Monday, November 24, 2008

Lazy Man's Diversification, Part I: Berkshire Hathaway

Visitors to The Jaded Consumer will doubtless have noticed me pointing out the views of Warren Buffett in connection with timing purchases, choosing an investment horizon, and deciding where the economy is going. One thing not much discussed is how to make money off Buffett's own investment decisions. So, how can you do it?

There is a very simple way to bet on the judgment of Warren Buffett, and to obtain a low-overhead, nicely-diversified portfolio of investments in the bargain. Buy Berkshire Hathaway.

For the bargain investor, the route is surely to buy the B shares, a class of shares with reduced voting power designed to enable retail investors to participate without forcing them to cough up something on the order of six figures per share (that's excluding any decimals). The B shares have traded from over $5000 apiece to just $2000, and are currently trading at $3300 (though when I started writing this piece, the number was actually $2500, sorry I was so slow on the draw). There is no dividend, because that would result in company profits being taxed twice before potential reinvestment: once when earned by the company, and once when paid to shareholders as a taxable dividend. Berkshire Hathaway shares are to be held not for income (which is zero) but for capital gain; The Jaded Consumer does not advocate trading, has no advice on trading, and has no idea how to time investments, and thus suggests BRK.B for long term capital appreciation. A year ago I would have said BRK.B would allow one to invest money in a way that enables owners to sleep well at night and to avoid worry that some fluke in the credit or capital markets or in some particular industry would require sudden action on the part of investors, but let's face it: in the current economic panic environment, virtually anything is possible (especially if you are using leverage). If you avoid leverage like the plague, though, I give you this : BRK.B is a fully-approved Jaded Consumer fire-and-forget scheme for investing for the long term, so you can dedicate your time to having fun and earning your living and not wasting precious time following the markets.

Berkshire Hathaway's Class B shareholders are equity participants in the exact same way as the company's Class A shareholders, but the B shareholders have less fractional interest per share (and even less voting rights). There are two arguments why to buy Berkshire: it's easy diversity, and the thing is well-run.

At the time present management took control of Berkshire Hathaway, the company was principally occupied with U.S.-based textile operations. Its risk was concentrated in a dead-end segment, but management was able to obtain control at a relative bargain. Management began directing cash to investments with a brighter future, and ultimately exited the textile business altogether during the 1980s. Presently, Berkshire Hathaway is a holding company with significant insurance interests, which invests cash not needed for current and near-term obligations in a variety of businesses purchased on the basis of value. Unlike banks, which pay depositors and other creditors for the use of cash, Berkshire Hathaway's insurance business holds money for policy holders rent-free while awaiting the day a claim needs being paid. In short, Berkshire Hathaway has an enviably low cost of capital, and because much of its capital comes from insurance premiums, the company faces the possibility that an underwriting profit will enable it to keep some of the "borrowed" money permanently. This is like BRK.B getting to borrow capital with a negative interest rate. Cool, no?

Of course, underwriting losses are possible, too; however, Berkshire Hathaway makes a point of engaging only in risks that are farly comprehensible, and staying clear of unknown risks that have surprised some competitors over the years. An example is the asbestos liability that threatened the London syndicates who reinsured commercial liability policies; surely, they didn't anticipate assuming something like long-term personal injry risk arising out of workplace breathing conditions, so the syndicates got hammered, but when it came time to reinsure this risk someplace that would remove it from the London syndicates' books, Berkshire Hathaway was there with a modern understanding of the asbestosis risk and enough capital to reinsure the whole thing forever. And Berkshire Hathaway gets to invest that mutibillion-dollar premium while the risk overhangs the company.

Berkshire Hathaway also accepts some other risks. Berkshire Hathaway isn't afraid of risk, you see: it's afraid of uncertainty. A good bet is still a bet, and the year Katrina hit the Gulf Coast was rough. On the other hand, the next year was a bonanza. Over the long term, accepting good risks pays off.

So Berkshire Hathaway has a multibillion-dollar derivatives exposure. Although Berkshire Hathaway isn't subject to FAS-157 and need not write down (or up) its holdings' value on a quarterly basis, derivatives are treated specially and give rise to unrealized losses (or gains) that don't impact the company's taxable income or its cash flow or its liquidity, but do impact its SEC-reportable income. Berkshire Hathaway manages this risk in several important ways. First, there is no counterparty risk. The derivatives that impact BRK.B don't depend in any way on the solvency of any third parties. The derivative positions were created when third parties handed Berkshire Hathaway billions of dollars in options premiums, and Berkshire Hathaway has that money in-hand. Berkshire Hathaway thus enjoys the ability to invest the premium, and obtain a return on these funds, while awaiting the expiration date; it's just like much of the insurance Berkshire writes, offering a potential underwriting profit while enabling investment free of interest. A more accurate way to view the options is that Berkshire Hathaway has written a naked put on the S&P 500, and gets to invest the premium until the expiration date. The second major risk management strategy is that the option cannot be exercised except on the expiration date. Thus, the current market gyrations may send the theoretical value of the options all over the place, but they can't give rise to a realized gain or loss because they will not possibly expire or be exercised for years.

The short answer here is you get Warren Buffett. However, you do get more. This isn't just a portfolio of publicly-traded stocks, although Berkshire Hathaway does own large stakes in a bunch of publicly-traded companies. Coco-cola, Goldman Sachs, American Express, Carmax, Wal-Mart, Anheuser Busch, Burlington Northern Santa Fe, Proctor and Gamble, Johnson & Johnson, NRG Energy, Conoco Phillips ... lots of stuff. You can read up on it in the numerous articles by folks suggesting you follow Buffett into the companies in which Berkshire invests. The problem? Berkshire is a big buyer, and can get terms others can't. Berkshire's deal with Goldman involves a Berkshire-only 10% dividend preferred and a pile of warrants. Berkshire gets 10% indefinitely, with a "free" option to buy in case Goldman goes through the roof. They don't offer this kind of thing to you and me. They offer it to Berkshire.

Some Examples of Berkshire's non-public portfolio:
GEICO (a massive cash cow, and possibly already your auto or property insurer, having about 7.4% share of the auto insurance market);
Dairy Queen, of which Orange Julius has been a wholly-owned subsidiary since 1987 (since 1998);
Sees Candies (since 1972); and
Berkshire USA (this is a reinsurer -- the kind of company that ultimately holds risks insured by insurance companies; with revenues of $18 billion, Berkshire USA had about 10% of the US reinsurance business in 2007).

Berkshire Hathaway's insurance business had $118 billion in revenues in 2007. While Berkshire stands back, waiting to see whether it will face claims, it gets to invest the premiums in a diverse portfolio of profitable companies that create cash. Pretty good, eh?

Berkshire Hathaway's investment in Burlington Northern railroad is part of Buffett's long-term bet on the American economy. Buying Berkshire B shares is a way to get a diverse portfolio with low overhead, and a bite of some great companies you can't buy on your own. Since there's no dividend, the tax consequences of long-term holding are nil until you sell; if you plan to own it until you die, there's no need even to put them in a tax-deferred account.

Berkshire Hathaway is a big buy.

Tuesday, November 18, 2008

Pystar Gets Poured Out

The court hearing the Pystar case (in which Apple sued a white-box maker for selling Apple's operating system without an OEM license as a pre-installed product on a non-Apple computer) just summarily dismissed Pystar's antitrust counterclaims. The fact that there's a universe of competition, and that Apple has been forced to offer more and more product for the same money, and has to advertise to attract buyers and has little power to entrap users unawares all seem to suggest this other anti-Apple antitrust case stands in similar jeopardy.

New Star Trek Movie Approaching At Warp Speed, Sir!

I noticed a new Star Trek movie when I stumbled upon its virtually content-free trailers. They are big on emotive grip, though: images of sweating welders with a sound track of classic clips from the first years of the space program, with the camera slowly giving the image of an Enterprise under construction. Looking over the official web site (warning: Flash), I note that there's no information about the timeline, characters, etc. However, it seems suggested that the story will pick up with the launch of the first Enterprise crew we knew from the TV series, complete with Kirk, Spock, Checkov, etc. -- but ... younger.

As seen here, the director of MI:III and Lost seems to envision Sylar from the first season of Heroes as the proper model for Spock. A bit much emotion in that one-handed choke hold, though. He's supposed to be half-Vulcan, and passionless. Or maybe they are playing on the half that isn't Vulcan, and writing him as an on-the-edge head case who hasn't yet mastered the irrational impulses with which he is cursed by his unnatural heritage. According to the web site, we're supposed to find out near Christmas, or else 5-8-09 -- a suggestion that maybe they blew an initial release target and ended up in summer of '09, and didn't take the time to re-edit all that Flash.

Being long addicted, I'll definitely want to see more ....

Election? We Don't Need No Steenking Election!

Apparently members of the Senate haven't been reading the literature produced by their near neighbor, the United States Supreme Court. This Reuters article discusses the fact that both Democrat and Republican members of the United States Senate are in agreement that a convicted felon should not be permitted to take a seat in the Senate. According to Powell v. McCormack, a chamber of Congress lacks the power to refuse to seat a duly elected member who satisfies the age, citizenship, and residence requirements articulated in the Constitution.

Presumably they will seat him -- then promptly conduct proceedings to expel him. Of course, if they do this too quickly, the Senate could embarrass itself if his still-pending appeal succeeds in overturning his conviction.

Bah! What am I saying? A member of Congress, capable of being embarrassed?

Shameless, the lot of them. The fact a mere felony should cause members of Congress to be up in arms over one of their member is silly: Mark Twain explained Congress was America's only distinctly native American criminal class. Felony is part of the initiation ritual, I'm sure.

Maybe his sin was getting caught. But, no: members of Congress have been repeatedly spotted doing terrible things -- sometimes, with the vote of their offices -- with no ill effects.

Why not let this felon join their exalted ranks? A convicted felon in Congress would be something new for that august body: truth in advertising.

Fannie Mae Ga-Ga For Golf

After being bailed out by federal regulators and recapitalized with taxpayer dollars, Fannie Mae launched a $6,000 golf outing. Maybe not as offensive in cost as AIG's luxury getaway (which included over $20,000 in spa charges alone), Fannie Mae's may be more offensive in principle because -- with only 20 attendees of which several were Fannie Mae execs -- it's much less plausibly a training or marketing opportunity.

It's just a bit of fun on your nickel.

Okay, so it was a lousy six grand. But it adds up. And there's the principle of the thing.

It's not a new problem, it's just a problem previously never of much concern: jobs holding others' money tend to attract folks inclined to treat it as their own. You see it in the public sphere (such as in Congress, where Clinton's aides referred to earmark legislation as a privilege which she used effectively for her constituents, which leads one to wonder who she thinks her "constituents" are) as easily as in the private sphere. It's a classic agency problem. The kind of immunity to oversight with which we've inoculated our top agents seems to prevent them from having their interests aligned with those of the public (for organizations like Congress when they decide how to use money taxed from strangers) or the shareholders (for corporations whose managers aren't the owners).

Fueling Conservation

The recent drop in oil and fuel prices has raised a new question: will Americans' recent decreases in driving (which seemed to be a consistent phenomenon as prices rose) evaporate like gasoline vapors on a hot day?

The answer -- at least in the teeth of severe economic turmoil -- seems to be "not yet."

Of course, this isn't all good news. As Jenna Wade of Roseville, California explains:
Q: How have plunging gas prices changed your driving habits?
A: Not at all. I’ve no job to go to any longer so I no longer drive.
Of course, others simply see their reduced driving as a good habit worth maintaining, and a way to keep money in the bank.

Speaking of keeping money in the bank, some utility companies want to be paid -- just as they would be paid for delivering a kilowatt-hour of electricity -- for investments that help reduce consumer consumption of energy. Their argument is that conservation is capital intensive, and that utilities have a lower cost of capital, so they should be paid to deliver what consumers aren't necessarily in a position to afford -- but to be compensated for it. Depending on the lifespan of some of those improvements, and the accuracy with which savings can be modeled, that might make sense. On the other hand, efficiency that leads to excess -- making the house colder in the summer than previously, because the home holds more of the chill -- might not lead to net gains. There may be some expenses users don't care to avoid, if the total cost isn't big enough to them. The idea is interesting, but I'd like to see the math. And maybe a local demonstration project to see that it works on a city-wide basis, among people unaffiliated with the power company.

If we really can induce good energy practices, all the better.

One Laptop Per Child

If Microsoft had its way, that'd be one software vendor per child.

The One Laptop Per Child (OLPC) program, led by Nicholas Negroponte, is hoping to deliver budget laptops around the world to keep even low-income people abreast of modern technology and to allow them to leverage high tech to improve their lives. OLPC is, in essence, about trying to maintain the possibility of modern education in a world of scarce resources; it is an idealistic effort to provide the tools needed to make sure children can learn to use the tools that make the future possible.

Microsoft's efforts to get pre-installed status on the XO haven't been exactly smooth. OLPC, after all, reportedly rebuffed a no-fee offer by Apple to license MacOS X (whose open-source kernel is derived from the FreeBSD project to which Apple is a contributor, and the Mach project which Apple's retired Avadis Tevanian had nursed at MIT), purportedly because of non-open-source code also involved in MacOS X made the system politically unsatisfactory to OLPC. But apparently you can buy satisfaction. Microsoft, apparently concerned about a future in which discount laptops around the world would obsolete its proprietary file formats and render its high-margin products irrelevant, poured significant resources into a version of Microsoft-Windows designed to run on XO. Microsoft has insinuated its products into the OLPC program, even to the point of causing hardware modifications in OLPC in order to allow its enormous code to be stored and run on the machines. The fact that retail buyers in the US are not yet assured the ability to buy XO with pre-installed Microsoft products is of little concern to either Microsoft (which assumes you as an American can afford a costlier copy, and will do so on your next computer purchase) or OLPC (which is trying to look like an Open-Source advocate).

The fact that towns in Columbia have begun deploying Microsoft-Windows-equipped XO machines in schools (at least in part on Microsoft's nickel, hence the product placement opportunity) suggests that OLPC hasn't really stuck to its principled stance that recipients need to enjoy the Four Freedoms when they use and study software. OLPC is more interested in keeping its own project from becoming irrelevant through lack of funding. And there, OLPC and Microsoft can find common ground.

Monday, November 17, 2008

Citizens Clobber Klan

The Knights of the Ku Klux Klan suffered a potentially serious economic blow when a not-really-an-illegal-alien-after-all (an American of Native-American and Panamanian descent) victim of a serious 2006 Klan beating was awarded by an all-White jury a verdict finding him entitled to $2.5 million in damages.

The Klan's freedom to assemble cannot be lawfully barred, but the likelihood that the judgment will be levied against the the group's 15-acre compound threatens to reduce the local Klan chapter's convenience in conducting identity-building ceremonies, indoctrination rituals, and creating a feeling of reassurance that one is surrounded on all sides by likeminded believers.

People who think jury awards are somehow out of hand haven't been paying attention. Without juries to see the right of cases, we'd have to cede justice to an entrenched bureaucracy. Without punitive damages, people could commit calculated evils for fun or profit and remain safe from serious consequences so long as they were careful in selecting their victims. This Klan verdict is a reminder that there are evils in the world -- old-time evils we would like to think long laid to rest -- and that we need juries to spot when the line has been crossed and the public should inflict a punishemnt designed not only to repay injured parties for their medical bills, but to reform behavior for future generations, to protect victims who would suffer if the same calculations that caused earlier injury were not derailed and replaced with something more concerned about the welfare of others.

I doubt the $2.5 million judgment will be satisfied in full, but it'll likely be enough to ensure that all the organization's high-profile, hard-to-hide assets are transferred to parties aligned with the defendants' victims.

UAW to Gov't: Loan GM Money!

Keeping GM in business -- and any other large employer of its members -- is surely of considerable interest to officials of the UAW (which, interestingly, stands for International Union, United Automobile, Aerospace and Agricultural Implement Workers of America). The reason strangers need to loan GM this money, rather than the UAW or its members, is that they aren't looking to lose money, but to get paid. The union collects dues it spends, and the members collect paychecks they spend. They can't be throwing good money after bad, or it'd quick catch up with them. And they feel they've done enough already to support GM, thank you very much.

That is apparently why loaning money to GM is your problem.

My problem with loaning GM money isn't just that many of its cars are being thrashed in the market by safe, reliable, price-competitive alternatives. This is a problem of U.S. auto makers generally. GM's special problem is sort of interesting. See, GM has been mortgaging its future for a while now.

A few years ago, a friend explained what a smoking deal he got on his new Hummer. He was upside-down on his SUV note, and angry at the dealership, and they worked out a financing plan whose details blew straight past him, but what he remembers is this:
  1. his monthly payment didn't go up (though it was no doubt extended), but
  2. he swapped out his little SUV for a bright new H3, and
  3. GM promised him price protection on the H3.
That third point was the sale-closer. To make him feel confident entering a sale on a vehicle in which he was concerned his collateral would quickly be worth less than the note securing it, and to make sure he came back to GM, GM guaranteed him that it'd give my buddy a trade-in price on the Hummer that was equal to his purchase price. I forget how many years that deal was supposed to last -- maybe the length of his note, or a year after -- but it obliges GM to pay way over market for a used car down the road when it's hungry to sell him some new vehicle. The problem is that GM won't be able to raise prices across all its lines in the face of fierce price competition in the auto business -- certainly not during a credit-crushing recession that drives up unemployment. All that surplus trade-in value is coming right out of GM's future bottom line: right out of the recession-discounted givaway pricing I expect GM to fall into as part of its fight to retain some kind of sales share.

The problem with simply throwing money at GM is that there's no reason to expect different results from the same operations. It's not like auto sales are exploding so greatly that there's good money to be had by every vendor with a product. The auto market is competitive, and everyone in the market is selling a different grade of commodity. Even the luxury vendors are up against luxury competitors; nobody is safe, and nobody's product is so differentiated that it hasn't got competition.

In the 1980s, when the Japanese economic miracle was producing cheap, efficient, reliable cars that were actually beginning to take safety seriously, some folks looked at Japanese organizations to determine what enabled their success. Pursuing Deming's teachings and using a number of innovations to detect, eliminate, and prevent product defects, the Japanese learned to build American designs better than could Americans. Americans who thought implementing quality circles, mixing management and line workers in teams, and broad cross-training to enable people to understand the whole process of a product's creation all tended to run into the same problem: the UAW. Collectively-bargained contracts enforceable under the NLRA specified that certain job titles needed to exist, and protected people from doing jobs outside those descriptions. Allowing (non-union) management to perform line jobs threatened the dues base, and cross-training tended to make people more easily replaceable.


So American auto manufacturers kept with their same old broken systems, occasionally scaring workers into fits of relative productivity but not addressing the systemic issues that led to the defects that embarrassed the non-Japanese manufacturers. I heard a tale from the early 1980s of an observer of an American auto assembly line watching a worker stop bolting fenders onto the passing cars long enough for a couple to go by with no bolts at all on that side. Confronted with the fact, the worker allegedly explained, "I had to light a cigarette." The same collectively-bargained agreements that prevented radical organizational re-engineering also made it extremely costly to threaten a worker's job, so there was no recourse. Even if the tale was apocryphal -- and it may well have been, though it sounded plausible enough when I heard it -- the fact remains that Americans have been unable (despite the famed productivity of the American worker) to build automobiles with as few defects, or for as little money, as Japanese competitors. To the extent that organizational re-engineering was thwarted by job classification rigidity in union contracts, and employers' inability to create meaningful incentives to encourage production quality targets under the union contracts, the industry was essentially destroyed by factional infighting. In theory, management and labor could have worked out a scheme that enabled superior competition; however, to the extent the solution appeared to require blurring the line between labor and management, it was political anathema for a union to accept such a proposal. Labor and management knew better how to exist as adversaries than they knew how to both profit from cooperation.

And the chickens have come home to roost.

While the same political forces keep the business utterly broken, I strongly urge anyone with a voice to speak out against throwing the innocent public's hard-earned and quickly taken tax dollars at an enterprise with such dismal prospects for the future. Americans can make cars, of course -- and without GM, they might have made them even better -- but saving these dinosaurs might not be in anyone's interest. Much better that GM be allowed to go into bankruptcy where creditors can work out how to arrange a future for GM that involves some profit. Saddling GM with its existing array of obligations -- including the collectively-bargained labor agreements that prevent the kind of labor/management admixture needed to duplicate the successes of American firms' Japanese rivals -- is sure to kill further investment just as it has killed prior investment.

What American auto manufacturers and their workers need is an opportunity to begin again with a clean slate. Saddling employees with brainless zombie employers doomed by longstanding agreements to repeat the organizational failures of the last forty years -- or saddling employers with sure-fail organizational designs enshrined in 1950s-style collectively bargained employment contracts full of specialist job titles and limited work duties that preclude process re-engineering -- does no good for employees' job security or employers' fiscal plausibility. We need better than a mere handout to GM.

What we need may turn out to be is a creative bankruptcy judge. Anybody know one?

Saturday, November 15, 2008

Islamofascists Maybe Trainable After All

Muqtada al-Sadr is in the news, and it's not for renewed attacks by his Medhi Army. The Islamist has, instead, called for a peaceful demonstration against an Iraqi government agreement on the terms of U.S. military presence in Iraq, to take place following evening prayers.

Grand Ayatollah Ali al-Sistani, who didn't take sides when Hussein was being ousted by the United States, issued a slightly cryptic statement "forbid[ding] any stance that targets the sovereignty of Iraq no matter how small it is." It's unclear whether specific terms of the force reduction agreement offend al-Sistani as impugning the sovereignty of Iraq, although one lingering and offensive issue involving U.S. troops has been the power to try U.S. troops for activities within Iraq. Obvoiusly, United States officials cannot agree to turn American volunteer soldiers over to a nation with a recent history of protecting those who were engaged in murdering Americans for the crime of being American; however, Iraqi officials offended at the conduct of Blackwater contractors have a natural reason to demand meaningful accountability for the activities of armed foreigners roaming freely in their jurisdiction.

I assume that Americans won't be clearly subject to Iraqi civil and criminal authority under the terms of the agreement governing the draw-down and withdrawal of remaining U.S. troops, and that this alone is sufficient to offend al-Sistani. The presence of U.S. troops on any terms is, of course, a grave concern to al-Sadr, whose efforts to sieze power by naked force have been reeatedly thwarted by U.S. response.

The question remains whether al-Sadr will keep preaching nonviolent protest after Americans leave, or whether this is simply an ad campaign for future Islamist revolt against civil government. In the meantime, the plausible threat of force seems to be effective in dampening the overt threat posed by al-Sadr to the rule of law in Iraq. The fact that peaceful protest results in fewer deaths will hopefully not be lost on participants.

On the other hand, Fox News reports al-Sadr's actual position is that a new agreement on force deployment will be grounds to renew attacks. Maybe he hasn't learned his lesson, after all ....

Friday, November 14, 2008

Time Running Out To Ditch Unruly Teens

The safe haven law, intended to reduce risk to children by granting immunity to parents who deposit unwanted children where they will be safe at Nebraska hospitals, was apparently intended to target unwanted infants and wasn't expected to draw a wave of despairing parents of unruly teens to drive into Nebraska to rid themselves of their little tormentors. (Of the dozens dropped off under the law, none have been infants.)

Seeing what conduct the law actually caused, Nebraska's legislature has amended it, effective January 2009, to make the teen drop-off-and-drive-away a thing of the fond past. Time is running out! And so are some teens who realize they're about to be turned over to the State of Nebraska ...

So, beat the rush and dump those worthless ingrates sooner than later. Fuel is getting cheaper again, so there's no excuse for delay. Holidays can be expensive, and you know times are tough ....

Thursday, November 13, 2008

Reading Tea Leaves: Predicting Obama's Moves As President

Okay, I'm guilty: I've been looking at the news for indications of what to expect in January. And I've discovered something. There's no telling what we'll get in January.

Aim High
The Second Amendment crowd has been in the news snapping up firearms in the wake of the election that strengthened Democrat control of Congress and placed its legislation in a place of relative safety from Presidential veto. Are they justifiably afraid? Back in February, before the Supreme Court clarified the issue, Obama as the democratic nominee said at a Milwaukee event: "I believe the Second Amendment means something. I do think it speaks to an individual right." The idea that Obama has taken the view of the Second Amendment as creating an individually-enforceable right even before that view was declared to be the clear law of the land is something I doubt came through NRA advertisements about the impact of the election on gun control. Democrats have long worked to create window-dressing legislation to restrict transactions involving firearms, even in the absence of evidence that such laws had any effect at all on anyone except law-abiding collectors and sportsmen. The ban on so-called "assault weapons" (a definition unknown to the world of firearms until Congress created it, entertainingly including weapons with plastic stocks but not necessarily weapons with wooden stocks, for example) was an old favorite of the NRA: it made no sense and helped prevent no identifiable evil, but offended gun collectors. If this article is right, it'll be coming back, with Obama's support. The right to bear arms might mean something to Obama, but apparently not what the NRA thinks it means. The Second Amendment folks worried about Obama's calls while in the Illinois legislature for federal taxation increases of 500% on firearms and ammunition haven't led him to introduce any related bills while actually in the federal legislature. Although Obama mentioned gun control in his speech accepting the Democratic nomination, he didn't confess any particular policy objectives and could easily have thrown that in to mollify those wanting all the party planks polished rather than because it's particularly important for him to address.

My question: if you plan employing Americans in a venture that involves boating into pirate-infested waters, or territory perilously near drug runners, is there some reason Congress doesn't want you to have high-powered automatic weapons with which to repel would-be attackers on the high seas? Granted, this isn't the general case. But it is a case I've had to deal with recently, and it was entertaining to learn that the accepted solution was to buy a weapon on the black market in the vicinity of the work area. Buying one in the U.S., paying taxes on it, and lawfully exporting it seems too fraught with red tape to bother with. European manufacturers will be getting this security business.

The good news? "With the U.S. economy in a tailspin, however, the president-elect's advisers say gun legislation is not a high priority." Well, thank goodness for that!

Order Up
One quick thing to do is to obsolete offensive Executive Orders.

Abortion: Under Reagan, a "Mexico City" abortion policy was attacked through an executive order prohibiting funding organizations that perform or promote abortion overseas. The order was dropped under Clinton and re-instated under Bush. I want to hail pro-choice movement, but I hesitate to cheer a move like the one Obama is believed to support. My question is this: given our tight economic situation, and ignoring the question of whether abortions are or are not appropriate for any particular case, why would we use federal dollars to help send people abroad for medical interventions available virtually everywhere in the United States?

Birth Control: Another executive order brings crazy funding into sharper focus. An executive order bans federal funding to organizations like the U.N. Population Fund that operate in countries that practice forced sterilization. Exactly why does the United States need to solve foreign public health problems when we have a desperate need for public health programs in this country? Forced sterilizations are vile, period. Sure. But why do we need to single them out for special treatment, and to fund some alternative? Unless it's a national security issue to promote stability, and therefore a justifiable part of the budget of the Department of Defense, why on Earth would be be involved in other nations' family planning programs? We need some education and immunization right here, and we could fund it better if the local money for these interventions weren't taxed away to the federal level then exported to some distant land and squandered where it will create no U.S. jobs and improve the quality of life of no U.S. families. Oh, I get it: visiting Africa is nicer for U.S. tourists if we control overpopulation there. Hello? Operator? I have found a brain, is someone missing theirs? I think there's a serious opportunity here to start looking at U.S. involvement in foreign charity conducted by federal officials using funds taxed from Americans by force. (To the bleeding hearts who disagree taxes are taken by force: try not paying it and see how long you can go without experiencing force. Hint: if you resort to lying about your income to avoid detection when you neglect to pay the taxes, that is cheating.)

Gitmo: Oddly, Obama sounds remarkably like Bush on Gitmo's on-base prison. He'd like to close it down, but he wonders what to do with its residents. He's going to have to spend a while reviewing their cases, and might set up some kind of tribunal that hopefully passes Constitutional muster. Ahem. Did I miss something here?

Oil: Drilling agreements in federal lands in Utah and other places beloved by environmentalists could be halted by the same kind of executive action that set exploration into motion. Well, assuming there's not already an enforceable contract, in which case you buy a lawsuit as you do it.

Stem Cells: An executive order barring use of federal funds for creating new stem cell lines from human embryos was entered by Bush43 out of pro-life concerns that each new attempt would end a human life. (At least, for some people's definition of human life; many reasonable people have not decided that a frozen embryo whose owners don't plan to use it, and won't be paying for its maintenance, and which might as easily be lawfully disposed of as medical waste and destroyed without contributing to a scientific study, is "human life".) Due to the creeping federalization of everything under the sun, it turns it that developing new medical therapies that can be sold for profit, and conducting research into treatments for human health conditions for which insurers and benefit plans routinely provide payment, are activities that are overwhelmingly intertwined with federal funding. This is so obviously an arena for health-related venture capital enterprises and state and private universities that take a share in the intellectual property created with university funding, that I cannot conceive of a reason the United States should risk federal funds without even a scintilla of a hope that the resulting findings will produce a return for the taxpayers whose money funds the elevation of the academic careers based on the research. The offensiveness of the executive order's impact on stem cell research was so great that California created its own multibillion dollar research program. This seems to undermine the very thesis that federal funding is required at all. Federal conditions of funding are obviously a political football -- in research as in education -- and should not be part of the American research landscape outside the limited scope of bona fide national security projects.

Real Change and Justice
One thing that can happen for the better is the appointment of an Attorney General who will restore to the Justice Department the nonpartisan ethic it once was felt to have. Ideally, an officer who believes in what the Constitution says and will stand up for those beliefs, even when under pressure by allies to do expedient things instead of good things. There's a serious opportunity to clean house in the Justice Department, and I for one hope this goes off like clockwork.

One thing to keep in mind is that the United States is an enormous employer, full of numerous bureaucrats that can't be fired at will (due to due process issues that don't face private employers in many parts of the country). A revolution at the federal level may involve long lag times between the initial acts of reform and the ultimate changes seen by people encountering the "new" government. The Justice Department, for example, will be run through with political recruits ideologically opposed to some of the changes that may be proposed. The INS, IRS, SEC, NSA, FBI, and numerous other agencies involved in surveilling Americans and their foreign dealings, and enforcing various interpretations of the rules governing the complex relationships people have in their business lives ... all these will have inertia and it could take a while for change to manifest even if initial efforts are swift.

The best case for quick change is high-profile change that makes clear not only to government agents but to the public that interacts with them what the new order of business is, so that nobody gets away with Old Business approaches once a new standard has been set. Unfortunately, the media won't be covering the details that will make the changes work. We run a risk that those implementing federal programs will either not be with the new program, or will be stuck with old rules that run contrary to the new program while waiting for legislative interventions that have not yet been devised.

Show Me The Money
With respect to the economy, there's some good news: the problem is so high-profile that it will get quick attention, and will be widely covered. Everyone will know what changes are afoot. Movement could be fast. However, as Buffett indicated, even doing everything right could leave considerable lag time -- many months -- while the effect of interventions ripple through the economic system.

Let's hope those initial steps are in the right direction, eh?

During the campaign, all the candidates said what they thought would get them into office. This isn't unlike Supreme Court nominees trying to give the right answers before being confirmed, after which they are free to do whatever pleases them until they hear their last case. If you give the right story, you eventually get a position from which you can pretty much do as you please and can't be removed until the timer rings. We therefore can't know what officials will do once in power.

However, we have a pretty good idea (a) what each party argues for, and (b) what the specific players have advocated. Still, this makes for a bad set of tea leaves: once in, they're free.

Also, to the extent Congress must create new positions, authority, or funding to make a solution work, the President needs to get a consensus from folks who may want quite different things. There will be quite a bit of salesmanship and arm-twisting. What we get on the other end of the sausage machine is hard to guess.

The really good news is that, unlike other countries that have sporadic revolutions, nobody was killed in ours. Even if this goes into the toilet, we will be in a position to start replacing officials in a mere two years. The Republican Party, whose high-profile and wholesale betrayal of its small-government and pro-individual rhetoric caused it to be driven from office in a major rout, will be hard at work trying to find something relevant to offer Americans, and the fallout should include some improvement in the public examination of our fiscal policy.

It's too much to hope Americans stay serious about their concerns over government -- already, they don't care how the Congress votes on issues -- but perhaps we can drive attention toward major economic issues and keep them in the spotlight long enough to make sure they don't become political casualties.

Wednesday, November 12, 2008

Responding to ACAS 3Q Comments

Thanks for showing up and taking the time to comment. The third quarter definitely got people's attention, and mostly for the worse. ACAS presented today at Merrill Lynch, and you can catch both the presentation and the Q&A on webcast. Make sure to look at the slides.

Kawa asked:
I thought a company incurs a liability when the board declares a dividend; so even though the record date of Q308 dividend is in October, I still expect to see a dividend payable line in its balance sheet dated 9/30/08. In the conference call when being asked, they replied that GAAP doesn't require it, but the analyst can do their on calculation and trade the stock themsevles; I'm a bit concerned/confused why they choose such response.
I was sort of surprised that when this question came up, the discussion turned to a discussion of materiality. I think the questioner and the answerer were talking past one another. I certainly can't explain why the questioner was fixated on an unpaid future dividend that had not gone ex- by quarter-end when he seemed to agree it wasn't an enormous amount of money, or why it was important to the questioner that management express an opinion on accounting that might be required under Delaware law. I also can't explain why -- other than hypothesizing unpreparedness due to surprise -- management chose to tell the analyst to go build his own pro forma financial statementss and to value the stock on their basis if he didn't like the accounting ACAS believed required by GAAP. I tend to suspect management didn't understand the question as having any purpose than to allege the balance sheet understated liabilities, which would explain why materiality would be offered as an argument and why home-made pro formas would be offered as a solution.

My own take is that everyone is probably right. Different accounting is used at different times for different purposes. Tax accounting is rather different from the accounting that is used to gauge internal performance (some of this internal performance accounting, particularly within portfolio companies, might not even use currency units as its functional unit of measure), and the accounting required by the SEC is surely different than the statutory accounting that might be required by Delaware law. With respect to state-law accounting schemes, I offer a little perspective: insurers are required to apply a statutory accounting scheme that values assets with huge discounts to the values of liquid investments. This doesn't mean that the insurers must report these values when filing GAAP financial statements with the SEC, this simply means that the insurers must balance their books with the statutory accounting tools and have these books ready in case they are demanded by someone making a lawful request for inspection of the state-law accounting. You probably will never see these accounting products for any insurer, because they are different from the accounting required by the SEC and aren't required to be made publicly available. It's not fraud, it's just different accounting. Indeed, publicly-traded companies don't show the public the tax accounting they do, and they all do tax accounting in addition to the SEC-required disclosures. Moreover, if investors reading financial statements filed with the SEC expect the statements to be comparable, it's important that some standard -- even one with clear flaws -- be used across the board. No matter what Delaware would want an accounting produced (say, in litigation over the value of a closely-held corporation) with one set of rules and effective dates for future payment obligations, it's clear that whatever standard obtains with the SEC is what should be in SEC-filed statements.

I don't pretend to have special expertise in accounting for future dividends -- I've never declared a dividend or accounted for it -- but there are explanations more plausible than "evil conduct" that have the advantage of also explaining all the observed conduct.

All these accounting principles have a purpose, all have some legitimate use, and all give different numbers. The reason I bash FAS-157 is that it tends to cause strange problems unconnected with investment performance. Warren Buffett doesn't have to report from quarter to quarter what GEICO would be worth if he had to liquidate it, and he doesn't have to report what that Israeli tool manufacturer would be worth if liquidated. Berkshire Hathaway accounts for these in a much less responsive fashion, and the best you can hope for is to see earnings. The book values BRK gives for acquisitions are simply not numbers you can trade on. Indeed, reading Buffett's letters, it's clear that some of the numbers Berkshire has published (or, has been required to publish) are straight-up fictions -- whether done to appease accounting standards, or whether discovered after the fact as hard-to-value assets' values became clearer. The difference is that with fewer assets Berkshire must mark to market, the effect of comparables pricing isn't visible.

Also, since Berkshire isn't levered (it entered the financial blowup chock full of cash), and isn't regulated to 1:1 leverage, nobody is worried about Berkshire having a liquidity problem brought on by net asset value throwing debt-to-equity ratios into chaos. The fact that organizations that aren't BDCs can avoid some of the liquidity challenges ACAS faces are a reason Malon Wilkus gave a long and rambling answer to the question about BDC status: BDC status is great for some things and has done well by investors, but it also creates problems.

Then, Kawa said:
I have no problems with cancelling the dividend to weather this financial storms with better capital position; I am delighted to see their NOI results; I think they have managed well given the tough mark to market and bond yield analysis rules. I can see the NAV for Q408 might go down another $1000M (20% down with market, 200M of dividend?, offset by realized gains and potential increase in NAV due to ECAS deal); however, I also think they'll successfully amend their ~1.3B credit facilities with Wachovia even though the covenant is breached. All in all, what is your view of a potential NAV range and why are many people stating management is losing their credibility?
I'm not sure how banks will view amendment's to ACAS' credit line. I think ACAS wants to maintain a big credit line so that as the current multiples compression expands, and as bond-yield analysis begins re-inflating ACAS' debt holdings' value, ACAS will be able to quickly produce cash to make attractive deals even if share price remains below NAV. Therefore, I expect ACAS to try as long as possible to cling to the current credit facilities. It wouldn't take much more abuse from the marketplace (in terms of FAS-157 valuations using bond yield analysis and comparables-based pricing) to bust the current debt covenants. I think management recognized that, which is why I believe Wilkus brought up operating with no leverage at all while answering questions. He's looking at the possibility of disaster on the horizon, and planning accordingly.

Management's credibility has taken a hit for several reasons. First, the stock price last summer nearly hit $50, and it's threatening now to scrape $5. People are scared. Yes, ACAS announced a NAV close to $25, but let's face it: on the date that NAV was calculated, the share price was close to $25. Heck, the NAV was just under $25 and the price was just over $25. And the share price is now about $6. Management's comment that ACAS was trading above NAV at quarter end tends to frighten people into wondering about present NAV -- a topic ACAS didn't provide insight on because calculating NAV for quarter-end takes lots of time for a three-digit number of people, and ACAS doesn't calculate NAV for any other purpose. However, failing to deliver a current NAV number leaves the door open for frightened investors to speculate that ACAS might still trade above NAV. But perhaps the biggest reason management has taken a credibility hit is management's own rhetoric. ACAS has long pointed to its dividend as evidence of ACAS' ongoing and increasing profits. ACAS has repeatedly stated that the paid dividends are a performance measure that cannot be faked in the marketplace and cannot be restated. ACAS has essentially instructed the public to look at ACAS' dividend as proof of management's competence and good faith. Cutting the dividend simultaneously admits that management was mistaken about its ability to set dividends at levels that would never require reduction and reduces to zero the performance metric management had been holding out as the gold standard and indisputable proof that management continued to execute successfully on behalf of shareholders.

The concern about management is therefore not without basis. However, management could have done what others have done and cooked the books -- but did not. Management produced the ugly numbers of increased debt:equity, and published the unvarnished FAS-157 writedowns exactly as required by the regulations governing its structure. Moreover, management didn't say that it had everything in the bag and all was hunky-dory, it admitted frankly its view that the economic situation was likely to continue forcing write-downs as multiples compression and bond-yield-analysis painted worsening pictures of existing holdings even though they performed as underwritten. In other words, ACAS openly stated that there is no good-case surprise scenario in which its effective due diligence would protect the company from writedowns: it repeated that regardless of credit quality, the existing accounting rules would cause ongoing mounting of paper losses provided the economy continued as badly as management expected. This kind of brutal honesty -- which as ACAS' chart shows does not help share prices during the quarter and doesn't set up ACAS to issue equity above NAV -- is not what one expects of a management that is out to cheat its shareholders. Openly admitting that ACAS' tax status is a subject of potential future review tends to reassure investors that management is willing to look at every option in order to keep the company operating for the long run, while in the short run driving out investors who invested in ACAS in tax-advantaged accounts and liked getting paid pretax dividends.

Management is clearly looking to the long term and not the quarter, and it doesn't conceal this when it explains its behavior or gives guidance.

Peachberry_Tea wrote:
The thing I hate about ACAS is that it's opaque. You really can't see how the portfolio companies are going, and it seems like management won't say anything in reassurance except they're "continuing to perform".


I listened to the conference call and it didn't sound anything like ACAS management was letting the quarter's numbers go to hell for the long term good of the company. To me it sounded like they screwed up big time and they didn't exactly just come out and admit it. I had a lot of faith in management with the deleveraging they've done, but today I didn't get the impression that management was being honest and upfront. With a black box company like ACAS, again, this should be cause for worries for shareholders.
I'm as disappointed as you that ACAS has been slammed like it has. For the reasons I state above, though, I don't think the 3Q2008 quarterly conference call or the subsequent presentation to analysts at Merrill Lynch are indicative of character flaws or of poor judgment. I can't imagine anyone planning to model for a VIX of 90. I myself got slammed as the markets tanked. Being levered less than 1:1 was a great benefit when considering that firms like Merrill Lynch that were levered 40:1 have already failed (Okay, been bought by a bank that itself is on sale and taking federal handouts), and management's prescience to have entered the quarter at even less leverage probably meant the difference between surviving the quarter and being destroyed in a liquidity crisis.

ACAS' willingness to announce it plans to use cash to de-lever is an admission that it will be focusing defensively on surviving for the future, rather than snapping up bargains now in the hope that a quick turnaround will make it possible to eke by with clever accounting. ACAS is really working to reduce its risk, not to play games or pray for federal deliverance. Nowhere in the conference call did I hear false hope offered to investors. ACAS did stress that its assets were performing, but was clear that this didn't protect it from FAS-157 in an environment of severe and widespread financial recession.

Peachberry_Tea also wrote:
The fact that they confirmed the dividend a few weeks back, and now all of a sudden this - this certainly shows cracks in their armour. Assuming management really believed that they would be able to fund the dividend a few months back, the only thing that could've caused the dividend to stop altogether is that some of their investments exits have seriously turned sour. Which again points to the health of ACAS' portfolio companies. I think this and the possibility of a prolonged recession should have ACAS investors worried.
I don't think the only explanation is that ACAS' due diligence proved faulty. Especially in light of the continued NOI and ongoing syndication of senior debt, it seems that the investments are performing and that third-party buyers (who are buying senior debt at par rather than at FAS-157 discounted rates) also see the investments as performing. Rather, the FAS-157 valuation reductions have caused a liquidity crisis of the sort I described in earlier posts (such as after the second quarter's report). With its debt-to-equity ratio regulated as a BDC at a maximum of 1:1, ACAS need not have investments fail to perform as anticipated (i.e., it need not suffer a reduction in operating earnings) in order to face a liquidity crisis. Moreover, the debt covenants create a further cause for concern.

As for the worries facing investors in the form of a prolonged recession: investors in anything should consider worry. Gold isn't safe, as the destruction of so much value by the financial implosion could cause deflation. Debt instruments aren't safe, as the valuation concerns that decrease the market value of ACAS' deb holdings will hit anyone's debt holdings (except, haha, for banks which are allowed to carry performing loans at face value) and credit deterioration could endanger repaymet prospects. Heck, with benchmark interest rates heading into the toilet to make money available in the economy, inflation is a serious risk -- especially as the turnaround gets underway and credit actually becomes available. Many vendors are in danger as consumers threaten to tighten their belts and unemployed people have to hock their belts for bread. Investing in criminal defense or bankruptcy representation might be an angle. Of course, betting on short-play instruments isn't safe: multiples are so compressed and investments are so historically undervalued that one would need great care in choosing an exit, or one would risk being slaughtered as prices return toward historically more common multiples.

On the news I heard that safes and firearms are currently enjoying a sales boom. This is probably a sign that many people view the investment markets broadly as a place to avoid. While this sentiment persists, where will investment come from?

If you have the skill to time the market, God bless you -- it'll be a fantastic opportunity as the market's gyrations unfold. I have no claim to such skill and am simply working to ensure I have no leverage with which a crazed market can destroy my portfolio without my having to have picked poor investments. Interestingly, this seems to be exactly what ACAS' own management is doing: de-levering to reduce risks generated by third-party pricing lunacy.

Although some folks have lost confidence in ACAS' management, and it's certainly worth running for the doors if your investment thesis has been undermined, I haven't gotten there yet. I bought ACAS because Berkshire Hathaway was too big to capitalize on the small opportunities that are ACAS' bread and butter. I wanted a company that was able to find something to do with its cash, and didn't have to sit on tens of billions because no good deals were big enough to bother. Obviously from the standpoint of a short-term trade, BRK.B would have been far superior to the performance we've gotten from the stock price of ACAS over the last year. On the other hand, ACAS turned in $0.74 in operating income last quarter, or more than 10% of the current share price; BRK.A earned just $1335 per share, which given today's $97,000 share price (a 2-year low) is still less than 1.4%. Derivatives contracts weren't much more gentle to Berkshire Hathaway than to American Capital, but just looking at operating earnings, it looks like ACAS is the one in the sweet spot.

Moreover, Berkshire Hathaway has been on a buying spree -- including in financials -- as the market has gone into a panic. Buffet doesn't claim to time markets, he claims to spot deals. The fact that Buffett can find "deals" in companies so large they are worth his time to invest in (read his letters to the shareholers about this; the company just can't make material amounts of money on little deals) offers serious reason to rethink the hypothesis that nobody can find deals, even if they are willing to look in illiquid, hard-to-value, smaller companies. I think this latter class of companies offers a better long-term return. I love Berkshire's management, I just wish they were small enough to make money on the little deals where the explosive growth lay. In the meantime, since BRK.B doesn't have mark-to-market pressure because it doesn't have a requirement to place quarter-by-quarter values on its portfolio companies (it's not a BDC), nobody is going mad over Berkshire's "losses" (because it isn't required to report them as losses; it's just, you know, depreciating goodwill and that kind of thing). Instead, Berkshire has suffered a substantial operating earnings haircut as its main-line business (insurance) comes under pressure. ACAS, which has nearly three hundred portfolio companies, hasn't got this kind of risk concentration in one industry.

Consider ACAS' requirement to apply FAS-157 across the whole of its portfolio with this comment about Berkshire's need to apply it to a couple of classes of investments:
The company has disclosed many derivative contracts tied to the performance of the Standard & Poor's 500 and three foreign stock indexes, and to the credit quality of high-yield bonds. Accounting rules require Berkshire to regularly report unrealised gains and losses on those contracts.
Reuters, "Berkshire Hathaway Q3 Profit Down 77pc"
Instead of having its operating income of $1335/sh turned into a quarterly profit of $682/sh, imagine how FAS-157 would have caused a massive loss as Berkshire Hathaway's performing intra-holding-company loans had to be written down, and the value of its numerous holding companies had to be slashed as multiples compression killed the value of tool makers, ice cream franchisers, print newspspers, and insurance companies. Were Berkshire Hathaway required to apply FAS-157, what kind of haricut do you think it would have?

So I don't think ACAS is somehow bad at managing a portfolio of companies, or has bad investement picks, or the like. ACAS' transparency makes it an easy target for people afraid of the market as a whole and who don't want to wait around to receive operating earnings from profitable portfolio companies and think they must liquidate everything, now, to obtain value from holdings. Frankly, I think that's crazy.

Peachberry_Tea offered:
So there is a lot of uncertainty with regards to ACAS. I'm not sure that it deserves the valuation it does ($6 a share now) but then again, even firms without this uncertainy are priced this way at this time.
Insiders like the pricing created by this uncertainty. Why shouldn't I?

Peachberry_Tea concluded:
I honestly think your analysis of ACAS has been excellent. But as to what to do with one's money in this market, there are certainly better places for your money than ACAS. That would be my take on this.
I'm all ears on investment ideas. I'm particularly keen on ideas that call for solid earnings growth through a severe recession. I don't invest for a living, so I don't end up with tons of investment ideas. ACAS has been a long-term pick of mine, and remains one. I've not sold. If I should see my thesis collapse -- that ACAS is an underpriced way to buy a diverse lot of medium-sized companies which have been selected through a gruelling due diligence process to offer outstanding opportunities to provide a return -- then I'm sure I'll bail. However, I am not inclined to bail from fear of near-term pricing. Moreover, I'm still confident that I'm no good at all at picking entry points, and will continue to have to make due understanding the companies in which I risk an investment.

That said, if you want to be sure you have money at the end of the recession, the value of a safe and an array of firearms with which to defend its contents is probably not as volatile as the value of most of what you might buy after reading the financial section of the newspaper.

Tuesday, November 11, 2008

AmEx Holds Out Hand In Bank Bread Line

Not too terribly long ago, American Express spun off American Express Bank and all its related financial services (offerings include checking accounts, financial advice, brokerage services) under the name Ameriprise.

Now, American Express announces it wants to become a bank holding company again, and quick.

What's with the sudden change of heart?

American Express runs a credit card franchise of which you may have heard. Although American Express once was a payment card but not a credit account (one paid balances monthly), AmEx issues a vast array of credit and non-credit charge cards that are functionally challenging to distinguish from cards issued by banks under the Mastercard or Visa marques. Consequenly, American Express has lots of small cardholders making charges to (and hopefully payments on) revolving accounts. This means that American Express needs money to loan these borrowers. So ... where does it come from?

Historically, American Express' clientele were thought to be of a better caliber than regular bank card customers, and to offer superior credit risk. American Express had little trouble issuing commercial paper intended to provide liquidity for the period in which it expected the card accounts to be repaid. Longer-term debt offered other alternatives: buyers looking for a decent return lined up for American Express' offerings of bonds secured with American Express' revolving credit accounts. Now that even inter-bank lending has taken a hit due to confidence concerns in financial-sector firms, American Express hasn't got such easy access to the cash it needs to keep making disbursements under its revolving credit agreeements. Without the cash outlays, AmEx can't generate the fee income it earns from the cards, and without payment on customers' demand to vendors around the world at all hours of the day and night, AmEx would kill the value of its brand. AmEx must keep making payments.

American Express wants some of the government's easy money, and wants to be able to grow deposits (a relatively cheap source of cash, but not without risks).

AmEx is a long-term solid company, one that attracted investment by Warren Buffett when it was battered to irrational levels by news of scandal, and it's a company that bears watching as the economy drives financial companies into the toilet. While entering an investment in a financial just now seems hard to contemplate -- credit markets aren't yet normal again, and financials' capacity to carry on regular business depends critically on the function of credit and capital markets -- it's a situation that is likely to bear a good buy down the road.

AmEx is a definite to watch.

Monday, November 10, 2008

ACAS: 3Q2008 Report

In the quarterly announcement, ACAS' management explicitly addressed the liquidity threat created by the tangible asset value in its recently-renewed debt agreement.

Performance for the quarter
Net Asset Value at close of quarter was $24.43, down from $27.01 at the close of the second quarter; the reduction is driven chiefly by FAS-157 writedowns of unrealized depreciation resulting from multiples compressions as the worldwide markets' pricing decreases, the drop in price of shares of publicly-traded companies to which portfolio companies are compared, and the effect of changing interest rates on valuations generated with bond-yield-analysis techniques. Because ACAS is not a bank and is not permitted to carry performing loans at face value, but must re-value fully-performing loans on the basis of market factors that are beyond ACAS' control or that of its paying obligors, the risk remains that these wrote-downs will continue evan as portfolio income remains strong and debt obligations continue to be paid.

Net Operating Income -- a number that will be more important going forward due to announced changes in dividend policy -- increased sequentially from $0.71 to $0.74 per share, though it was down from $.81 in the year-ago quarter. It's worth noting that in 2007, ACAS' operating income involved a rather

Pretax Earnings were $0.98 compared to a projected $1.05 for the quarter; however, because ACAS elected to retain capital gains and was obliged to pay on behalf of shareholders the taxes on the "deemed dividend" represented by this retained amount, the earnings involve a tax charge, reducing the earnings to $0.72. Even the $0.98 is below estimate, though: ACAS expected to close deals that didn't close, and missed out on some realizations as a consequence.

Shareholders of record on September 30, 2008 are entitled to a $0.25/share tax credit (this means when one files an individual Form 1040 for 2008, one is entitled to claim having already paid $0.25/share in taxes above whatever else was paid or withheld for the 2008 tax year), and also to adjust their basis upward $0.49 per share (which only helps at exit). This is a result of retaining long-term capital gains that would have been payable under the prior dividend policy.

Realized Earnings -- the number that drives ACAS' BDC-related dividend-paying requirement -- were $0.72 for the quarter after taxes associated with the deemed dividend and other items.

GAAP Earnings -- the SEC-reported "earnings" that reflect mark-to-market price changes as if they were realized -- were negative to the tune of $2.63, giving rise to the NAV decline of $2.58 to $24.43. Due to ACAS' changed dividend policy, dividends will be driven by NOI rather than net taxable income, and will still bear no definite relation to the "earnings" reportable under GAAP. The GAAP earnings will be as crazily out of whack with dividend-paying capacity later on, when multiples expand and asset values explode beyond actual earnings.

Although ACAS' management claims that its net realizable value is hundreds of millions of dollars above GAAP values, the utility of this measurement seems slight in light of the fact that it represents neither ACAS' current liquidation value for the assets, or ACAS' expected actual return on exit. (The number sounds like that, but when faced with a question last quarter about the losses baked into the non-GAAP valuations given, management said it didn't expect to realize those losses, either, and that it expected the future to hold, in fact, some other undisclosed return.) The non-GAAP numbers are thus not so much a beacon illuminating the coast as yet another siren amidst the rocks, offering only puzzlement.

ACAS' portfolio company exits were within 1% of the prior quarter's valuations. The thesis that ACAS' management is lying about valuations seems further weakened by actual sales performance. This doesn't mean there's not a case to be made against ACAS, but it's not based on malfeasance by management in stating portfolio company valuations. The best thesis against ACAS is the thesis against any financial: the economy is heading into the crapper.

Management believes the company is operating amidst in a severe recession and is conducting itself accordingly, including by de-levering. Valuation drops pushed ACAS' debt:equity ratio back to 0.9:1, and management is working to reduce it again.

ACAS is addressing the liquidity threat with several initiatives
In a return to its older dividend policy, ACAS will retain capital gains (and pay taxes on them) rather than pay this portion of earnings to shareholders. ACAS needs the money to cushion its asset value's distance from bare-minimum debt-covenant levels. Future dividends will be driven by operating income, not capital gains. This dividend policy is far more apt to result in steadily-increasing long-term returns than a policy in which all gains are distributed, preventing increases in invested capital. Interestingly, the incentive of ACAS was reversed when shares ordinarily traded materially above NAV. Under the DRIP at prices well over NAV, ACAS kept more money by keeping pretax capital gains and issuing shares than it did by retaining post-tax capital gains and then reinvesting only operating income pretax. The policy of paying all earnings was sustainable only to the extent that above-NAV share pricing remained the normal state of affairs. In the last year, above-NAV trading has gone from uncertain and unpredictible (between the announcement of a share-buyback program in January due to the below-NAV share prices, and the next trade above NAV, was sixty-one days) to doubtful (ACAS has continuously traded below NAV for months).

Rather than announce in advance a schedule of dividends and stick to it, ACAS has announced that its board will set quarterly dividends after each quarter, based on quarterly results. Consequently, the pre-announced $1.10 dividend projected to be paid for the fourth quarter of 2008 will not be declared as predicted; any dividend to be paid on the fourth quarter of the year will have to be set after the quarter is over. Given management's repeated discussion of protecting capital, I would not expect to see a dividend from ACAS regardless its quarterly performance for some time. The benefit of longer dividend retention is lowered cost of cash: ACAS is borrowing it interest-free until earnings turn into declared dividends. When ACAS' shares traded above NAV, dividends didn't result in loss of liquidity, but in the issuance of shares above NAV. With a share price below NAV, cash dividends sap investable equity and threaten liquidity and drive the company toward the minimum tangible asset levels established in its debt covenants. Do not expect to see ACAS with a pre-annouced all-income dividend again; the procedure of having the Board set dividends following each quarter will place ACAS in the best possible position to game the dividend game on the basis of share price, market conditions, and tangible net asset value. The new policy is wiser and more fiscally conservative in addition to being more flexible.

The ECAS Transaction
Assuming all the necessary approvals are reached, asset volatility attributable to share volatility in ECAS -- whose below-net-asset-value price of its publicly-traded shares has given rise to terrible volatility in ACAS' portfolio value -- will be subdued in a financial engineering exercise in which ACAS will purchase ECAS' outstanding shares in an all-stock (1 ACAS share will buy three ECAS shares) transaction; the result will be the destruction of the NAV discount in ECAS and the increase in ACAS ownership of ECAS, which will mean an increase of about $1.25 per share in NAV for ACAS (and presumably the elimination of expenses related to ECAS' publicly-traded status). The 11.5 million ACAS shares issued in this transaction would bring ACAS' outstanding shares to 218.5 million shares, meaning that the anticipated $300 million in net operating earnings being rolled from 2008 into 2009 for payment of dividends would be about $1.37 in operating income ACAS would be required to declare by the end of June for payment by September 30, 2009.

Tax Status
ACAS addressed a question about its tax status with a long exposition about the fact that BDC status had been good for a long time, and that many investment forms (banks, BDCs, REITs, C-Corps like F, government-chartered entities like FRE, you name it) had suffered during the quarter, and that careful thought would need to go into long-term decisions on issues raised by the last forty or so days. It became clear that abandoning BDC status in favor of treatment as a bank or investment holding company or some other form of investment was not being clearly taken off the table as an option, and that management would continue to evaluate all the options available when deciding how to protect shareholder value in light of developing conditions.

ACAS' share price (under $8 as I write) is less than a third of its NAV. ACAS continues to enjoy liquidity from investment exits, its debt portfolio is performing extremely well for an economic catastrophe such as that we see now (nonperforming loans are less than 3% of marked values), and its net operating income appears strong. The 2008 profits rolled forward into 2009 must -- in order to avoid threatening ACAS' status as a regulated investment company -- be declared as a dividend by the end of June 2009 and paid by September 30, 2009; these appear to be approximately $1.37 per share. Assuming ACAS paid no other dividend in 2008 besides this minimum regulatory requirement (if ACAS retains its RIC status, 2009 profits would face a similar distribution requirement but with dates in 2010), ACAS would still have a double-digit dividend yield in 2009. ACAS' plan to use returning profits to reduce debt will protect ACAS from liquidity emergencies, ensuring that ACAS isn't placed in a "forced sale" position that would destroy the investments ACAS has made, and obliterate the prospect of participating in these companies' return to performance as the economy improves. The slowdown in exits -- and I believe there has been a slowdown in exits, as evidenced by the deal closings that didn't occur, no doubt related to the contraction in liquidity on the part of buyers -- makes ACAS' strong NOI that much more attractive. (ACAS has deliberately invested in counter-cyclical portfolio companies as the recession approached, and NOI continues to look good even though it is dwarfed by FAS-157-related writedowns that haven't been realized as losses and may well never be realized as losses.) As a long-term investment, ACAS at about a third of NAV and in light of its steady NOI seems a solid holding.

Management seemed to warn of expected future FAS-157 writedowns as the economy continues in recession. It's possible that ACAS will consider steps such as abandoning its BDC status and becoming an entity whose accounting enables it to value its assets differently, in order to avoid liquidity pressure caused solely by accounting issues and not by investment performance. (Becoming a bank, for example, would allow ACAS to carry performing loans at face value rather than at a value modeled on the basis of bond yield analysis; being treated as an ordinary C-Corp would enable ACAS to retain earnings like most corporations, and support its value with earnings accretions; and so on.) ACAS is battening down the hatches for a financial storm, and as usual is willing to upset analysts in the current quarter in order to protect long-term interests.

Management takes a dim view of the current economic environment and its future, but is impressed by continued performance of portfolio companies, including some selected for being acyclical or countercyclical. Credit market issues will likely cause further FAS-157 writedowns in irs debt portfolio -- not because of credit or performance issues, but because bond yield analysis will drive down current holdings' values as credit becomes less available (more costly) to current credit seekers in a worsening economic market. ACAS cannot be treated as a dividend stock until further notice. At one less than one third its NAV, and with new access to earnings for reinvestment and for de-leverage, ACAS' shares represent an opportunity to make a value play at a diversified portfolio of well-managed middle-market companies that are still making good money in a crummy market, and allows participation in a diverse debt portfolio.

In the short run, more scares lie ahead. In the short run, multiples compression and debt-revaluation on the basis of bond yield analysis will continue to threaten equity levels, requiring earnings retension and forcing debt retirement. Expects shorts to return in droves, no longer fearful of having to cover ACAS' dividend as they bet on a financial meltdown at ACAS. In the long run, this company will do extremely well on investments made at a bargain and as holdings are re-valued in economic environments that support higher P/E multiples.

Friday, November 7, 2008

New Boss: Same As The Old Boss?

The anti-establishment lyric of The Who's classic hit Won't Get Fooled Again came to mind when I started reading about the folks President Obama is tapping to advise him on the problems facing Americans. The new boss may look different, but is his policy really new?

The prevailing theory on the success suspected from the sitting lame-duck's successor is pretty simple: it was so bad it couldn't be worse, and you can't fall off the floor. It's got to be better.

But ... do the signs really give reason for this optimism?

During the campaing, fact-checkers discredited efforts to link Obama to Freddie Mac executives. Obama apparently wanted to offer the nation a clean slate, a team in which the public could have confidence. With the first several names appearing already for President Obama's top advisory team, we get some insight what kind of group will be contributing to the internal dialogue on how to address the nation's ills.

Top Pick
First, President Obama named Rahm Emanuel for Chief of Staff. Explaining the choice, Obama said, "I announce this appointment first because the chief of staff is central to the ability of a president and administration to accomplish an agenda, and no one I know is better at getting things done than Rahm Emanuel." The Reuters article describing the appointment also described the office: "chief of staff ... is a top White House appointee whoserves as one of the closest advisers to the president and typically can decide who gains access to the president, while also developing administration policies." So: a gatekeeper and policy advisor both. According to the Sun Times, "[w]ith Emanuel, Obama gets an enforcer, a bad cop who loves the f-word[.]" So, what might we expect from Mr. Emanuel?
Through his [Richard Daley campaign manager David] Wilhelm connection, in 1991, Emanuel joined the Clinton campaign as a fund-raiser, rewarded with the White House political director post. He flamed out in a few months, to be resurrected and end up as a senior adviser to Clinton.

After seven years in Washington, Emanuel moved to Ravenswood, making millions of dollars as an investment banker in a few deals, and making more money when tapped by Clinton for a plum spot on the Freddie Mac board.

Lyn Sweet, via Sun Times
With regard to that plum appointment to the Board of Freddie Mac -- a corporation which as described here has been chartered by Congress to facilitate confidence and liquidity in housing morgages, whose management's unrealistic predictions drove out famously "forever"-holding investor Warren Buffett, and which sits now in conservatorship as a condition of a massive taxpayer bailout -- a brief look might be warranted. Freddie's oversight agency (the Office of Federal Housing Enterprise Oversight) said the Board on which Emanuel sat "failed in its duty to follow up on matters brought to its attention." The blogger Jammie Wearing Fool suggests that if Emanuel were a Republican, everyone would be up in arms over his appointment to a key post (mentioning not only Freddie, but other issues that might make one wonder).

Emanuel, who already has a spokesman to field embarrassing questions about his past performance, is ducking Freddie Mac criticism with the claim that he was on the Board of Freddie for the "relatively short period of time" of just over a year. Well, quickly dumping plum jobs wasn't new to Emanuel by the time he dumped the Freddie gig, though it was longer than a few months. Despite stating that Emanuel "believed that Freddie Mac needed to address concernes raised by Congressional critics[,]" his spokesperson did not describe any steps taken to ensure that Freddie's bookkeeping was honest, that its guarantee pricing was rationally risk-adjusted, that the special oversight body created by Congress to keep Freddie on a leash actually received appropriate information, that Freddie's investment objectives didn't interfere with the mission to which it had been chartered .... These things would have required careful work. They would have required diligence. They would have required responsibility. They would have reflected a genuine belief in accountability.

Not seeing those things in Emanuel's hummingbird-like flit from post to post is, of course, enturely unsurprising for a politico looking to increase his juice in the District, or the nation. However, Obama didn't run on a platform of elevating good-looking young politicos in the District or the nation. Obama ran on the claim he would bring fundamental change to the District of Columbia and to the United States. Is Emanuel evidence Obama is merely a new Chicago political insider, doing Chicago political insider things, and not really changing anything substantive?

Maybe Emanuel's stick-to-it-iveness has improved and he'll keep the Chief of Staff job long enough to evaluate his contributions. And maybe those contributions will be more impactful than his contributions at Freddie Mac. On the other hand ... maybe not. Being a skeptic of professional politicos, I'm not exactly gushing with excitement about Obama's pick of Emanuel for a position that demands serius judgment: gatekeeping for the President of the United States has a serious implication for the range and quality of viewpoints that can go into top-level policy evaluation. Assuming that groupthink is a major factor in the Charlie Foxtrot we've ... ahem ... enjoyed ... heh, heh ... over the course of the outgoing administration, a gatekeeper known for loyalty and making a good guard enforcer is a serious reason for concern.

Getting Solid Financial Advice
As mentioned in interviews linked on this old post, Obama's supporters include the legendarily risk-averse and long-term investor Warren Buffett. Optimism is warranted: steady, long-term, risk-averse analysis is definitely what is called for in the job of protecting the public fisc. Waiting to see just how Buffett's pre-election confidence would prove justified won't take long: Obama has begun naming members of a financial advisory committee, called his Transitional Economic Advisory Board.

So, who's on this economic advisory committee? What track record have they got?

President Obama's economic advisors include Robert Rubin. A board member of Citigroup, Rubin's advisory services failed to stop the company from pursuing a course of business that caused the company's dividend to fall from 54¢/q to 16¢/q (a 70% decline) while the stock price dropped from the mid-fifties to the low teens ... um, lower: eleven-and-change is still double-digits, but it's not the teens; the stock dropped over 70%.

Had Rubin's oversight included comments about the propriety of lending to people who don't bother to substantiate their incomes, or the wisdom of valuing quarterly fees above long-term capital risk, we would surely have heard about it. The upside: the stock didn't go bust. On the other hand, the quietness involved in the federal purchase of $150,000,000,000 in stock of the nation's largest banks, including Citibank, means that the public can't easily determine how desperate Citibank was for the money when the government decided that the company -- and all banks -- needed their public confidence improved.

In similarly desperate fashion, Rubin's alma mater Goldman Sachs has had trouble. Rubin was an architect of the proprietary trading expantion that left Goldman holding the bag on a bunch of derivitive instruments whose counterparties were bust, plus an inventory of never-syndicated home mortgage CDOs whose liquidity has gone to zero and whose ultimate performanc may turn on the largesse of those with their hands on the faucet of the Treasury's money vat. Although Rubin's personal investment of firm capital may have been largely in arbitrage trading, he had a tremendous impact on the firm's risk exposure during his stint as the seventieth Secretary of the United States Treasury.

As Treasury Secretary, Rubin opposed regulation of derivitives when Brooksley Born at the Commodity Futures Trading Commission proposed oversight. Successfully keeping such instruments as Credit Default Swaps (CDS) unregulated, opaque, difficult to value, and illiquid was a key factor in the confidence collapse that destroyed so much value in the financial sector this year. With regulation, CDS could potentially be standardized in such a way as to be subject to trading like standard options -- a common derivative instrument which can be used in complex combinations to make risk-limited hedges against legitimate portfolio risk, and which generally have a knowable value because their regulation and standardization render their performance, liquidity, and valuation subject to everyday and mundane analysis. Instead, like health coverage through non-state-regulated employee benefit plans, the participants have rather less idea at any given time where they stand and what the contracts are worth.

As observed by The Economist, Rubin's dismantling of the Glass-Steagall legislation that had kept a firewall between banks and other financial institutions had the effect of driving financial institutions into new businesses in which they lacked prior expertise. Taking on risks they did not appreciate, while acquiring a multiplicity of regulators with no familiarity with such combined entities, did not create an environment in which the public's interest in financial stability had an effective voice. The trouble with financial behemoths wasn't that they would scoff at small customers and price them out of the marketplace in the hunt for big fish, but that they led to a regulatory mess that needed as much help as the Glass-Steagall-era financial institutions needed improvement in diversity:
But the price of financial services will surely not rise: new technology, especially online financial services, is too powerful a force in the opposite direction. There is a bigger worry, though. Why, if politicians are at last to do something about the Depression-era rules that govern financial firms, have they not tried to update America’s supervisory structure at the same time?
Meanwhile, derivatives exposure was exploding in a non-regulatory environment championed by Mr. Rubin, magnifying risk and decreasing liquidity and transparency.


Getting Rubin on-board might have been a great idea under the theory that he should offer a close-up view of how the system was augured into the ground. However, this assumes he was looking at the world about him rather than in a college textbook. Rubin's longstanding credentials as a faithful Democrat didn't lead him toward any policies that seemed calculated to help the little guy; rather, he helped endanger the financial institutions that make everything in his life affordable. Instead of playing the traditional Democratic song of increasing government regulation, or the idealistic notion that government regulation might be made more efficient, Rubin agitated to have his own field de-regulated. (And wasn't this what Obama said was wrong with his Republican opponents? Too chummy with the folks who created the mess?) Maybe Rubin was overly optimistic about the effectiveness of his colleagues and competitors in navigating a wild and woolly new combined financial environment, or didn't appreciate the purpose of insurance and bank regulation (solvency) because he was so long steeped in the culture of investment banks and their priorities (profits from fees and trading).

The Jaded Consumer isn't particularly excited with what's come to light so far. Perhaps there are some truly exciting members. If I should hit more information on them, I'll surely try to post it here.

If the nation's financial advice comes from the mouths of those who architected the collapse, confidence in an effective solution being developed might understandably wane. While the re-appearance of sound federal financial .... uh, right -- when was that? Okay; it'd be nice to feel the public fisc were in better hands, but it honestly looks like this is a point on which evidence will need to be collected before we become excited about the crew manning the tiller.