Tag Archives: economy

Affirming the Case for Quality (GMO White Paper); Share Repurchases

Quality Companies are often under appreciated by investors

I hope my wretched scribbling will help your investing journey. We want to learn from the lessons all around us. Study failure so as not to pay a high tuition for knowledge and study success so as to develop your own investment method.  Yes, it is fun to point out the disasters like Sunpeak Ventures (SNPK)—nothing but a “pump and dump”—yet focusing on great companies is more valuable, yet less popular than you might think. Your time is best spent understanding and investing in great companies—either hidden champions that are emerging or dominate hidden niches or great franchises with dominant moats.  This is why I try to write often about competitive advantage, franchises, and quality businesses.

Here is a GMO White Paper (June 2012) that affirms the case for quality. Companies with high and stable profits (KO, PEP, EXPD, M, and GOOG) tend to have lower bankruptcy risk, lower leverage and generally higher returns compared to risk of loss. Please read carefully: GMO_WP_-_2012_06_-_Profits_for_the_Long_Run_-_Affirming_Quality

Ben Graham argued that real risk was “the danger of a loss of quality and earning power through economic changes or deterioration in management.”

The returns earned by stock investors are entirely a function of the underlying corporate profits of the stocks held in a portfolio.  Note the focus that Buffett has placed on knowing where a business will be in five to ten years—a chewing gum company versus a high tech start-up). As he says, “We favor businesses and industries unlikely to experience major change…operations that….are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.”

Oligopolies tend not to revert—note the persistence of corporate profitability of companies that operate within corporate barriers.

Look at the stability of companies like Tootsie Roll and WD-40. Tootsie Roll (Tootsie Roll_VL) has slowly declining returns on capital but it is shrinking its capital structure. Note the low price variability. Everyone knows about WD-40 (WDFC) (lubricant oil) and Tootsie Roll (candy)—the products will not disappear in the customers’ minds nor become obsolete.

Note on page 4 of the GMO White Paper: While it has become conventional wisdom that the market misprices price-based risk factors like low beta outperforms high beta, we find that it also misprices fundamental risk. . Companies that report negative net income underperform the market by a whopping 8% per annum. The market overpays for risk at the corporate level in much the same way that it overvalues the risk of high beta stocks. Conversely investors had historically underpaid for the low risk attributes of high quality companies.  To us (GMO), investing in Quality companies simply exploits the long-term opportunity offered by the predictability of profits in conjunction with the market’s lack of interest in the anomaly. Their predictability higher profits are not quite high enough to command the attention of a market in thrall to the possibility of the next big jackpot. 

Lesson: focus on quality companies to find better returns for lower risk.

Radio Show on Quality Stocks

For beginners and (those who are willing to sit through or skip the commercials), there are discussions about high clean-surplus ROE companies here: http://www.buffettandbeyond.com/radio.html

More on corporate buybacks

Assessing Buybacks from all Angles_Mauboussin


Tomorow I will post the prize to all those who lent their wisdom to: http://wp.me/p1PgpH-Qw

MF Global Accounting Lesson

If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a great defeat. If you know neither the enemy nor yourself, you will succumb in every battle. –Sun Tsz 2,500 years ago

When you come to the market, bring your investment discipline; bring your analytical powers; bring humility.–the Two Cents Philosopher

June 7, 2012 at www.nytimes.com

Accounting Backfired at MF Global

This article illustrates the importance of converting accounting information into economic reality and the pitfalls for both management and investors when ignored. 


Back when I was studying accounting at Columbia University’s business school, the professor had a handy way to determine whether it made sense for a company to recognize revenue: Had it completed the hard task in its business?

GAAP — generally accepted accounting rules — were not so simple, he said, and sometimes let companies record revenue — and post profits — far too early. Companies that took advantage of such rules could well be reporting earnings they would never see.

The hard task varied from business to business, he said. For a farmer, the hard part was done when the crop was harvested. Even if it had not yet been sold, there was a ready market for corn or soybeans or whatever, and money had been earned. For a manufacturer of tourist tchotchkes, making them was the easy part. Persuading someone to buy them was the difficult part, and revenue recognition should be delayed.

Over the years, I’ve seen any number of accounting disasters, ranging from Enron to subprime mortgages, where that simple principle was ignored. Sometimes that accounting was within the limits of GAAP and sometimes it was not. In all cases, it produced profits that vanished before they were actually realized.

Now there is another example at MF Global, the brokerage firm that Jon Corzine ran into the ground.

The accounting maneuver allowed MF Global to buy bonds issued by European countries and book profits the same day. That is the rough equivalent of a farmer’s booking profits as soon as he plants the crop.

To be fair to MF Global, it did disclose what it was doing in a footnote to its financial statements. The accounting appears to have been proper under accounting rules that are now being reconsidered.

In a minute, I’ll explain exactly what the company did and how the accounting rules came to make it possible to report profits that were at best premature and at worst fictional.

But for now, consider the effect such rules had. MF Global, when Mr. Corzine took it over in 2010, was unprofitable. Here was a way to report instant profits and make the financials look better. There is no way to know whether the firm would have taken fewer risks without the foolish accounting, but perhaps it would have. In any case, regulators and investors might have seen a less rosy — and more realistic — picture in the months leading up to the firm’s failure last fall.

The transactions were laid out this week in reports from two trustees trying to unravel the MF Global mess and return as much money as possible to customers.

The fact that there are two trustees, one appointed by the Securities Investor Protection Corporation, which provides reimbursement for brokerage customers under some circumstances, and the other by the bankruptcy court judge, only begins to address the complexities of the mess made by Mr. Corzine. There are also “special administrators” in London, since many of the trades were carried out through a British subsidiary. The three sets of trustees and administrators have spent a lot of time fighting one another.

“Among the lines of business that Mr. Corzine built up to attempt to improve profitability at MF Global was the trading of a portfolio of European debt securities,” states the report by the SIPC trustee, James W. Giddens. “These trades provided paper profits booked at the time of the trades, but presented substantial liquidity risks including significant margin demands that put further stress on MF Global’s daily cash needs.”

How, you might wonder, could MF Global report profits immediately? Shouldn’t it wait for interest to be paid on the bonds, or at least for the market value of the bonds to rise?

To my old professor, the answer to that would have been yes. But that is not what the rules said.

To explain how that worked, we must venture into the world of repos. But don’t let your eyes glaze over. A repo in reality is usually just a loan. The lender gets an agreed rate of interest, and it gets possession of the collateral while the loan is outstanding. That way, if there is a default by the borrower, the lender can sell the collateral and not have to wait to be paid.

MF Global having bought a Spanish government bond, for example, would then repo it, meaning it would turn over the bond in return for a loan. MF Global would get the cash, but it retained all the rewards and risks of owning the actual security. If the bond defaulted, MF Global would suffer the loss.

Most repos are accounted for as loans. But sometimes they are accounted for as sales. One such case involves what are called “repos to maturity,” or R.T.M.’s, in which the repo does not expire until the security matures. MF Global called these transactions R.T.M.’s even though they expired two days before maturity. That was because a London clearinghouse, which was on the other side of the trades, was not willing to lend the money for that long. It wanted to be repaid before the bond reached maturity, so as to be protected from loss if the bond went into default at maturity.

Under the rule, MF Global could say it had sold the bond, not just lent it out. And with a sale, it could post a profit based on the fact that it borrowed more than it paid for the bond. Theoretically, it should have also taken a reserve for the fair value of the default risk it was taking. The details are not clear, but it appears that reserve was not very large, leaving MF Global with a profit to report.

Just now, that seems truly absurd. But the Financial Accounting Standards Board says that until MF Global failed, no one had complained about the rule. Since then, the chief accountant’s office at the Securities and Exchange Commission has voiced concern, and the board hopes to propose a new rule later this year.

I wondered how that rule came to exist. The answer, as in many cases of abused accounting rules, seems to be that FASB was trying to stop a different abuse.

That abuse came years ago, when United States Treasury securities were trading at large discounts to face value.

That was because interest rates had risen, not because anyone doubted the bonds would be repaid. Under the accounting rules, owners did not have to take losses on the bonds so long as they held onto them, no matter how low the market price was. But if they sold them, they had to take the loss.

Enter the clever strategy. The owners would do repos on the bonds, and treat them as loans. The repos would not expire until the bonds matured.

For all practical purposes the owner had sold the bonds at a loss, been paid for them and moved on to other investments, but no loss showed up on his financial statements.

The FASB ruled that a “repo to maturity” was really a sale. In the above case the owner of the bond would have to report a sale, not a borrowing, and report the loss.

The accounting board provided guidance indicating that if the repo ended very close to maturity, that amounted to the same thing. That made sense if you ignored default risks, and in those days repos were usually of very high-quality bonds with little or no chance of default.

That is the rule that MF Global was able to use, except that rather than avoiding a real loss, as in the previous case, this time it was reporting a profit that would arrive only if the countries were able to pay their debts.

As everyone knows now, people grew nervous about sovereign credit over the last couple of years. Regulators worried about the risky nature of the sovereign debt forced MF Global to maintain higher capital levels, which the report by the bankruptcy trustee indicates the firm tried to evade by shifting some of the positions to an unregulated subsidiary.

But the firm still needed more and more cash to meet margin calls as the market value of the bonds fell. In the end, it ran out of cash, and — intentionally or otherwise — seems to have misappropriated hundreds of millions of dollars from customer accounts.

It would be wrong to say bad accounting caused MF Global to fail. But it did both encourage and obscure risk-taking that ended in collapse and scandal.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

How Do I Get A Job on Wall Street?

Job Search Strategy

Some may find the links below helpful.

How do I get a job on Wall Street? http://www.economicpolicyjournal.com/2012/06/how-do-i-get-job-on-wall-street.html

Beware of the typical advice, “Conditions are bad now so go get an MBA and then come back in two years when things will be better.”   First, “things” may be worse and how does an MBA equate to investing success?

Go where the money is: http://www.economicpolicyjournal.com/2012/06/hottest-area-in-finance.html

Yes, Wall Street is grim since it is over-bankered/brokered after decades of easy money and over leverage. But areas like manufacturing and energy will grow. You don’t have to be on Wall Street to use your skills. Be creative.

Inflation, Price Controls and Rome; Tweedy Browne, TAVF

My last mention of the Roman Empire, http://wp.me/p1PgpH-vM.

The fall of the Roman Empire ushered in the Dark Ages (Wow! Now THAT is a bear market–an age of fear, despair, fiefdoms, and darkness)  http://en.wikipedia.org/wiki/Dark_Ages_(historiography)

If Only Edward Gibbon Could Have Read Mises

By Daniel J. Sanchez at www.mises.org

Monday, June 4th, 2012

Thanks to Ed Smith for pointing out this passage in the Decline of the Rome Wikipedia article:

Historian Michael Rostovtzeff and economist Ludwig von Mises both argued that unsound economic policies played a key role in the impoverishment and decay of the Roman Empire. According to them, by the 2nd century AD, the Roman Empire had developed a complex market economy in which trade was relatively free. Tariffs were low and laws controlling the prices of foodstuffs and other commodities had little impact because they did not fix the prices significantly below their market levels. After the 3rd century, however, debasement of the currency (i.e., the minting of coins with diminishing content of gold, silver, and bronze) led to inflation. The price control laws then resulted in prices that were significantly below their free-market equilibrium levels. It should, however, be noted that Constantine initiated a successful reform of the currency which was completed before the barbarian invasions of the 4th century, and that thereafter the currency remained sound everywhere that remained within the empire until at least the 11th century – at any rate for gold coins. According to Rostovtzeff and Mises, artificially low prices led to the scarcity of foodstuffs, particularly in cities, whose inhabitants depended on trade to obtain them. Despite laws passed to prevent migration from the cities to the countryside, urban areas gradually became depopulated and many Roman citizens abandoned their specialized trades to practice subsistence agriculture. This, coupled with increasingly oppressive and arbitrary taxation, led to a severe net decrease in trade, technical innovation, and the overall wealth of the Empire.[8]

The passage of Human Action in which Mises discusses the decline and fall of Rome was recently featured as a Mises Daily.

Tweedy Browne Annual Report:



Third Avenue Value Funds 2nd Qtr. Report: http://www.thirdave.com/ta/documents/reports/TAF%202Q%202012%20Shareholder%20Letters.pdf

Welcome to the Bronco Ride!

Money supply growth is falling.  Go here: http://www.federalreserve.gov/econresdata/statisticsdata.htm The latest numbers show 13-week seasonally adjusted M2 annualized money supply growth is down to 5.7%. Non-seasonally adjusted is down to 5.8%. 4-week data averaged over 13 weeks is at 3.8% annualized. This four-week number shows the intensity of the decline in current weeks versus that of the longer term 13 week number.

Jim Grant in his Interest Rate Observer (www.grantspub.com) writes in his June 1, 2012 issue, “To judge by deeds, not words, the Bank of Bernanke is as tight as a tick. Over the past three months, Federal Reserve Bank credit has shrunk at an annual rate of 9.3%. At the peak of QE2 one year ago, Fed credit was billowing at short-term annualized rates of as much as 47%. Waiting for QE3.”

Also of note is Grant’s expectation of a QE3 to reverse the trend. Indeed, that’s the kicker here. The trend in money growth and credit is slowing (credit declining) and that’s negative for the stock market and economy, but a major reversal is likely in the not to distant future.

Welcome to the bronco ride.

Use this opportunity to pick up good companies when they go on sale.

Fear and uncertainty are the friends of value investors. However, the pain may be intense at times.

To understand wwhat a bear market FEELS like go here:http://www.youtube.com/watch?v=0OmkmeOMC6Q&feature=related

We are far from the 2008/2009 situation. Hang in there and Enjoy your weekend.

Cooperation without Incarceration from Competition Demystified

Let’s face it. In most of life we really are interdependent. We need each other. Staunch independence is an illusion, but heavy dependence isn’t healthy either. The only position of long-term strength is inter-dependence: win/win. –Greg Anderson

The original cases from Chapter 14 and 15 from Competition Demystified http://wp.me/p1PgpH-J3

For easier reading the PDF of this post:Chapter 14_Cooperation without Incarceration

Chapter 14: Cooperation without Incarceration: Bigger Pies, Fairly Divided

What are the three parts of the “fairness principle” needed to sustain cooperation?

Utilizing “fairness” principles to divide the spoils while sustaining cooperation

For cooperation to be sustained, all of the cooperating parties need to be satisfied with the returns they receive from continuing to cooperate. If any player becomes sufficiently dissatisfied, it will inevitably abandon its cooperative behavior. Non-cooperation from a single player may lead to a cascading collapse in cooperation by others.

Individual Rationality

The first condition of fairness is that no firm in a cooperative arrangement should receive less than it could obtain in a non-cooperative setting. Unless it makes sense for each firm to cooperate, meaning that each firm does at least as well by cooperating as by refusing to cooperate, then cooperation will not be sustainable. In this sense, the original division of the spoils will not be fair. Because of the fairness conditions, it is important to consider the outcome that firms can achieve when they do not cooperate. The “threat” being non-cooperation and a myopic pursuit of one’s individual goals. The same outcome is referred to by the acronym BATNA—the best alternative to a negotiated agreement. It is the yardstick against which the firm’s rewards under a cooperative arrangement are measured. In organizing a fair division of the spoils, the non-cooperative outcomes for all the participants have to be taken into account.

If the component and equipment makers existed in a world without cooperation, new entrants and internal competition would drive their economic profit to zero, meaning that they would earn a return on their invested capital equal to the cost of acquiring that capital. The threat point or BATNA, for these companies, the point at which they would be better off without cooperating, is at this level of reward, when they earn no more than their cost of capital.

Firms that operate without competitive advantages should not expect to earn returns above their cost of capital even when they work in a cooperative environment. The principle of individual rationality implies that the only benefits of cooperation that are subject to divvying up are those gains above the non-cooperation outcomes, that is, gains that are the benefits to cooperation itself. When among all the cooperating companies only one firm enjoys competitive advantages over its actual potential rivals, it will reap all the rewards. In many instances, however, more than one firm benefits from competitive advantages, and has some claim on the cooperative gains. In the personal computer industry supply chain, both Microsoft and Intel enjoy significant competitive advantages.


Under the principles of symmetry, if all the legitimate claimants to the benefits of joint cooperation, that is, all those enjoying competitive advantages and therefore not forced to cooperation by competitive pressure, look essentially the same, then they should divide the benefits of cooperation equally. If, among essentially identical cooperating firms, some of them consistently appropriate a disproportionate share of the benefits of cooperation, then the firms that have been shortchanged are going to be dissatisfied, and legitimately so. Forms with authentic grievances will not cooperate indefinitely.

If two firms in an industry both enjoy competitive advantages, cooperation requires that both participate. Then, of the benefits of cooperation can be shared between them, so that each dollar of benefit surrendered by one firm is transferred to the other one, the division of the benefits should be equal. The firms are equal in that each is essential for there to be any benefits of cooperation, and therefore, according to the symmetry condition, they ought to expect to share in them equally. If either makes a determined effort to seize more than an equal share, threat move will ultimately undermine the cooperation between them, hurting them both. As in so many other areas of business strategy, a calculated restraint on aggression is essential to long-term success.

Linear Invariance

The need for fairness applies to situations in which several firms, all with competitive advantages, occupy the same segment in the value chain and divide the market horizontally. In this case, the fairness principle dictates that if there are two firms in a segment, and one of them has twice the size or strength of the other, then its portion of the benefits from cooperation should be twice as large.

Nash used the term linear invariance for this version of the fairness requirement. It works by assigning shares of cooperatively exploited horizontal market in proportion to the cooperating firms’ relative economic position–to each his own, on other words.

What are the benefits in analyzing how an industry and its players could cooperate even when there is no chance that the companies in a particular industry can overcome their competitive behavior?

The cooperative perspective is instructive even where there is no chance that the companies in a particular industry will be able to overcome their antagonisms and work out some kind of cooperative arrangement. It can identify potential areas of cooperation, even if they are limited to only one or a few of the areas was listed earlier in the chapter, like specializing research and development to avoid duplicating one another’s efforts. Only after it has made these decisions is it time to turn to the question of what rewards it might reasonably expect to earn from these focused activities.

It is also useful in highlighting a firm’s genuine strengths by pointing out where it would fare if the industry were organized cooperatively. In this respect, it can help clarify realistic expectations and terms for prospective strategic alliances and relationships between suppliers and purchasers.

Finally, if a firm’s own prospective position within a cooperative configuration of an industry does not look promising—at the extreme, the firm has no reasons for existing if there is no cooperation because, for example, it is a high-cost supplier—this information provides an important strategic insight into a company’s future. Its survival will depend on the failure of the other companies in its industry to cooperative effectively with one another. If it wants to continue, it will have to improve its position before the stronger market participants learn to cooperate successfully.

By recognizing the ultimate consequences for itself if others cooperate, the firm’s management can get a sense of how long it has to live and how far it has to go to survive. These are essential pieces of information for formulating a useful strategy for such a disadvantaged firm. Such insights add to the overall value of a cooperative viewpoint which is an indispensable supplement to the more standard forms of competitive analysis.  In the area of competitive analysis, it is important to keep in mind the fundamental complexity of the problems at issue.  Clarity depends on a picture built up carefully from a group of simplifying perspectives. Fully cooperative view of the world, however unrealistic in pro-active, is a perspective that contributes meaningfully to that clarity of vision.

Successful cooperation is neither common nor easy. The rival firms have to find a way to work in harmony to advance their joint interest, and they have to do it legally, to avoid drawing the wrath of the agencies charged with preventing and punishing restraint of trade.

In Chapter 15 we will study several potential outcomes of a potentially cooperative arrangement in the case of Nintendo and Eythl Corporation

So What Can You Do With $100?

“And right here let me say one thing:  After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this:  It never was my thinking that made the big money for me.  It always was my sitting.  Got that?  My sitting tight!  It is no trick at all to be right on the market.  You always find lots of early bulls in bull markets and early bears in bear markets.  I’ve known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit.  And their experience invariably matched mine – that is, they made no real money out of it.  Men who can both be right and sit tight are uncommon.  I found it one of the hardest things to learn.  But it is only after a stock operator has firmly grasped this that he can make big money.  It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.”  — Jesse Livermore http://www.gold-eagle.com/gold_digest_03/hamilton110303.html

What would you say?

If I said to you RIGHT after the October Stock Market Crash of 1987 when the market fell by more than 500 points in one day: http://wiki.mises.org/wiki/Black_Monday_%281987%29 give me $100 to put into a growing company with a profitable, understandable and focused business, excellent management and prospects, but I will pay 20 times owner earnings for it, would you think about it? But what if I said, “The catch is that you must not sell a single share for 25 years or until 2013. Also, during this time there will be massive stock market booms and busts, a huge credit crisis, wars and uncertainty, There will be periods of 50% to 60% declines in the stock market.  Can you sit tight?

Stay tuned to what happened and is happening….


Volatility at World’s End or the Alchemy of Risk

Volatility at World’s End

Deflation, Hyperinflation and the Alchemy of Risk

Artemis Capital Q12012_Volatility at World’s End

The above 18 page report will help you understand how huge debts can either cause deflation or hyperinflation. A thought-provoking read that I highly recommend.


Earlier I posted on hyperinflation here:http://wp.me/p1PgpH-1h

When NO ONE accepts a fiat currency then the inflation is infinite. No amount of paper currency–even by the ton–will be used as a medium of exchange. ….Back to barter we would go until a new medium of exchange is found or used.

Current Market Situation



Money Manager Presentations; Investment Philosophy; and Words of Wisdom

Columbia Graduate Business School established a Graham-and-Dodd chair, but oddly assigned it to Bruce Greenwald. Greenwald, an MIT-trained economist had married into money, made a million or two in bond futures, lost a similar sum in oils, and quit at the insistence of his in-laws. “At investing I’m a complete idiot,” he noted, rather affably, adding that it was speculating that turned him on. He invited Buffett to give  a guest lecture but did not think him imitable. “I’m sympathetic to the Graham-and-Dodd point of view,” Greenwald said, “but I’m not really a Graham-and-Dodder.” (Buffett by Roger Lowenstein-1995)

Notes on Money Manager Presentations

A reader graciously shared his notes on the VIC in Omaha (2012). I added supplementary materials

VIC_2012_Brian_Bares on the Small Cap Advantage

VIC_2012_Cara_Denver_Jacobsen 10 Years in Micro Cap Land

VIC_2012_Damodaran and Investment Philosophies:Damordaran 200 pages on Inv Philosophies

VIC_2012_Francisco_Garcia_Parames Finding European Value

VIC_2012_Jeff_Auxier Value of Cumulative Research

VIC_2012_Jeff_Stacey Global Value Investing

VIC_2012_Lauren_Templeton John Templeton’s Strategies

VIC_2012_Lisa_O-Dell_Rapuano Value Investing with a Contrarian Bent (Rec!)

VIC_2012_Pat_Dorsey on Moats (Important to read)

VIC_2012_Paul_Larson Morningstar Stockinvestor Newsletter Editor

VIC_2012_Robert_Hagstrom Investing: The Last Liberal Art. He recommends, How to Read a Book by Adler

VIC_2012_Seng_Hock_Tan Value Investing in Asia.

Words of Wisdom


As always, adapt to your style, personality and aptitudes.


My Research Director: http://www.youtube.com/watch?v=RXromsE-S7g

My shocked face: http://www.youtube.com/watch?v=i8edTjSx1nM&feature=related

Back with Buffett Case Studies: Dempster Mills and Sanborn Map

“We are what we repeatedly do. Excellence then, is not an act, but a habit.”–Aristotle

My Black Ops Ninja team was able to crack Buffett’s safe in Omaha and bring back these case studies for your enlightenment and study. Mr. Buffett was found passed out on his desk from a Cherry Coke drinking binge.  This video was running on his TV: http://www.youtube.com/watch?v=-0PrTkE5jG4&feature=related  Mr. Buffett is preparing for this weekend’s Buffett Lovefest.

Buffett’s Case Studies:

Dempster Mills

& Sanborn Map

Dempster_Mills_Manufacturing_Case_Study_BPLs What lessons are there here for us to build upon?