Brighton Perspective

Sage of Omaha

Warren Buffet's highly anticipated annual report is now out - here - and, as always, its an outstanding read for anyone even slightly interested in investing and/or running a business. Buffet is a classic value investor and reminds readers, by defining is operating goals, how fundamental that can be:

1) diversified earnings streams, excess liquidity and modest near term obligations
2) continue to build competitive advantages in your operating lines
3) continue to seek further diversification
4) retain outstanding management

Easily said, not so easily done but these are fundamental goals anyone can apply to both their portfolio and their business. Strong cash flow, clean balance sheets (low leverage and no exotic off-balance derivative arrangements), excellent and conservative management, and strong competitive positions are all key to positive operating performance and positive stock performance.

It's not rocket science, yet it's remarkably difficult to achieve, particularly Buffet's success. According to his annual report, Berkshire has a compound annual gain from 1965-2008 (44 years) of 20.3% vs ust 8.9% for the S&P 500 (which is not shabby in its own right). So what differentiates Buffet from everyone else. I think it's discipline. So many investors and corporate managers lose faith in their strategies at the first sign of weakness. It is important to adapt but it's just as important to maintain confidence even when it appears unjustified.

Finally, Buffet comments on the "moral hazard" I've written about earlier. On page 12, he notes that "Though Berkshire's credit is pristine - we are one of only seven AAA corporations in the country - our cost of borrowing is nor far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one." This can't last - it must be addressed at some point by the government. If it persists, healthy, well-run organizations, such as Berkshire, will have diminishing incentive to maintain healthy and well-run.

I encourage everyone with a desire to better understand how to invest and how to build a business to read the Sage's report every year.

Markets Need Clarity

There's an axiom that "you don't throw good money after bad". I get the feeling that is what the government is doing in the new Citi deal. And that's after, or if, Citi is able to convince additional private preferred holders to convert to common! I think it'll be interesting to see how many are willing to do so and on what terms. Moving down in the capital structure commands a premium - if I'm going to assume more risk I need to get paid for it.

I prefer this approach. There's been much discussion about "good bank/bad bank" strategies. Woodward & Hall's make sense, isn't complicated, and free's up lendable capital.

Absolute Returns

Most investors, individual or institutional, tend to view returns on a relative basis, that is, how did we do relative to a benchmark like the S&P 500. I don't think this is necessarily a good thing. My issue is that these benchmarks are long-only. Relative performance doesn't mean much when your portfolio is down 30% and the S&P is down 37%! My view is that investors should focus on returns in an absolute sense. There is still a benchmark involved which means there is still a yardstick against which manager performance can be measured. In fact, it is a much more difficult benchmark because most mutual funds are also long-only and thus will struggle when prices decline. So I'm proposing investors hold their managers to a benchmark which is much more difficult to beat and against which their portfolios are structurally mis-aligned.

Doesn't make sense, right? My argument is that most investors should perceive their portfolios as endowments. I believe it is the intent of most investors to grow their endowment during their lifetime such that that endowment will fund their retirement in its entirety and potential provide a legacy for future generations. Focusing on an absolute return orients investors toward achieving this goal. Long-only benchmarks go up and down while absolute return benchmarks, primarily 3 month T-bills, don't. This orientation changes how a manager perceives the asset allocation. If the objective is to generate a consistent positive return, the manager must consider investments outside of the traditional long-only asset classes. That means such options as commodities, real estate, timber, absolute return, market neutral, and long-short (such as 130/30 strategies). Now you're incorporating more poorly correlated assets into your portfolio which should improve diversification, should reduce volatility and should orient the portfolio return objective toward an absolute return. It is a challenge to accomplish in the retail mutual fund world but I believe it can be done.

Treasuries, Savings and Export Growth

I read several interesting posts this morning on other blogs. First, Brad Setser Brad Setser-Follow the Money discusses who bought Treasuries in 08 and who'll buy in 09. Essentially, most of the Treasury action was U.S. private investors, not China, as most people assume. Thus, he believes it will have to be U.S. investors once again in 09 leading the Treasury buying to finance the stimulus. Current economic theory as noted by John Cochrane states that investors will buy government bonds if they believe the "stimulus" money will not be withdrawn by the government, i.e., taxes will increase to pay down the debt. Thus it would make sense to me that U.S. investors will buy Treasuries to the extent need in 2009 only if they believe they will be paying significantly higher taxes in future years. I think this expectation is accurate so I wouldn't be surprised by strong Treasury market activity this year.

However, if consumers choose to save, by buying Treasuries, rather than spend, domestic demand will remain weak. That means the economy will continue to struggle despite the "stimulus". According to classic Keynesian theory as explained by Richard Posner the solution then would be to stimulate exports. "Buy American" protectionism isn't going to stimulate exports. It seems logical that export growth must be a primary objective going forward.

This is good news!

Ben Bernanke - the Fed Chairman commented today that the government has no plans to "nationalize" banks or other financial services. This is good news. I've posted before about the moral hazard involved with partially nationalizing an industry. As the article notes, he leaves open room for the government to get involved in a different capacity. This isn't necessarily a bad thing. I've heard several options considered:

1) Voucher program - essentially financial services firms are provided capital in tranches and receive the new tranche only after demonstrating that pre-conditions have been met. This would force management to take designated actions to continue to draw down funds. It's an improvement over the TARP approach which essentially skipped attaching strings.

2) Government as co-investor - this could take several roles - debtor-in-possession financing for bankrupt companies unable to secure financing elsewhere, for example. This is the pronounced fear of the auto industry - no one will lend to them in bankruptcy. The government can provide the DIP financing with stringent criteria attached.

My thought is that the government should engage an experience distressed debt manager as a lead manager and function, effectively as a distressed debt fund. I know, fox in the hen house, but this could lead to better terms for taxpayers and tighter controls on management. Essentially, we, as taxpayers, become investors in the fund and the fund manager is/should be functioning in our best interests. Taxpayers win, companies get work-outs, management takes a beating. But that would happen in a private work-out, so that's nothing new. I don't have the access to detail that Bernanke and Geithner, et al, have but I think its an interesting approach to a complex dilemma.  

How does your 401k compare?

The Employee Benefit Research Institute released its 09 survey on 401k performance - Here - that highlights several items of interest. Performance was impacted by:

1) Account balance size - individuals with larger account balances suffered larger % declines
2) Tenure with firm - longer tenured employees suffered larger % declines (I'm sure account balance & tenure are highly correlated)
3) Equity concentration - clearly higher equity concentrations lead to larger declines

On average, 401k accounts were down roughly 25% compared to (37%) for the S&P 500 and +5% for the Barclays Aggregate Bond Index. At issue for many is an excessive allocation to equities regardless of age. Remember, the "rule of thumb", a starting point, is that you hold a % equal to your age in fixed income. So a 60 year old will have 60% of their assets in fixed income. That number can be adjusted to fit your personal situation. 

The report also notes however, that thanks to consistent contributions and employer matches, account balances are significantly higher than in 2000. Those aged 36-45 for example, saw their account balances increase by more than 100% on average despite the 2000-2002 and 2008 bear markets.

Going forward, the report recognizes that new rules which promote automatic enrollment and QDIAs (qualified default investment alternative) will help plan participants recover and move forward toward their retirement goals. Why? Auto enrollment ensures participation and QDIAs such as life-cycle funds and target date funds help improve participant asset allocations because they make that fixed/equity decision for you.

Disappointing!

I had hoped the President would acknowledge market concerns about the lack of direction provided by the White House tonight. Unfortunately, there was none. I'm concerned the Administration just doesn't get it. Market participants are hedging because we don't know yet if this Administration is intent on nationalizing our financial services industry. The moral hazard issue would undermine many if not all for-profit competitors of the nationalized firms and severely weaken the financial system. Yet, the address focused on familiar platitudes that served only to reinforce the notion of the partisan nature of the "stimulus" plan and the housing foreclosure bailout plan (see the Santelli YouTube video). I really want to see this Administration succeed in assisting in an economic recovery because we'll all benefit but haven't seen any evidence yet that they have any credible ideas. Crossing their fingers and really, really hoping they're right doesn't cut it.

My Company Just Cut it's 401k Match?!

Regardless of your belief about the rate of taxation at retirement, the advantages of tax-deferred compounding are significant and shouldn't be overlooked simply because your employer no longer matches. While other tax-advantaged investments exist, if the 401k was well designed and the plan sponsor adhered to its fiduciary duty, the plan will likely have lower expenses than other tax-advantaged options and will have more than adequate diversification. Staying with your contributions forces you to continue saving for retirement and enables you to continue to enjoy the benefits of tax-deferral. Of course, don't neglect your asset allocation. That's critical to long-term success.

You may have other options and they're worth exploring. Does your plan offer a Roth account? If yes, consider funding this account. Your contributions are after-tax but all growth is tax-free even when you withdraw it during your retirement years. If you don't have the Roth option, you could open a self-directed IRA and max your contribution. Upside is you control the investments, downside is the max is less than in your 401k. So, consider all of your options carefully but make a point, as long as your personal situation enables you to do so, of continuing to contribute to some form of a tax-deferred account.

Stimulus?

"Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?"

Every well written treatise on whether or not "fiscal stimulus" works. The short answer is generally "no" because its predicated on individuals assuming the additional money supply will be eliminated in the future. If consumers don't believe it will be retired, they will hold the additional money in government bonds so they can be the additional taxes around the bend. Fiscal stimulus in form of investment, that is government debt issued in exchange for high quality securitized corporate debt, should work. Unfortunately, this doesn't appear to the government's current plan.

Nationalization

If we nationalize financial institutions such as Citgroup and AIG, how do we avoid the moral hazard such an action will create? Imagine a Citigroup or an AIG without a clear profit motive or at the urging of the national government, returning to exactly the same business practices that got them in trouble in the first place. What price will sound, private competitors to these institutions pay? How can a well run, financial sound company with a profit motive and or creditors expecting to be paid, compete with company which will not be penalized for poor business practices? If AIG and/or Citigroup and their ilk are nationalized, good companies like Chubb, BB&T, M&T Bank, US Bancorp and Lowe's could see their own businesses and stock prices disintegrate virtually overnight.

S&P 500 Dividend Aristocrats

Standard and Poors maintains a list of S&P 500 Index constituents that have increased their dividend every year for the past 25 years. 52 companies are currently on the list and they're a Who's Who of large cap value stocks. See the list here - Dividend Aristocrats. I'm not advocating anyone invest in these stocks, that's a personal decision. I found the list while doing other research and thought it interesting.

I did a quick analysis - just equal weighted performance as of the end of December 2008. An equally weight portfolio of these 52 stocks would have outperformed the S&P 500 by 5.85% for 4Q08, by 14.85% for calendar 2008 (still down 22% however), and by 5% or more for the trailing 3, 5 and 10 year periods. Statistically, the portfolio looks like the index except for a much lower debt/capital ratio (26 vs 32). So, superficially, there doesn't appear to be much justification for this portfolio's relative performance. The common threads are likely a history of consistent cash flow growth, conservative management and a comprehensible balance sheet. These are always solid principles of investing yet somehow they can fall out of favor. Appears they're back in fashion now.

2009 Deloitte Top Five Total Rewards Priorities Survey

Deloitte recently released its 2009 survey on retirement and benefits trends. Deloitte Survey Many of the findings are not necessarily suprising but re-confirm what you're probably already thinking. That is, most employees are planning to work longer to recoup what they lost in 2008, want to participate in their retirement plans and want more education on what's available to them. In fact, according to another survey, the average 401k plan balance was down 27% in 2008. Employers are more focused on retention and recruitment in 2009. Plan participants benefit tremendously from a more formalized educational process that covers the plan options and pre-retirement considerations. The onus is on management to step up the process and improve offerings. This is a win-win for everyone. The more comfortable employees are with their understanding of their options, the more likely they are to participate. The greater the degree of participation, the greater the commitment to the organization. That helps employers manage costs, build morale and strengthen the organization. What's surprising is that this joining of the minds hasn't been more widespread and isn't already a best practice.

So what do you think of the stimulus bill?

One of the most frequent questions I've received in the last week or so. Like most of Congress, I haven't had an opportunity to fully review the 1,000+ pages but I've read as much as possible. My academic training causes me to lean toward less government intervention and toward monetary theory. That is, I'm not a big fan of government - really, if you believe the best and brightest in the financial markets are the reason for the recession and economic/liquidity crises, why do you believe the government, the government, which does not contain the best and brightest and is not motivated by altruism, is the solution! In this case, something like less than 15% of the $800 billion will be injected into the economy in the next 18 months. Meanwhile, the economy will recover on its own as the natural sine curve takes it's course.

So if the economy recovers on its own, before most of the $800 billion is poured in, what happens? Economic growth combined with an increasing money supply leads to.....inflation! My fear is this stimulus package will in fact stimulate only inflation in our near future. That's not what anyone wants, of course, but that is a highly probable outcome. So, bottom line, I'm not so hot on the stimulus bill. I don't expect it to accomplish its intended purpose and do expect it'll fully comply with the law of unintended consequences.