMO and John Hussman of the eponymous Hussman Funds have explored this concept as it applies to the overall stock market.  Their analysis is worth reviewing.  If you would like to play along at home, you can download the spreadsheet model we used in this analysis here.