Tuesday, November 29, 2011

Comparing Platform Revenue at Apple and Microsoft

Mactrast's graphs illustrate the revenue by business segment for both Apple and Microsoft. Apple's business shows distinct seasonality in the iPod business during the holiday quarter over the period depicted, but little other seasonality. Both Apple and Microsoft show some product-launch effects, though Apple has more product launches: Microsoft doesn't release Windows 7 very often. The graphs are educational.

However, the conclusion Mactrast draws from the graphs – that Apple's Mac business (a largely-consumer-facing hardware business) is larger than Microsoft's Windows business (a generally OEM-facing software licensing program) – seems at first blush to be an irrelevant, apples-to-oranges comparison. Is it?

Microsoft's Windows business is a software business with software margins and software capital requirements. This has historically been great for Microsoft: it forces third parties to handle potentially troubling hardware manufacturing and fulfillment issues, while reaping profit on every unit regardless who sells the units. The result has been a market in which PCs are scarcely-differentiated commodities; Microsoft cares not who wins, so long as the unit volume in the entire marketplace carries enough licenses to support MSFT's bottom line numbers. MSFT's only pricing concern is that consumers pay enough for the machines that OEMs can afford to pay MSFT's demanded licensing fees. Toward that end, MSFT has segmented its OS lineup into a dazzling array of versions with different features enabled or disabled, ranging from "home" editions to enterprise-directed and high-end gaming versions, each at a different price to accommodate the margins on the hardware sold to various buyers.

Part of Microsoft's product segmentation in its Windows business has been its OS segmentation between its client-licensed operating system and its server-licensed operating system. Considering that Microsoft's Windows revenue includes high-dollar multi-user licenses for MS-Windows installations supporting enterprise Outlook, multi-CPU web servers, web servers backed by database applications – all revenue that Microsoft gathers under its "Server and Tools Business" segment – the direct comparison of Macs to the "Windows and Windows Live Division" is deceptive. Moreover, Microsoft's platform business – the OS licensing scheme – is so interrelated to Microsoft's software tools business (how else will people compile applications designed to exploit the APIs with which MSFT distinguishes its OS products from DOS, Unix, Plan 9, MacOS 9, MacOS X, etc.?) that the whole of Microsoft's "Server and Tools Business" has to be thought of as part of Microsoft's Windows business. Without servers that require MSFT's client software (Outlook, anyone?), Microsoft would not enjoy the enterprise lock-in it has acquired and maintains. The only reason Apple gives away developer tools for free is that when Apple announced the death of MacOS 9, it had to make migration to MacOS X tolerable to developers or the whole thing would fizzle: no apps on a computer, no point in buying the computer. Tools are an essential part of the platform ecosystem, and Apple's are free because Apple's revenue is based (historically) on hardware sales rather than (chiefly) on software licensing.

Then, one has to ask one's self whether it is seriously reasonable to separate Office from MSFT's Windows platform business, since Office is sold for no other platform and in effect is an upsell of the Windows platform itself? (E.g., to get uncrippled mail and calendars, one buys Outlook with the rest of Office, which one needs to exchange documents with everyone else on MSFT's Windows platform; Apple includes its calendar and mail client with every OS installation so the platform appears to have value – that is, utility – right out of the box, to differentiate it from cut-down no-frills PC offerings. Had Apple the market power of Microsoft, Apple would likely charge for these things as it does for iWork.)

Apple's Mac business generates a lot of revenue that doesn't flow straight to the bottom line because it flows to the likes of Intel, nVidia, Samsung, and a host of lesser-known suppliers whose wares are less known to the public than CPUs, GPUs, and LCDs. To match Microsoft's profit in its Windows business, Apple would need a lot more revenue. True, Apple is selling more and more Macs. And Apple did eclipse Microsoft in quarterly profit, but after rather than before passing it in revenue. Apple hasn't acquired such market power that it can charge developers for compilers and other MacOS X tools, though it does charge for higher levels of Apple Developer Connection that include additional software, support incidents, hardware discounts, etc.

I have high hopes for Apple's Mac business. Apple's Mac business is probably already larger than Microsoft's consumer-driven OS licensing business. However, Microsoft's enormous platform ecosystem dwarfs Apple's Mac business, despite Apple's Mac business including hardware sales.

This is not in itself a bad thing for Apple: it means that the opportunity to take share is dramatically larger than the revenue Microsoft currently milks from its huge platform base. With Tim Cook at the helm, Apple may even be capable of developing enterprise-friendly infrastructure products to enable direct competition with some of Microsoft's most profitable customers. Under Jobs, such thinking was mere fantasy.

On the other hand, adding iOS platform revenues (e.g., iPhone, iPod Touch, mobile apps) to MacOS X platform revenues makes a certain sense, because they share the same Mach-derived multithreaded kernel optimized for multi-CPU environments and use the same set of developer tools and the same APIs for programming applications. Both iOS and MacOS X have the same advantages in languages and localization and single-image installation, and derive from a common infrastructure investment in exactly the same way as MSFT's client and server operating systems. Adding iOS to MacOS X to guage the size of Apple's platform moves things a bit, because Apple crushes Microsoft in mobile. Asymco's graphs start to paint the picture, but make the same assumption as Mactrast that Apple's Windows business is captured entirely in the "Windows and Windows Live Division", when high-margin server OS licensing is captured among the Server and Tools Division's numbers.

Excluding servers from MSFT's platform business is as arbitrary as excluding mobile devices from Apple's, and either exclusion would omit the crown jewel from each business. They must be considered together. Whether Apple eats MSFT's lunch or co-exists peacefully will ultimately depend on Apple's inclination to deliver a server back-end that offers to enterprise things like Microsoft's back-end offerings to support Outlook. Well, maybe "peacefuly" is stretching it a bit: Microsoft keeps trying to do mobile phones and notebooks, which are Apple's bread and butter. Expect the competition to continue, and delightful declarations by Steve Ballmer to continue unabated.

Saturday, November 26, 2011

Apple's Cash Creates Opportunity

How often have we seen calls for Apple to turn its massive cash hoard into a big dividend? Big mistake. The Jaded Consumer regards ready access to massive capital as an asset to Apple as much as it is to Berkshire Hathaway.

The latest example is Apple's billion-dollar (that's billion, with a "b") investment in a cutting-edge Sharp LCD plant. Many years ago, when CRTs dominated the computer landscape, Apple ensured its supply of quality LCDs by making a $100 million investment in Samsung, to avoid parts and quality issues in its not-yet-shipping iBook portable. The payoff? When Apple wanted to make sure it didn't lose sales of MacBooks or iBook G3 units (remember those?) to production-related fulfillment delays, it guaranteed supply by funding the production in advance. The hundred million looked like a lot of money. Structured as a 3-year unsecured convertible note with a 2% yield, the investment was eventually sold back to Samsung in 2001 for $117 million. What did Apple get for tying up $100m from 4Q1999 to 2Q2001? For starters, Apple avoided LCD shortages that threatened the industry just as monitors were transitioning from desktop CRTs to LCDs. Apple's migration to an all-LCD lineup created significant exposure to LCD availability problems, which Apple cured with its Samsung deal. The $100m investment was a hedge against the risks of bidding in an open market for key parts.

A conservative strategy, perhaps – and effective at protecting high-margin production. What's different now? Apple isn't struggling toward averaging a million total devices sold a quarter while netting just over a half-billion in profit, it is selling tens of millions of LCD-based products per quarter at over $100 billion per year to earn over $25 billion a year. Apple's desire for premium displays isn't a matter of building LCD notebooks in a world of CRT desktops, it's a matter of filling an LCD lineup from iPod Touch, three different iPhone models (3GS, 4, 4S), two classes of notebook computers, the all-LCD iMac desktop line, and the stand-alone displays sold for users of every type of computer Apple sells – while maintaining a quality edge intended to support Apple's traditionally high-margin hardware.

In other words, the order-of-magnitude increase in Apple's LCD infrastructure investment reflects Apple's greater-than-an-order-of-magnitude increase in LCD consumption. A billion bucks – to buy entry into Apple's next-generation supply contract with Sharp – is just the increase in ticket price Apple faces as it seeks to maintain its supply-chain strategy in a world that can hardly supply its needs. And Apple gains a significant benefit from its supply chain management. By making capital investments in key suppliers, Apple ensures that it is supplied first rather than last as manufacturers line up for parts when supplies tighten. Being able to ship products is a necessary prerequisite to closing sales – and Apple doesn't want to risk being the one waiting for parts.

But let's think about Apple's strategy. Steve Jobs made it clear that Apple preferred to own the intellectual property behind all its products, yet it depends on third parties for absolutely critical elements such as LCD panels, wear-resistant glass, and so on. Apple is the planet's single largest buyer of Flash memory. To secure Flash supplies in a market subject to pricing variation and shortages, Apple has done things like pre-pay 10-figure sums for its expected Flash supplies. Supply risk isn't merely theoretical. Apple's consumption has been blamed for causing Flash memory shortages on a worldwide basis for years. In 2005, Creative blamed Apple's supply-chain management for Creative's inability to build MP3 players. Gartner predicted iPod-related Flash shortages in 2006. The supply/demand ratio for Flash parts remained unfavorable to buyers through 2009, with Apple's consumption for mobile devices expressly named as the culprit. In 2010, the shortage was being blamed on the iPhone rather than the iPod, but Apple was still being seen as the responsible party. Apple needs to deploy substantial capital to ensure its own supplies are met.

Yet, Apple doesn't want to create a free-rider opportunity for competitors. If Apple simply coughed up money to competitors by investing in their common suppliers as it did over a decade ago with Samsung, Apple would enable these suppliers to develop techniques and machinery they could deploy in their effort to supply any customer, not just Apple. Apple would, in effect, be funding the R&D of its competitors by enabling their suppliers to produce more products better for less money, on exactly the same terms available to Apple. Ick! What could Apple do to ensure that machinery it funded didn't lower the cost of production to competitors?

For that insight, let's look at Jobs' comments at the D5 interview in which he and Bill fielded questions.
Q: What did you learn about running your own business that you wished you had thought of sooner or thought of first by watching the other guy?

Jobs: You know, because Woz and I started the company based on doing the whole banana, we weren’t so good at partnering with people. . . . And we weren’t so good at that, where Bill and Microsoft . . . learned how to partner with people really well.

And I think if Apple could have had a little more of that in its DNA, it would have served it extremely well. And I don’t think Apple learned that until, you know, a few decades later.

Now let's think about what "partnering" has meant in connection with Microsoft. After Microsoft "partnered" with Apple to write applications for Apple's hardware, Microsoft earned more profit on MS-Office for Macs than Apple earned selling Macs themselves. PC vendors who facilitate Microsoft's OEM operating system licensing program have been reduced to mere commodity vendors, while Microsoft enjoys monopoly pricing (and profits) on its operating system. Vendors seeking to supply Microsoft with technology have been crushed. "Partnering" in this context is a sophisticated form of competitive positioning in which vertical integration is achieved not by owning the entire production column, but by arranging that non-owned portions of the column lack profit, differentiation, or competitive positioning.

This kind of "partnering" is what Apple learned from Microsoft. However, Apple has gone a step further: rather than license software under conditions that eliminate hardware differentiation (either by eliminating the profit motive for investing in it, or by making it impractical due to the limitations of the software ecosystem), Apple has used its supply-chain expertise to enhance its hardware differentiation. As described above and elsewhere, Apple contracted by using large advance payments to guarantee its components supply under conditions that leave competitors scrambling to find parts with which to build competing devices. But Apple has apparently gone far beyond that. When Apple bought all the production of key manufacturing tool maker, it didn't just deprive competitors of the ability to buy the same drills as quickly. As described at asymco in the article "How much do Apple's factories cost?", Apple isn't just ordering manufacturing equipment for use by its contractors. Apple is buying the manufacturing equipment and owning it itself. Apple has to own scads of capital-intensive manufacturing equipment, because it's got so much of it on its own balance sheets.

Think about this. Apple doesn't have to enter anticompetitive contracts with its own vendors, it only has to make clear that Apple's production equipment is for making products for Apple. In one swoop, Apple takes whole plants out of availability for competitors. Why? They're full of Apple property available only for use in Apple products. This sort of production partnering – Apple takes the capital investment risk because it can afford the capital and is willing to bet on its own products, but doesn't want to have to duplicate high-volume manufacturing expertise that can be provided more efficiently by production partners – allows Apple to negotiate for pricing much closer to the marginal cost of production than its competitors, who don't take the capital risk and have to pay for amortization of production facilities that the manufacturers and assemblers have had to take the risk to build. Apple-risk facilities are just for Apple-benefiting production, boys. If an Apple joint-venture factility were used to produce something for a competitor, of course, Apple would (as a joint venturer) share in the profit: competitors would in effect pay Apple to have their parts built.

Apple can do this with LCDs, NAND storage, microchip fabrication tools (it's designed its own mobile CPUs, which now include both the A4 and the A5, and has someone building these for it), hardware cases (this page offers some video of Apple-developed manufacturing tech, including a technique for machining the unibody Mac notebook chassis from a solid block of aluminum – no doubt in use by a contractor), batteries – everything that might possibly differentiate an Apple product from a competitor vending Wintel boxes or MP3 players or ARM-powered phones. Every time Apple gets a pricing advantage with its capacity to fund the manufacturing investment required to fulfill its orders, Apple puts competitors in a position of fighting just that much further uphill just to stay even.

Billion-dollar parts prepayments aren't normal except for Apple. Next-gen LCD development investments in the ten-figure range aren't normal except for Apple. The only thing that makes capital risk of this magnitude a safe activity for apple is that with so many tens of billions of dollars available, a mistake won't impact Apple's ability to execute on the rest of its operational requirements. The $80B is not some kind of retirement nest egg, it's a license to invest in the future and a ticket to the front of the line for parts and an AARP discount all rolled into one.

A day may come when Apple can't imagine anything it might want to do with all its cash, but that day isn't here yet. Let's not hear demands for dividends when we could be hearing demands for more insanely great products at prices competitors can't profitably match.

Thursday, November 17, 2011

Foolish Newsletter Subscriptions?

The Motley Fool has been an interesting experience.

(In 2007, I became interested in diversifying my portfolio, which had come to be utterly dominated by my ballooning holdings in Apple. I started looking for other good ideas, and it was hard to find ideas as good as Apple. But I was committed to "diversifying" and tried. Oops. I'm sharing here some of what I learned after the crash of 2008 about getting advice on how to diversify.)

Over ten years ago, I heard David and Tom pitching a "Dogs of the Dow" strategy: in less than fifteen minutes every year, you could manage a portfolio mechanically by rebalancing a portfolio into some of the highest-yielding companies in among the Dow Jones Industrial Average's industrial stalworts. The strategy promised the security of buying only brand-name companies, the certainty of crystal-clear buy/sell signals that offered no room for judgment one could doubt, and a speed that would allow anyone to manage a portfolio that (the strategy proclaimed) would crush the market in just fifteen minutes a year.

Among the advantages of this system are (purportedly): (a) you don't lose built-in management fees to advisors, which sadly is the case with funds – including ETFs – because they typically siphon off about 1% of assets or more each year, whether they make you any money or not ... and TMF is fond of pointing out that this management fee becomes a big deal as one considers compounding; (b) advisors don't do particularly well, and you can do better yourself, champ! And sleep better! Because the system works! Besides, (c) investment professionals are dishonest scum. These points are made across the Fool web site and in the Foolish Four book to varying degrees. But the impact is the same: you can do better yourself, the pros aren't good, and the pros cost too damn much money.

In contrast to the mechanical investing thesis but in synch with the do-it-yourself meme, the Motley Fool web site offers a bunch of support to individual investors. The thesis is that like Warren Buffett, its readership should be able to spot undervalued investments and, by cherry-picking the best of the bunch, glean outsized returns without paying fund-manager fatcats premium fees year in and year out whether they earned or lost on the money entrusted to them. The Motley Fool web site was chock full of discussion about individual stock picking, and began vending newsletters to aid investors hoping to cherry-pick stocks, or small-cap stocks, or dividend stocks, or options plays . . . the list seems to be growing. These newsletters are available by subscription. They cost money. The good news? The subscription doesn't scale with your investments; if you have infinite capital, your transaction costs associated with any given subscription approaches 0%.

But investing based on the no-charge site involves work and it involves judgment. These are diametrically opposed to the mechanical investing thesis blessed by the Motley Fool in The Foolish Four. They invite homework, open-ended analysis, judgment . . . in short, a mess.

The subscriptions aren't much help in that regard, whatever their cover price. They recommend such a huge variety of stocks – especially in the aggregate – that no investor would plausibly pursue them all. One would need to be involved in so many positions that there was no possible way way to stay informed about them all, unless it was full-time work. Unless one chose to buy everything advocated by one of the newsletters without the exercise of judgment, one would drown in homework staying abreast of a portfolio. Unfortunately, the list of stocks that are "active" as recommendations of its flagship newsletter – Stock Advisor – has over a hundred and five (that's 105) different issues listed. Just counting them is a trick, though: every time David or Tom "recommends" a stock, it gets a new line and is tracked as a new recommendation. When calculating the newsletter's "performance", Stock Advisor's management count each recommendation from inception to close date. So the "active" list has over 140 entries, and much of the newsletter's "market-crushing performance" consists of re-recommendations of the same good idea.

What's a subscriber do to mirror the newsletter's "performance" – re-purchase Apple or Disney each time it's (re)recommended? Is that even plausible? The newsletter identifies a group of "core" stocks, but doesn't really tell new subscribers at what price they should consider stocks off the list. There's a list of "best buy now" stocks, but the newsletter's management doesn't help investors figure out what off the "best buy now" list is worth getting into immediately. In what proportion does one invest?

And the newsletter can be slow to react to reality. GameStop – which evolved into a sort of Blockbuster for computer games sold on physical media, and you can see how Blockbuster is doing by following how Blockbuster in bankruptcy (OTC:BLOAQ) converted into BB Liquidating Inc. (PK:BLOAQ), which has negative earnings – was listed as a "hold" (what does that mean, anyway?) for a couple of months before finally calling it a sell in 1Q2010. That company was in (what I concluded was) an obviously-dying business for a long time, folks. Yes, it was still up from its two recommendation dates at the end of 2005 and the third quarter of 2006, but let's look at the graph:

Until December of 2009, GameStop was still an active recommendation. (Well, it was "active" until the March issue of 2010, but on "hold" – whatever that means.) So subscribers were led from 4Q2007 (for example) until 4Q2010 to think it was a Stock Advisor pick, and encouraged that it was the dominant game retailer in a world awash in video games, and one of Stock Advisor's picks for crushing the market. Maybe you'd beat the market trading on the dates of the recommendations – which might be hard, if you read it when it arrived in the mail; the sell rec is in the March issue but bears a sell-rec date of Feb 18 – but investors are given no advice what to do between recommendations if they show up mid-movie, so to speak. And with 100+ recommendations, it's hard for investors to figure out what on Earth to do with them all.

Since the Motley Fool offers a nice tool for working out weighted, annualized rates of return on your self-reported portfolios, I can report this about my post-2008 investments:

In case it's hard to read, it says that the Stock Advisor recommendation Dreamworks Animation is my worst-performing investment entered since the last market crash, whereas my decision to nearly double up on American Capital Ltd. at $1.80 in early 2009 has more than quadrupled my money (while my overall performance of an annualized 23.7% in post-crash purchases has to date outperformed the S&P by 9.6% on an annualized basis). ACAS has, over time, dropped from a 5-star ranking at the Motley Fool to a four -star ranking, and it's never appeared in Stock Advisor.

I was going to write that I have no idea what the publishers thought about entering a position in Dreamworks in the first half of 2010, and that if they had any reservations I was unable to find evidence they shared it with subscribers. However, this is not true. I've been reminded that in May of 2010, Dreamworks was re-recommended at $34.87, making it a loser – even for the Stock Advisor – in excess of 50% of the stock's value. Of course, you can't win them all. And it's not over until the fat lady sings, and all that.

But down 50+% is a painful start, because recovery to your starting point requires going up more than 100%. Apple gave me a few -50% days while I held it, but I first bought Apple at $20.35 per stub, after which it then split 2:1 twice, so losing from $100 to $50 wasn't so hard, particularly not with the perspective of $380 AAPL (after it's received a "haircut"). From the Stock Advisor commentary, I sense the editors are hoping someone acquires Dreamworks. I don't see the market-crushing behavior (I'm ignoring the stock price here, and looking at the company's performance in competition with its peer) the Motley Fool discusses in its sales materials for the Stock Advisor. DreamWorks isn't a Rule Breaker, it's a Pixar imitator which – until I saw How to Train Your Dragon – was failing to make movies anything like Pixar. (I discussed what I viewed as Dreamworks' evolution from a "me too" to a "real me" in this post.)

General Electric, which the Fool's performance-analysis tool cheered as a "two-bagger" (and here I sigh, because I read Peter Lynch's book in hardcover when it was first published, in which he lamented buying a washing machine instead of Berkshire shares in the 1960s, before there were any B-class shares to buy), wasn't a Stock Advisor recommendation, either. It was a Peter Lynch inspiration: I was familiar with some of its outstanding products, and realized that the stock was hated simply because nitwits thought GE Capital made GE a financial and after 2008 nobody wanted to own a financial so it was beaten like a red-headed stepchild. I looked at its historic dividends and glanced at its financials and said "of course!" This was while it was below $7. And that reminds me: the Fool's performance analysis tool won't give you your annualized yield on anything but the equity itself; it ignores dividends. GE pays a dividend, so my return is better than the Fool relates.

The Fool's return calculator's dividend-ignoring behavior stands at odds with the Fool's apparently normal practice (at least, in other places on Fool.com) of subtracting dividends from basis to calculate returns. This is crazy, of course: a stock held for ten years doesn't cost less in year 1 just because you later held for dividends. This only makes sense in a tax-deferred account with dividend-reinvestment engaged – but that's not what the Fool assumes, as it doesn't increment your share count, it decrements your basis. The Fool tool would treat each reinvestment purchase as a new investment, each with a declining basis. So folks who recommend big dividend stocks in the Motley Fool's CAPS system (the Fool's community-rating system) should appear to crush the S&P just by holding on until their basis approaches zero, no? Check out this player's recommendation of American Capital Agency – the Fool claims the player's basis in June of 2008 was less than $9, so of course he's crushing the S&P 500 now that AGNC is flirting with $30. The lowest I was ever able to pick up shares was $15, though it dipped a little below that. But AGNC never traded at $9, ever.

But ProEdgeBiker is up 213.33% on his AGNC recommendation! Yeah, right. I know this guy selling a bridge .... CAPS scores are flawed, and if you want to game them pick a dividend stock, yo.

The confusion generated by the dizzying array of stock recommendations and the drinking-from-the-fire-hydrant problem of trolling CAPS for ideas seems to be the chief selling point of the Motley Fool's costlier service, Million Dollar Portfolio (MDP). Entry is $1k/y, with a discount for new members. (There's a money-back guarantee, I'm just checking it out, though if impressed I'll naturally renew. But read on.) MDP invests a real-money portfolio that begain with $1m. MDP's deliverable is based on all the Fool's subscriptions, making it something of a best-of aggregator, but it does not include either all the newsletters or a list of all the recommendations. The managers have access to this, not you.

MDP gives concrete instructions to subscribers before each trade: not just the name of the stock, but the percentage of the portfolio that has been assigned to it so you can follow along at home. In advance, even. And for new subscribers, MDP offers "catch-up" plans, advising you what to pick up and when, to bring your portfolio in line with the MDP. If that's not fast enough for you, the portfolio lists "buy around" prices for each pick, so you can make your mind up as prices change. And some of the stocks are nice picks I myself have loved for years: Berkshire Hathaway and Markel, for example. Unfortnately, despite my Berkshire shares having more profit in them than MDP's (I bought before MDP picked it), both I and MDP have done worse than the S&P 500 in our BRK.B investments. And I read that for a while last year, the MDP pulled out of its picks and bought an index fund. True? If so: Would Buffett pull a move like that?

You either have a sound investing thesis (and damn the torpedoes! – until real information impacts your analysis) or you are a lemming. Period. If your own decision isn't so rock-solid that it withstands a criticizing public, you don't even believe in your ability to pick promising companies from the dregs that haven't yet been ejected from the S&P 500. Of course you can pick a few losers! Right? If not, why are you managing others' money?

MDP was down something like 10% last year. Since inception, the tale of the tape is:

This is at least honest. It might not be something I'd want to admit while selling a stock-picking service, but it's honest. The portfolio's first purchase was a symbolic one-share purchase of Berkshire Hathaway (a pre-split B share, $4,256 a stub) made four years ago in October of 2007. Losing only ~13% in the crazy time between October 2007 and the present is something to be proud of, but it takes some perspective to perceive it. I have to think carefully about my own performance to realize what a positive statement -13% really is over that time period. And they did beat the S&P by about 5%, which in a big enough portfolio might even be worth the annual fee. And let's think about that a moment. Berkshire Hathaway's 2008 result was a 9.6% decrease in book value per share, which beat the S&P by 27.4%. At $1k/y, MDP's charge represents a 1% management fee on a $100k portfolio, for what turns out to be a 5% advantage. Over what period? Is this a deal? Wasn't avoiding recurring management fees such a big part of the Fool's pitch?

And did they really allocate 80% of the portfolio into SPY in 2007 while they waited to figure out what to buy? While SPY charged a management fee? (The note says "Plus it has a really cool, James Bond-like ticker symbol." Thank goodness for that!)

But back to the cheaper subscription services for a moment. You can't use Stock Advisor as a substitute for judgment, because you'll end up with 100+ stocks and can't be assured that you will get advice to sell that's worth a nickel. In fact, you can't be sure the advice even makes sense. Check this out: in its latest issue, in discussing Stock Advisor picks that don't pay dividends, the Motley Fool wrote of Berkshire Hathaway:
a recent offer to start buying back shares has us thinking a new dividend may also be in the offing. Among our Core non-payers, Berkshire's our most likely candidate to start.
This is, of course, utter nonsense. Berkshire is doing a stock buyback in lieu of a dividend because of the double-taxation problem inherent in C-corp dividend payers. (A REIT like AGNC is a tax pass-through, so there is just one tax, levied on the dividend recipient; earnings retained by the REIT are limited if it is to retain its tax status, and subject to excise taxes.) Imagine you are a multibillionaire with the power to declare yourself millions a year in dividends, on which you will pay 35% taxes; or you could sell a couple of extra shares, raising the same amount of cash, and pay 15% taxes. Which would you pick? And if you don't for sure need the money this year, why would you subject the money to a personal income tax at all? Why not let it continue to enjoy reinvestment within the corporation that's already paid taxes on it once?

The third option is a share buyback. If management is right, and Berkshire's announced strategy of making purchases at a premium of 10% to book value (which is based on things like the carrying value of land that is being depreciated, and may bear no connection at all to the market value of any of the company's holdings) will lead to a purchase at less than intrinsic value (which presumably would be based on the company's expected present value of its entire stream of future cash flows), then buying shares on the open market will reduce the outstanding share count, concentrating the company's post-purchase assets in a smaller number of shares. As long as the purchase price is less than the real value of the company per share (whatever that speculative number may be), the remaining shareholders enjoy an increase in value per share. This has the same impact of AGNC's strategy, which is the same thing in reverse: by selling new shares above the net asset value per share of prior shareholders, the original shareholders end up with shares backed by more assets than before the issuance. The reason this is better for Warren Buffett than a dividend is that only the selling shareholders face any risk of a tax impact: remaining shareholders get this benefit tax-free until disposition. Since Warren Buffett has announced he's giving his wealth to charity, none of his shares should be expected to be subject to income tax. Nice trick, eh?

Warren Buffett has no reason to issue a (taxable) dividend to individuals in the hope they know what to do with the money, if he knows full well that he can invest it somewhere safe and undervalued like his own company. A dividend prediction like this is nonsense. Paying dividends also ties Berkshire's hands in the event it finds great opportunities: it either won't have the cash, or will have to worry about "confidence" issues associated with halting a dividend, or will have to think about liquidity in case a risk matures into a loss on one of its multibillion-dollar-premium reinsurance contracts. The only safe thing for Berkshire to do – and the only sensible thing from a tax perspective – is to hold the money patiently awaiting good buys, including good buys in Berkshire's own stock.

The other thing I noticed is that the Fool – despite having long railed against paid money managers – not only sells a subscription specifically to alleviate your need to exercise judgment as to capital allocation but also runs an actual, honest-to-goodness, publicly-traded fund. Launched in June 16, 2009, FOOLX (an open-ended fund; we don't know how long it's had the capital it's currently deploying, or how much of it is new) is worth $13.88 at the time of writing. After the advisory fee, which my broker informs me is 0.95%, and the fund has an expense ratio of 2.2% (which offsets the lack of transaction fees, though there is up to 2% redemption fee), FOOLX has returned (according to my broker's metrics) 17.04%, which beats the S&P's 10.04% by 10%. If the 17.04% total return is accurate, its annualized yield – the fund has been in existence a bit over two years – is less than 8%. Other than the fund's holdings in a cash reserve fund, its largest holding is (according to Google) the POSCO ADR (PKX) – a Korean steel producer I've never heard of. An unknown is a great place to look for underfollowed, unnoticed, and mispriced opportunity. It'd be nice if I'd heard about this opportunity in one of the Fool's paid-for services, if it's so compelling that it's the largest equity in its namesake fund.

The Motley Fool provides a diverse array of conflicting advice: mechanical investing so you have simplicity and certainty; do-it-yourself because individuals can beat institutions; paid-for services because you haven't the time to find stocks; super-premium paid-for services because you can't tell which of our recommendations to buy, or in what amounts, and you're tired of standing like a deer in the headlights while your subscription ticks by; publicly-traded funds because you don't really believe that with all the brainpower at The Motley Fool there isn't an institution that can beat the markets, and you don't believe The Motley Fool when it says professionals' fees will sap your returns, and you just want to pay someone to take the responsibility off your hands. The Motley Fool does this while stuffing your email box with advertisements for its many services, using pitches that run absolutely counter to its Buffett-style patiently-investing-forever party line (e.g., click to see free report on hot stocks about to take off; act now before it's too late! Entry to this premium opportunity will close quickly so act now before you miss out!). Worse, they sell your email address to third parties who send you the same drivel – except for more complicated schemes costing even more money, that you have even less inclination to actually perform as recommended by the service, though it's hard to click the stop button while they discuss their slick ideas for enriching you ... which, if they worked so well, they'd hog to themselves instead of poisoning with a bunch of traders who'd play it out.

I'll continue to read the material – The Motley Fool is certainly one place to get ideas – but I have sincere doubt that I'll be maintaining any of these subscriptions (even at the newbie discounts). The quality of the analysis in the areas with which I'm familiar makes me deeply concerned with the quality of the analysis in areas in which I am not familiar. Thus, knowing nothing about Dreamworks except the quality of its latest product and its track record for turning merde into gold, I was made susceptible to buying the worst investment I've made since the crash – because I assumed they'd checked out the fundamentals. As I better appreciate the depth of the analysis (or lack thereof) behind the recommendations made in The Motley Fool's flagship Stock Advisor product, the less confident I am about the content of the paper or the homework that may (or may not) lie behind the short paragraphs pitching the companies. Whether I re-up will turn entirely on the quality of the investment ideas I actually get from the services. And this soon in, it's far too early to tell.

But here's this to think about. If subscribers have to do their own due diligence after reading The Motley Fool's flagship advisory products and their premium subscriptions, what is it exactly they are being sold? If all the customers want are ideas, they should be aware that trolling CAPS for pitches and/or combing the markets with free screeners is, well . . . free.

Examining Apple

David Nelson writes that Apple is doomed to slower growth and that Apple investors are living in denial.


As a longtime advocate of Apple as an investment, the Jaded Consumer was immediately intrigued. Several years ago on this very site, one could read about significant concerns arising out of the lightning-not-striking-twice problem facing Apple as an investment:
Apple had just returned to profitability from the long-suspected brink of death, and proceeded to grow sales so that its fixed investments were no longer consuming its revenues, and expanded margins by an order of magnitude. Apple introduced highly-successful new products that showed Apple could provide a worldwide online market place, and could deploy its operating system on mobile devices. While it's possible to deploy further new products, becoming recognized as a plausible going concern and growing gross margins to thirty percent are just not stunts one can repeat.
The link at the end of that paragraph is to a piece that includes this pearl:
The Future Is Not The Past
Apple's miraculous movement from 1997 to the present involved a movement from non-profitability to profitability. Margins improved by an order of magnitude. These are changes that can't happen twice.
So, the "news" that Apple can't repeat some of the most significant elements of its meteoric rise – the ranking increase of its world-recognized brand into the very top tier, for example – is not news at all. And everybody knows that doubling a $300B company is a different problem than doubling a $300M company. What's wrong with the easy conclusion that Apple's goose is cooked?

Apple has a margins advantage other manufacturers won't readily duplicate. Despite price declines in products, Apple is not a commodity vendor competing on price, but dominates its markets' capture of profit. Long garnering an outsized share of mobile profits, Apple now exceeds the handset profit made by all other handset makers combined (and has room to grow in units and in share). As Apple grows in its power to reach larger and larger addressable markets, its enormous advantages of scale will only increase its competitive advantage. Consider the difference in the effect of large volumes on the businesses of Dell and Wal-Mart: instead of paying for share like Dell (which must cut costs to move units against its competitors), Wal-Mart gets advantage from its scale. Apple's premier position promises to mature into a Wal-Mart like cash cow rather than a Dell-style yawnfest. Not that Apple's businesses are all headed from growth to stable maturity overnight – far from it. Apple has only just entered the top 5 PC vendors in Western Europe, for example.

And China has only a couple of Apple Stores. And South America hasn't been cracked yet. Russia? India? To claim Apple is done when it's just hit double-digit PC share in the US and hasn't yet done so worldwide is short-sighted, to say the least.

The end of the old piece on whether Apple had a safety net remains relevant:
The next ten years won't be the last ten years. They will, however, involve competition against some of the same players -- players Apple has apparently mastered fighting. They will be ten years of new hardware, new markets, and increasing price per unit of performance of component parts. Apple's addressable market will grow, and with it Apple's opportunities to reach out with sales opportunities.

If Apple's price becomes really crazy this suggests an excellent long-term buy. The question is: at what price have the shares become crazy enough?

On the other hand, in this fearful market and facing the liquidity concerns that it poses, there is no safe price for someone unable to tolerate short-term price collapses. The opportunities presented by this market are most attractive, I believe, to solvent investors who will remain without a need to liquidate positions for the foreseeable future.
Between then and now it's become clear that Apple's competitors include its former information services partner Google, and every handset and tablet manufacturer on the planet. Not just the smartphones; anyone listening to Tim Cook on the last call sees that Apple is aiming long-term at the entire mobile phone market. Looking at the evolution of the iPod ($499 at 5GB and fits into a pocket) to the iPod Nano ($129 at 8GB and clips to your sleeve), I don't doubt Apple has a plan to reach Everyman with an iPhone product. In fact, Apple was derided at the iPhone launch both by naysayers who declared phones were too difficult for Apple to master, and by competitors who laughed at the outrageous subsidized price of $499 – and it was a hit. Now – for the first time ever – Apple is selling an iPhone at a subsidized price of $0. That is the sort of change that dramatically alters the accessibility of the product, and grows its addressable market tremendously. Remember how Apple's quick iPhone price drop from $599 to $399 drove sales like wildfire into the holidays? Apple's iPhone 3GS and iPhone 4 models are still topping sales charts, not because they are new (they're old) but because their price is right. Imagine $0.

And in the meantime, Apple has launched a tablet product that has actually made the tablet market meaningful for the first time, and is the sole curator of the world's largest software store. Apple's huge transaction volume in its music, software, and hardware stores put it in an interesting position to become a major transaction processor itself (don't laugh, Apple considered becoming a telecom carrier in order to control the whole stack) – an important step in becoming a major conduit for RFI-enabled transactions based on Apple devices linked to iCloud accounts. Mastercard has a market cap of $46B, and Apple has better global brand recognition. Visa's market cap is about $75B. Suppose you didn't need to carry a wallet, just your phone? Making things simpler is part of the genius of Apple's broader pitch, and this fits right in.

Processing small charge transactions is a capability that – combined with Apple's demonstrated ability to offer $0 subsidized phones – places Apple in a position to become a fully-integrated payment system in developing countries where vendors have no infrastructure investment in traditional credit cards. I can imagine some markets in which Apple's capabilities could turn into enormous market advantage. And with $80+B in cash, Apple can create the banking back-end to ensure everyone is paid on time, all around the world.

Strategic investment, indeed!

Given Apple's enormous advantages of scale, its desire to improve both efficiency and control through integration of all the elements of the customer's experience, and the enormous fractions of the PC and mobile handset markets that remain open, it seems premature to conclude that Apple's growth is done. Rather, it's reasonable to conclude that Apple has found substantial room for growth and is exploiting that opportunity with the same quality of execution Tim Cook exercised before he became CEO.

UPDATE: The three major US carriers are struggling to fill customer orders. In the first three days of sales, Apple sold some four million iPhone 4S units in seven countries. Seventy countries will have access to the phone by year-end. The quarter's sales are likely to be brisk in comparison to the prior quarter: whereas the entire prior quarter saw Apple moving 17m units, Apple moved 4m in three days this quarter and is now rationing iPhone 4S units to retailers; Apple is still selling them by reservation before they arrive. Given the apparent shortages in evidence before the 70-nation availability has arrived, it's clear that even Apple's outstanding supply chain can't meet demand. Nice problem, eh? And this holiday, it appears Santa may be particularly good to Apple.

Tuesday, November 15, 2011

Reverse Barometer Prediction: Windows Era Forever!

Steve Ballmer, previously described here as a reverse barometer, has once again made a major public prognostication. This one, in response to a question about his agreement or disagreement with Jobs' description of today's world as a post-PC era, is a whopper: "We are in the Windows era -- we were, we are, and will always be."

Not that the Jaded Consumer would stoop to comparing such a Ballmer pronouncement to a declaration that the newest Reich will last a thousand years, but . . . imagine that declaration from the depths of a bunker . . . within earshot of Soviet artillery . . . . I'm just sayin'. It's an image.

At any rate, the presentation (as recounted by Electronista) included classic Ballmer unintentional poetry such as Ballmer's answering a question about why no good Windows tablets can be bought by holding up a developer's preview tablet from Samsung that is not available in stores and can only be had through attendance at Microsoft's build conference, and which runs a Microsoft operating system that has not yet been released. Not quite an answer, is it?

Similarly, Ballmer claimed that post-PC devices like cellphones and tablets were, in fact, good for Microsoft – notwithstanding that Microsoft's share of the phone OS market plummeted past 2% in the year immediately preceding his claim, and that tablets crushed the market for netbooks running MS-Windows. This, after saying last year that figuring out how to compete with iPads is "job one urgency", isn't particularly persuasive – especially after utterly failing to deliver for over a year. (Which has led to a drive to port MS-Windows to ARM, because the hardware for which MS-Windows has been compiled in the past just can't cut the mustard in the mobile space. Naturally, despite earlier representations, the ARM port will break legacy apps – including all x86 apps, which could be a problem for the effort to convince consumers that all they need to know about is "Windows compatibility", and a chore for developers with substantial code bases using any of the multiple APIs sold to them by Microsoft over the years – including Win32, the NT "Native API", Silverlight, and/or dotNET. Code to Metro, or go home.)

Mobile Platform Wars

According to Electronista, Gartner (whose direct link I didn't find; help welcome on this) reports that the 3Q2011 unit sales in worldwide mobile devices totaled some 440.5M units, of which 115M were smartphones.

Mobile device sales share by vendor looked like this:
23.9% Nokia
17.8% Samsung
4.8% LG Electronics
3.9% Apple
3.2% ZTE
2.9% RIMM
2.7% HTC
2.5% Motorola
2.4% Huawei Device
1.9% Sony Ericsson
33.8% Others

Considering that Apple's stated objective at iPhone's launch was 1% of the global share, this is quite a result. (Apple's 17m unit volume result was down sequentially from the prior quarter, presumably in anticipation of the imminent release of its new iPhone model, which at launch sold 4m units in three days before the rationing started.) Apple has increased its reach into numerous countries and has made a recent effort to focus on China, where the 300m+ middle class is a growing population. The whole list is included so that the just-over-a-third-of-the-market chunk that represents other smaller manufacturers is put into proper perspective. There are lots of handset vendors, and a big chunk of the phone space appears open to competition by small vendors with no particular advantage in scale or platform advantage.

Gartner reputedly reported that smartphone unit share, broken down by operating system, stood as follows:
52.5% Android (Google)
16.9% Symbian (maintained by Accenture, but appearing largely in Nokia devices)
15.0% iOS (Apple)
11.0% Blackberry (RIMM)
2.2% Bada (Samsung)
1.5% Windows Phone (Microsoft)
0.9% All Others

The story in platform is very different than in handset hardware. Only four vendors have double-digit share, and one of them appears on only one line of phones. Nearly the entire rest of the non-Apple segment of the market – 85% of smartphones – appears to use one of a few large-volume multi-phone operating systems. Leading among them is Android, which is a free Linux-derived operating system running WebKit and V8 and other no-charge open-source software. That it is free is certainly a reason OEMs would prefer it to a per-unit licensing fee as required to join Microsoft's tiny (by unit volume; I'm sure its enormous by code size) mobile ecosystem. Microsoft's 1.5% result was a drop from the 2.7% it had held of the phone platform share in the
year-ago quarter. The Nokia deal has apparently not yet paid off with a large volume of unit sales. Unless Nokia's fortunes reverse it will have little power to lift Microsoft's mobile share over the long run; if Nokia thought it was winning, it wouldn't have needed to abandon its own OS to partner with Microsoft, no? Since Nokia's >16% share of the smartphone platform sales gleans it just 4% of the operating profit in the mobile space, it's clear Nokia hasn't isn't sharing with Microsoft a yummy peach of a market segment; it's sharing a hatful of picked-over apple cores.

Research in Motion also suffered a nasty drop from the year ago quarter – from 15.4% of the market to 11% – and its effort to maintain relevance will be aided by enterprise relationships, which will buoy it somewhat as it heads past your window toward the parking lot below. Whether it will survive the fall is for another post.

On the other hand, the biggest share-loser over the year has been the Symbian platform, which plummeted from over a third of the smartphone market (36.3%) to 16.9%. Although 16.9% is still good enough to turn in a second-place finish, the trajectories of the share of Symbian and Blackberry don't suggest good things against Android and iOS, whose trajectories are plainly skyward. Symbian appears to be running out of momentum as a platform, especially since Nokia has announced a deal with Microsoft that seemingly spells the end of Symbian as a Nokia platform.

Smartphone unit sales are increasingly concentrating in a small number of OSses. Budget vendors operating in the commodity space have a strong incentive to choose the only available free contender, which is Android. Android should, over time, accumulate most of the OEM business available from smaller commodity vendors, and there is little reason for larger competitors not to use it as well. Microsoft, which hasn't had success selling phone handsets, should have trouble unless through strategic partnership with larger vendors – but how many larger vendors will be willing to do business with Microsoft while its business model remains per-unit licensing fees?

Microsoft's mobile flop won't likely cost it anything noticeable on the bottom line – the billions it gleans from its cash-cow legacy businesses in operating systems and office software utterly swamp anything it could be spending on its mobile team – but things look grim in the mobile space for the company in light of its current strategies. Sure, some radical new idea could take hold – but radical new ideas haven't exactly had a track record of survival in Redmond, so I'll venture to say that until Microsoft's culture changes, the window-dressing won't have long-term impact on its mobile performance.

This seems to leave iOS and Android. Google's software-only contribution to most Android devices means that, like Microsoft, it need not profit on hardware. Being the magnet for vendors fighting over the sea of Android users – and all OEMs seeking to avoid per-unit licensing fees – will cause the Android segment to draw a significant fraction of the commodity hardware competing with similar technology on the basis of price (for which discussion, see here). Android will represent the larger mobile device share by unit volume, while – at least for the next several years – Apple will remain the vendor with the largest share of the mobile device profit (as it is in PC profit). (UPDATE: Apple's phone handset profit now exceeds that of all other handset manufacturers combined.)

In this view, Google will succeed in chasing the revenue it expects users to generate using Google's services on a growing population of devices capable of accessing them, and Apple will succeed in earning the profit to be had on handsets, and enjoying the post-sale revenues deriving from use of its App Store, Music Store, and so on. Neither must currently destroy the other to achieve their objectives, because their objectives are currently orthogonal.

This leaves the question whether Apple will succeed in developing a post-sale profit that derives from non-purchase transactions, as Google does. For example, via Siri-accessible services. Anyone care to venture a guess whether Apple reaches a point at which handset profits are dwarfed by post-sale revenue and Apple directs its economies of scale to making low-cost devices to grow user base? Is that where older devices such as iPhone 3GS are headed over time? Any thoughts?

Monday, November 14, 2011

Apple Bucks Declining PC Sales in Europe To Enter Top 5 Vendors

According to Gartner, Apple's nearly 20% rate of unit sales growth rate over the year-ago-quarter helped to push Apple into the top 5 vendors (by unit volume) in Europe. Apple now stands at #5 in unit sales. Over the same period, three of the top five vendors (HP -7.5% to 21.8%, Acer -45.1% to 24.5%, Dell -10.0% to 9.6%) experienced an absolute decline in unit sales. Only Apple (having sold 5.7% share of units sold in Western Europe) and ASUS (at 7.8% unit share) enjoyed gains, each about 20% over the period.

In the UK, Apple is a top-5 vendor (ranking #4, at 7.8% of unit share) by volume; in Germany and France, Apple is not ranked. Western Europe bought about 14.8 million PCs in 3Q2011, and there's quite a bit of that market Apple hasn't snagged.

This market doesn't include the tablet market in which Apple's iPad competes.

Of course, unit share isn't profit share. Apple doesn't sell an undifferentiated commodity box; it competes in a high-margin segment of the PC market. Apple's gains in PC share represent even greater gains in the share of the profit to be had in the PC business in a given market. And as the Western Europe numbers demonstrate, Apple has opportunities for future growth in the PC business.

Thursday, November 10, 2011

Security Researcher Misjudges How To Demo Exploit

Forbes' Andy Greenberg interviewed Charlie Miller ahead of Miller's SysCan presentation on an iOS 5 bug that can be exploited to permit developers to have unsigned code downloaded to and run on an iPhone.

Code signing is Apple's technique to ensure that hostile programs aren't used to replace trusted ones, and to ensure that only trusted code is permitted to run on users' iOS devices. Apple's code-signing policy is a major differentiator of Apple's devices from those running Google's mobile operating system. Apple's relatively superior security record with respect to Trojans and viruses results directly from Apple's platform's refusal to run software not bearing a valid signature from an Apple-authenticated developer (available only through the App Store).

In order to demonstrate this flaw to Greenberg, Miller didn't show him an iPhone side-loaded with a developer demo app to prove it worked. Miller never explained why he didn't use his development tools to make a non-distributable demo. Other developers use this to test apps prior to submission, to ensure they perform as expected on actual running hardware. It's a natural fit for this kind of display: it's a test, and doesn't require making a known security risk available for public download.

What Miller did was to submit to Apple an app that pretended to be a garden-variety stock tracking app, but which surreptitiously phoned Miller's server to see if Miller had any unapproved code Miller wanted to run on the phone. Miller's server was set to "innocuous" mode when the app was approved, and he cheerfully set it to malicious mode and took remote control over the phone during the Greenberg interview. Greenberg's article was published November 7 at 2:38 PM. At 8:15 PM the same day, Greenberg was already publishing that Miller's app had been removed from the App Store and Miller removed from Apple's developer program for violating the developer program license agreement through a scheme to "hide, misrepresent, or obscure" material features of the fake stock ticker program.

Apple has already released an update resolving the code-signing workaround.

Since Miller didn't deploy the app using a non-distributable signature generated by a dev testing key, but actually persuaded Apple to approve an app that allowed Miller to take remote control of strangers' iOS devices, Apple didn't have much of a choice in how to handle Miller. Miller did exhibit a certain amount of humor: “I miss Steve Jobs,” he says. “He never kicked me out of anything.” Perplexingly, Greenberg seems to miss the critical difference between Miller's conduct and that of security crackers with whom Apple has extended friendlier treatment (to crackers whose work is expressly permitted by regulations promulgated by the Librarian of Congress under the authority of the DMCA).

The rule seems pretty easy: don't lie to anyone who relies on your code. Like, say ... Apple.

This leaves us with two questions --
(1) What will Miller demo at SysCan?
(2) What will Miller have ready when he's allowed to re-enter the developer program next November?

Wednesday, November 9, 2011

End Of The Mobile War Over Flash Player

The long-running account of the jabs and counter-punches exchanged between Apple and Adobe over Flash Player and its suitability for mobile devices seems to have wrapped up at last. ZD Net first reported that Adobe's Flash player will not be developed for new mobile devices, mobile browsers, or mobile OSes or even their future OS versions.

All Things D notes that Adobe recently announced a 750-FTE job cut, which may be related to its lack of stomach for a platform war that, as chronicled right here (from its inception or shortly afterward through a number of pieces of evidence suggesting the ultimate outcome), Adobe was plainly losing.

Will anybody miss mobile Flash?

Will anybody see a reason to maintain desktop Flash? If it eats cycles (i.e., electricity), weakens security, is unnecessary (or mobile devices wouldn't work), and messes up accessibility on users' diverse platforms, what will the basis be for deploying content that requires Flash players on any platform?

Monday, November 7, 2011

Earnings Obfuscation Under FAS 157

The Jaded Consumer has previously discussed how FAS 157 impacts American Capital Ltd. (ACAS), but this only scratches the surface of the pricing errors one can find in the wake of SEC filings whose earnings reports are poisoned by FAS 157. Watch this explanation of how –

"What's that?" you say. "Poisoned?"

Yes, my friend. Poisoned. You see, the Securities Exchange Commission is supposed to require filings with representations about earnings and performance so that the public is informed. When Joe Public reads a number like quarterly earnings, Joe wants to know if it's better than last quarter or the quarter that occurred the same time last year, and wants to understand whether the company is gaining or losing money and whether that gain/loss is slowing or accelerating. Joe Public may be using stock screening tools to identify in batches companies with improving profits (or exclude companies without them), and he may have little depth of knowledge about the particular companies whose headlining numbers he's reading. Goodness knows, Joe Public may be buying on a friend's stock tips or the raucous exhortations of a television personality.

So let's look at a company that's not speculative at all, for the purpose of identifying to the reader how FAS 157 confuses the public about a company's earnings and creates opportunities to catch utterly rock-solid and well-known companies being mispriced in the public markets.

So-Called Efficiency
Yeah, the markets that are supposed to be "efficient" so that all information is reflected in the prices – those markets. Markets that are so inundated with information of varying degrees of kind and quality that no participant can plausibly comprehend it all. Markets whose participants frequently have full-time work doing things so totally unrelated to the markets that they are inclined to buy or sell or invest or withhold investment on the basis of trust in third parties who themselves almost certainly arrived at a decision on the basis of incomplete information. Markets whose prices are not fixed by an arbiter of fairness, but on the purely mechanical conditions of the number of buyers, the size of their orders, and the prices at which their brokers will admit they are willing to pay for the size of order the brokers are willing to admit their clients are interested to obtain – and the number of sellers whose brokers are equally opaque with respect to the intentions of their clients. If you want the price of a thinly-traded stock to go down, simply enter a sell order and watch the numbers drop (which is a major reason to be skeptical of many pink-sheets listings). Or, as Cramer has described, wait until just after lunch when trading in all the issues is thinner and – by using the leverage inherent in standard options contracts – push even major issues one direction or another (I recall Cramer describing this technique as also involving a bogus rumor, which though poor-quality news – and easily exposed after time – still drives people into fear-based or greed-based moves, their confidence in which is increased by the "real" position taken by the manipulator to make the rumor look like it has substance). One can create or destroy quite a lot of market cap – utterly out of proportion to the capital at risk – or at least appear to.

But I don't have personal experience manipulating stock prices, except by accident while attempting to enter or leave a thinly-traded equity position. And in that case, I was accidentally manipulating the price against my own interest, which – lemme tell ya – is sorta a drag. Look carefully at trading volumes before buying thinly-traded issues; if your position is bigger than daily trading volume, how do you plan to exit? Even a big fraction of daily volume is frightening to think about planning an exit.

FAS 157 In Action
So what's accidental manipulation got to do with buying mispriced stocks after an earnings release that's impacted by FAS 157? Simple. When the earnings report comes out with a number that is heavily influenced by FAS 157, some people will look at the number – which is a good number so far as SEC compliance is concerned – and confuse it with an earnings number that one might take to the IRS. Depending which way that error runs, people may confuse the company with one that is unexpectedly profitable – or conclude that it's suffered a terrible hit that has, in fact, not occurred.

I promised a safe, stable, low-risk example. So, I give you Berkshire Hathaway. Berkshire Hathaway (BRK.A, BRK.B; after the 50:1 split that took place at the time of the Burlington Northern acquisition in 2010, BRK.B represents 1/1500 the equity interest of a BRK.A) is a holding company that includes retail insurers like GEICO, a reinsurance business so big that it was about the only place in which Lloyds could offload Equitas, which held the long-tail risk of its asbestos liability overhang (and where AIG just did the same thing), and a whole slew of portfolio companies in which Berkshire Hathaway invests money received from its insurance business in order to make money while waiting to see what long-term risks materialize. If you haven't read a Berkshire Hathaway annual report, you haven't seen how an annual report should spell out business to investors.

Berkshire Hathaway's earnings derive primarily from the consolidation of portfolio company earnings into its own balance sheet. Those earnings result from a diverse array of businesses (in no special order): GEICO, Dairy Queen, Sees Candies, Star Furniture, Burlington Northern Railroad, ISCAR Cutting Tools ... I could go on, but you can read the annual reports yourself. Berkshire also receives dividends from Bank of America, Coca-Cola, American Express, and so on. All good earnings. All pretty easy to understand. What's not to like?

Indeed. Berkshire's broad-based and powerful cash-generation is greatly to be admired. It's the kind of thing that, in the hands of investor-friendly and transparent operators such as Berkshire Hathaway's present management, inspires immense confidence. You see the earnings number, and you know there's no accounting game: you can take it to the bank.

And, yet ... FAS 157.

FAS 157 is an accounting standard. FAS 157 requires booking changes in values of derivatives (among other things) as income or loss in the period in which the value change occurs, without regard to the realization of that gain or loss. In other words, a company that reports that its book value has increased because its holdings are more valuable also reports that its income is up by the same amount, despite that no realization has occurred (and, due to market conditions, may never occur). This has the impact of causing unrealized gains and losses to be counted twice: first, against book value (which one would expect), and second, against earnings. It's that second application that's unexpected. Reported earnings are going to be understood by the public as earnings, not holdings. Reactions are sure to follow the headline number (earnings up!) rather than the number you or I would work out using the tax accounting with which we are more familiar – but investors will treat the headline number as if it were a taxable income number.

When The New York Times publishes an article titled "Derivatives Cut Into Berkshire Hathaway's Profit" there's no asterisk to indicate that the "profit" described in the title isn't taxable profit, or even realized profit, but a number that reflects an accounting principle no investor would ever apply to his own bookkeeping. Readers assume the New York Times is being accurate when its lead paragraph proclaims that Berkshire's profit declined "after losing more than $2 billion on derivatives related to stock market performance." Then, the lead of ¶2: "That was nearly three times what Berkshire lost on the same instruments a year ago." Readers' conclusion is obvious: Berkshire has no idea what it's doing with dangerous derivatives, and is in the grips of an ongoing losing streak. Quotes from Buffett on derivatives' dangers seem to fly in the face of the reported derivatives exposure, and suggest the company's leadership is unable to implement its publicly-proclaimed beliefs. The New York Times isn't some kind of outlier in describing earnings reports impacted by FAS 157. Bloomberg's headline, "Berkshire Profit Declines 24% on Buffett's Derivative Bets" is at least as lurid.

Readers value the company accordingly. Maybe readers think Warren has lost it, or that Berkshire is awash in rogue traders who imperil its good business with scary derivative-related risk. Who knows? What we do know is that Berkshire's shares are trading as if it's making a lot less money than it is.

Berkshire's Earnings and FAS 157
In the most recently-reported quarter, operating earnings of $2,309 per A-share exceeded estimates surveyed by Bloomberg (which averaged just under $1,800). Instead of publishing "Berkshire Beats Operating Earnings Estimates by 28%", Bloomberg publishes what in places reeks of character assassination. This is because Berkshire's assets (Berkshire holds investments in Coca-Cola, American Express, Bank of America, and lots of other long-term investments that it won't exit and whose price changes don't impact earnings) include some asset types subject to FAS 157, so that their change in asset value must also be reported as a change in income. In this case, it's derivatives.

In Berkshire's 2008 annual report, Warren Buffett explains how unnamed investors paid Berkshire $4.9 billion (cash Berkshire can use; there's no counterparty liability) for custom-made equity index options for which no market exists (neither party can possibly buy/sell to close the position before expiration), and which can only be exercised (if at all) on the date(s) of expiration (ranging between 2019 and 2028). In other words, market volatility can't cause early exercise; the option is either worth $0 (Berkshire hopes), or is worth more than $0, at the expiration date 15 or 20 years following issuance, and Berkshire either makes a payment under a contract (which may or may not be greater than the premium) or does not. If each of the indexes are 25% below their level at the date the options were written, Berkshire will be on the hook for about $9 billion. While there's risk of paying out more than was received in premiums, there is certainty of being able to invest the $4.9 billion for well over a decade and a very good chance that the indexes aren't so far below their value the day the options were written that Berkshire pays in 2019 (or 2028) more than it received in premiums. This is, in essence, like its insurance business: it invests a float while awaiting possible risk. This is in many ways better, because (unlike life or health or auto risk) the risk can't come due until expiration date. Berkshire has also insured some bonds, and some of that bond insurance (but not all of it) is subject to FAS 157.

It's worth pointing out that Warren Buffett's 2008 letter to shareholders makes a detailed explanation both of the risks in the derivatives, and the case to be made that the mark-to-market valuation given the equity index options systematically overstate Berkshire's risk. In the 2008 letter, he explains why, despite the apparent outrageousness of the liability overstatement, Berkshire Hathaway reported a "liability" in connection with its derivative holdings that led to a mark-to-market "loss" exceeding $5 billion. If you have any doubts about this as you read here, Buffett's letter provides delicious examples anyone can follow. Despite that the 2008 annual report listed Berkshire's derivative contract liabilities at $14.612 billion, it's worth noting that in the 3Q2011 report, Berkshire Hathaway's derivatives liability stood at $10.421 billion – not a bad move, considering what's happened to credit and equity between 2008 and the end of 3Q2011.

Berkshire Hathaway didn't exit derivatives positions in the last quarter for a realized loss of $2.443 billion, or even $2.443 million. First, neither party can exercise the 15-year and 20-year options except on the expiration date, and only then if they are in the money, and in that case the exercise only results in payment to the extent they are in the money. Second, 3Q2011 investment gains were $100 million in the insurance segment and $0 in the finance and financial products segment.

The fact that Berkshire Hathaway reported $2.278 billion in net earnings in the quarter while claiming to have "lost" $2.443 billion in unmatured derivatives suggests that Berkshire's real financial condition over the quarter amounted to (1) a real but speculatively-scaled reduction in assets associated with the unfavorable market conditions that impact the value of the illiquid derivatives that can't be exited for years, while (2) Berkshire experienced earnings of $4.721 billion.

Valuing Berkshire Hathaway Despite FAS 157
The question of how significantly the asset devaluation should impact valuation of Berkshire Hathaway is a fair question. However, to believe the impact is the equivalent to reducing Berkshire's earnings in the quarter by more than 50% is simply ridiculous. This quarter, FAS 157 caused Berkshire Hathaway's SEC-reported earnings (not its IRS-reported earnings!) to be lowered from $4.721 billion to $2.278 billion – a reduction of about 52%. What that means is that without FAS 157 to confuse people into mistaking Berkshire's unrealized gains/losses in long-term investments for income, its 3Q2011 earnings would have been higher than actually reported – 107% higher.

Yet, that's what FAS 157 requires: if bond insurance transactions are structured as a derivative rather than as an insurance product, it is subject to mark-to-market rules and impacts "earnings" every quarter regardless of actual realizations; yet if the same transaction is structured as an insurance product volatility becomes unimportant and earnings isn't impacted unless actual and anticipated payouts diverge. It's hard to escape the conclusion that FAS 157 causes Berkshire Hathaway's income to seemingly halve or double based on the Black-Scholes valuation of 20-year index puts (which is based on transient volatility and not the likely end-of-the-decade valuation of the equities in question, which is why the model has serious problems with long-term options that bear no pre-maturity exercise risk).

Berkshire Hathaway's income is clearly subject to material misstatements (that are required by the SEC) on the order of 100% or so in a quarter. In the wake of earnings announcements that are based on these reports, Berkshire's price is likely to be based on dramatic misconceptions of its earnings. The tone of the Bloomberg news item in particular suggests that Berkshire is led by a doddering gambler on a long-term losing streak, which can't be good for the non-numerical evaluation of the company, either.

Since more people will read articles like those in Bloomberg and The New York Times than will read Berkshire's annual reports, it's fair to say that Berkshire's valuation is based more on Bloomberg and New York Times spin than on the sober, thoughtful, and respectful content of the reports filed by Berkshire with the SEC. A sober investor might be expected to be able to weigh the impact of current earnings against unrealized changes in asset value, but those aren't the rules we have following FAS 157. Now, we're given an "earnings" number that tries to include unrealized changes in some – but not all – asset classes. The rule leads to confusion because it makes earnings difficult to compare across industries (some transactions of identical substance are subject/not-subject to FAS 157 simply based on the form of the transaction), and because it leads to "earnings" reports that are different from the experience of investors.

FAS 157 increases the opportunity to locate mispriced securities issues.

By identifying companies with significant exposure to FAS 157-generated confusion regarding quarterly profit, it is possible to use vastly overstated/understated earnings to ride substance-free movements in stock prices. Buying on the heels of a selloff resulting from a "bad" quarter like Berkshire Hathaway's recent above-expectations quarter provides an opportunity for outsized recovery following a report with a FAS-157-induced misstatement in the other direction. Don't hate FAS 157, use it to get an information edge on the nitwits that dominate the market.