Buffett was wrong about this one. (Unfortnately it is the most important one of all.)

This is an issue that has become very important to me lately, and I hope readers will be patient and read through my thoughts. It is not a pleasant topic and most people would prefer to pretend the problem doesn’t exist. But it needs attention soon.

One evening last spring I took my wife to a local movie theater to see the premiere of the documentary I.O.U.S.A., the movie designed to increase awareness of the “inconvenient fiscal truth” that our nation faces. It was a great event, and was followed by a live Q&A with some of the stars, including Dave Walker and Warren Buffett.

Walker was the doomsayer, and expanded on the already strong case made by the movie that due to the national debt and other liabilities of the federal government, our children are destined to end up worse off than we are today. Buffett was the counterpoint, arguing that although it is a serious problem, America will be fine in the long run.

Buffett was wrong.

I wanted to believe the guy, my hero, the Oracle of Omaha. But the facts just didn’t support his Alfred E. Newman-esque stance. Here we are a year later, and things not only look bleaker than ever, it almost seems as if the sky has started its fall.

When Bush 43 took office in 2001, our nation had $5.6 trillion in outstanding debt. In the eight years since then, through a combination of tax cuts, wars and expensive Medicare supplements, the amount has mushroomed to nearly $11 trillion. Think about that: the balance of our national debt is climbing at an annual compound rate of 9%. And this doesn’t even include the unfunded liabilities of Medicare and Social Security, which will come due at ever increasing rates in the coming years and by most accounts dwarf our current $11 trillion in debt.

The Peter G. Peterson Foundation estimates that our “real” national debt, after accounting for all these unfunded liabilities that will presumably have to be financed by taking on additional debt, is now $56.4 trillion – four times our current GDP. Comfortably paying this off is simply an impossibility.

Now, in a misguided Keynesian approach to solving the financial crisis(which is not unrelated to the problem of government overspending in the first place), Obama and the others are spending a trillion dollars MORE of money WE DON’T HAVE. Of course, this is not a Democrat or a Republican issue. Democrats like to spend money, Republicans like to cut taxes. BOTH are equally dangerous. No one will want to do it, but what this country needs is higher taxes, lower spending and a higher personal savings rate. How the hell are we gonna pull that one off??

I don’t think we will. And that is why I think Buffett was wrong. Washington, now more than ever, lacks the political will to correct this problem. And that is why we are doomed. Sadly, what will eventually happen is the government will have to print enormous sums of new money, causing hyperinflation and prohibitively high interest rates. What it cannot do, ironically, is choose to simply default on its mountain of debt as the Russians did in the 90s. This is because the vast majority of our debt is actually owed to ourselves, via Social Security and Medicare entitlements. What a fricking trainwreck.

What I am saying is nothing new. People throw these kinds of numbers around all the time. At some level, this may even be counterproductive – people get desensitized to the enormity of problem. What we don’t hear enough about is what life will actually be like when this hits the fan some twenty years down the road. How will we be living when 75% of our GDP is committed to simply servicing our national debt? Where will jobs come from when reinvestment ceases because corporations are forced to forfeit their earnings to the government? How will the citizenship react the government is forced to confiscate nearly all the earnings of the public while simultaneously eliminating the programs upon which everyone has become so accustomed to relying? From a sociological perspective, this is terrifying. Chaos could ensue. Good thing the second amendment hasn’t been completely repealed.

Perhaps most frustrating to me is that the root of the problem seems to be something that is all but impossible to change. It is a societal attitude towards debt – the entitlement philosophy that WAY to many (though not all) Americans adhere to. I DESERVE that 52” plasma tv, because I work ten hours a day flipping burgers, and burger flipping is hard work. That kind of attitude will kill a society fiscally, because the truth is that simple hard work does not entitle you to anything more than someone else is willing to pay you for that work. If they don’t pay you enough, you need to find a way to become more economically productive so as to boost your wages so that you can afford that Cadillac Escalade only AFTER having saved for it.

It’s a chicken-or-egg situation to determine whether it is the government setting a bad example for individuals or if it’s an infiltration of the government by entitlement-minded individuals, but clearly both segments of our society have the same attitude towards debt. This MUST change.

I worry about my one-year old son, David, and what type of world he will face as an adult. For his birthday earlier this month, a good friend of mine gave him a $50 Series EE “Patriot” savings bond. I loved the message of savings and responsibility in such a gift, I only wondered if it would be in default when David goes to cash it in 2039. I tell you, I would do anything possible for my son but ensuring he lives in a prosperous economy seems beyond my control. That worries the hell out of me.

I am sure many folks will think I am wacko for this outlook, but I hope those that do take an honest look at the situation before concluding I am wrong. At a minimum we need to put ourselves on track to reverse the current trend.

*** Clarification, 28 Apr 2009***
In this post, I did not mean to imply that I think Buffett was wrong just because of what has happened over the past year. Buffett said last spring that "America will be fine in the long run" and by long-run I assume he means 30, 50 years. I just happen to disagree becuase as long as we continue this trend of enormous deficit spending ($1.7 trillion this year alone) we will not be fine in the long run.

GM - What a joke

Let’s face it. General Motors is in terrible shape. It sells an unpopular line of vehicles and is completely captive to its inflexible cost structure. Despite what political pundits would like to suggest, the company’s troubles are not the result of a lack of environmentally friendly products – they are due to the fact that consumers just don’t want to buy their cars. It’s really pretty simple.

Now, having said this, the stock of the company is not inherently a bad investment. For one thing, the company seems to (for elusive reasons) be wholeheartedly supported by US government. This is almost certainly the only reason why the company has not already filed bankruptcy, after all in the past three years GM has posted cumulative losses equal to twice market cap of the company when the stock was at its peak.

There are a lot of stakeholders in a company as large as GM, but of all of them bankruptcy would hurt the shareholders the most. So there is value to the nonzero probability that the company will somehow avoid bankruptcy and survive as a going concern. (Aside: In the case of a GM bankruptcy I would say there is an above-average chance that absolute priority would be violated and shareholders would not lose completely, in light of the “too many people have their 401(k)’s invested in GM stock” mantra.)

But GM stock is cheap. Really, really cheap. From its 2007 high, the stock has lost an astounding 96% of its value. So, for the moment, let’s assume the company does not file bankruptcy and that we must rely on the future cash flow production of the company to assign the stock a value. Believe it or not, even the current stock price of $1.69 may be too expensive because this price implies Required Business Performance that is actually greater than most people expect.

At the current price, revenue can decline by only 12% in the upcoming twelve months, and this is assuming a moderate improvement in gross margins. This does not seem likely to happen. In the absence of the unprofitable sales generated in 2007 by heaving discounting and promotion, sales of the company have been steadily declining for several years, in fact in Q4 of 2008 sales fell 35% versus the same quarter a year earlier. And now the company faces not only its internally generated hardships but also an unforgiving macroeconomy.

For these reasons, even though the stock is basically as cheap as it has ever been, the company still has only a 50% RBP Probability, indicating that it’s pretty much a flip of the coin as to whether it will produce the results need to support an already miserable stock price. There are a lot of cheap stocks in this market. GM is one that is cheap for a reason.

A dual-class arbitrage in Berkshire stock?

Hat tip to Ray for pointing this out to me. A few days ago BRK.B was trading at a level significantly lower than 1/30 of BRK.A. In fact the spread represented 7% of the value of BRK.B.

This was a decent arbitrage opportunity, as the two BRK classes have historically been pretty good about reverting to parity fairly quickly. Indeed, within two days the spread has already narrowed to less than 2% (as a % of BRK.B). Below is a chart of the difference over the last year.



It is interesting to see how the spread became more erratic as market volatility increased in the fall. Note that the spread rarely dips into the negative. This is by construction, since BRK.A is convertible in to BRK.B but not vice versa. This means that a mispricing favoring the B shares could immediately be corrected by arbitrageurs converting their A shares to B. But the opposite cannot be done, leaving the arbitrageur at the mercy of the market to correct the mispricing.

In the rare cases when the spread does bounce up to the 7% range, this makes for an opportunity for a quick profit for those vigilant enough and quick-fingered enough. The recent bounce lasted at least 24 hours from what I could tell, which is plenty of time to implement the trade.

A few other notes: BRK is a great stock to play the dual-class arbitrage with because it is so liquid and small investors should have no trouble finding A shares available for short. Of course, you need at least $78,000 in capital so I guess the really small investor is out of luck.

Moreover, the differential in voting rights between the A shares and B shares is inconsequential in the case of Berkshire since Buffett et al. control the voting power of the company anyhow. Thus we can expect the 1:30 ratio to hold irrespective of the differential voting rights of the two shares.

I suppose measuring the spread as a % of BRK.A would be more appropriate, because a true arbitrage strategy would short BRK.A and long BRK.B, holding until the difference was zero.

At what point does Berkshire get "stupid cheap"?

I own a lot of Berkshire stock. I don’t like seeing it go down because I don’t have a lot of liquidity at the moment, otherwise I would welcome the buying opportunity. But this begs the question, is this indeed a buying opportunity ? Or is it the beginning of the demise of the greatest investment of all time?

With is decline today, Berkshire stock has just experienced its largest drawdown ever. From Jun 19, 1998 to Mar 10, 2000 (the same day the NASDAQ hit its high, by the way), BRK lost 48.9%. From December 7, 2007 to today, BRK has lost 49.33%. It is worth noting that its current low is 81% higher than its 2000 low, which equates to a 5.6% annual compounded rate of return (trough-to-trough). Not exactly Berkshire’s historical annual average.

In my opinion, Berkshire currently suffers from a tremendous lack of transparency. This may sound blasphemous, but it is not. Although Warren Buffett prides himself in holding simple, understandable businesses, Berkshire’s portfolio is anything but. The company has an insurance business that only Buffett fully understands, with mysterious macro bets that seem entirely inconsistent with the style of investing that got the company to where it is today.

Investors are rightfully very suspicious of all these derivatives, particularly since Buffett refuses to talk about them except in broad, vague terms. I’m not faulting him for this necessarily, since for many companies such refusal would be expected. But we expect Buffett to explain everything to his investors much more thoroughly than a typical CEO would. If he believes the annual report should provide investors with enough information to allow them to accurately value the company, as he has said in the past, then it might seem he is now failing in this regard.

In last year’ letter to shareholders he goes in to quite a bit of detail about what derivatives the company owns, but in the current market environment this information is stale and insufficient. For instance, he says,

We have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

This is clearly a much higher level of disclosure than many companies would provide. But it almost raises more questions than it answers. $4.7 billion? Has this happened? The third quarter 10Q provides no more detail, but does indicate that a) the company wasn’t substantially hurt by the derivatives up to that point and b) that it increased the size of its derivative portfolio. (I lump both the options and credit default swaps in to this category.) The real problem is that there is no telling what has happened since September 30.

Of course there are more obvious reasons for the Berkshire’s stock’s slide. Two of Berkshires three largest common stock holdings, Wells Fargo and American Express (Coca-Cola is the third) have each been clobbered by more than 70%, costing the company at least $11billion were we to mark them to market. Ouch. Kinda makes you wonder if he (along with just about everybody else) misjudged the threat of financial contagion on Berkshire’s investments in financials, or for that matter the ability of management at these (supposedly very strong companies) to resist it.

The annual report that is due out in the next few weeks will be very interesting. We have heard the “end of Berkshire” refrain before, not coincidentally at the same time as its last trough that I mention above. So on a superficial level one might be inclined to assume it’s another chicken-little situation. But this recession is different from the tech bubble burst and I’m not counting any chickens just yet anyway. There is just too much uncertainty this time around.

RBP Investing Update

Back in June I mentioned on this blog that I had started working for a company called Transparent Value, which developed the Dow Jones RBP Indexes based on their proprietary methodology called "Required Business Performance," and that I had been writing a blog for them.

While I realize it may sound like I am just trying to sell the company, I seriously think anyone with an appreciation for value ought to give this methodology a look because it looks like the guys at Transparent Value really are on to something. This is evidenced by the performance of the indexes in 2008. If you had used their methodology to construct a long/short market neutral portfolio you would have beaten the market handily (and actually earned a positive return in 2008!). Granted we only have one year of performance history, but what a year it was to test an idea like this!

For an academic and value investor like me, their methodology is the perfect blend of empirics and fundamental value. Basically they take each company determine what assumptions one would have to make about it in order to make a DCF valuation yield whatever the current stock price is. Then based on historical performance the assign each company a probability that they will be able to deliver up to those assumptions. The indexes simply select stocks based on this probability.

I am always looking for empirically solid but economically logical investing strategies (in fact my other blog, Empirical Finance Research, is devoted to this idea alone) and RBP fits in perfectly. If any readers of this blog have questions about it, let me know because its sometimes hard to understand at first. But once you get the gist of it it's pretty rockin.

Fundamental Value Investors: Characteristics and Performance

My good friend Wes Gray and I recently wrote an academic paper about value investors. Wes is a fellow coauthor mine over at the Empirical Finance Research blog. In our paper we analyze the investment recommendations on the website Value Investors Club, which in my opinion has some of the highest quality research accessible by the general public.

VIC started about nine years ago and today has more than 3000 very high quality research reports written and published by its members. Most, though not all, VIC members are professional money managers and membership in the club is limited and coveted. Wes and I wondered (from an academic point of view) if these people were actually able to beat the market given that, in an efficient market, we would expect them to not.

Our results indicate they do beat the market and can produce substantial alpha over one-year holding periods. They do best picking small cap stocks, but for horizons longer than one year they fail to beat the market. From this we conclude that there is more inefficiency in small caps and that the broader market recognizes these inefficiencies if you give it a year. This was an exciting finding for us since it logical and makes economic sense and also means we aren’t wasting our time reading VIC write-ups!

Anyway we posted the paper at SSRN yesterday and Guru Focus has already republished it themselves, although I am keeping an updated version on my personal webspace. We would love getting feedback on it as we are looking to improve it and prepare it for academic publication.

Doing the math on CEG (back of the envelope)

I post this not as any type of authority, but just to figure it out for myself. Can anyone explain better than I have here why CEG stock fell yesterday?

This past summer MidAmerican Energy agreed to acquire all outstanding shares of Constellation Energy Group (CEG) at a price of $26.50 per share in cash, or $4.7 billion.

EDF came along a few weeks ago and offered to pay $4.5 billion to acquire half of CEG’s nuclear division.

In 2007, the nuclear division generated about 60% of CEG’s revenue. So, effectively, EDF was offering to pay approximately as much for 30% of CEG as MidAmerican was offering to pay for the entire company. EDF emphasized that this offer priced CEG stock at a minimum 100% premium to its market price.

Before the EDF offer, CEG stock languished at around $23.50, about a $3 discount to the MidAmerican’s cash offer price of $26.50. Upon the offer, CEG stock shot up to around $28, clearly because EDF’s offer was so superior.

Yesterday, both companies confirmed that MidAmerican was terminating its agreement to acquire CEG. As part of this termination, CEG was to pay MidAmerican a breakup fee of (approximately) $500 million plus shares equaling 10% of CEG’s equity. Upon the announcement of the termination and subsequent details of the breakup, CEG fell 12%, to less than $24/share.

If EDF is offering to pay $4.5 billion for 30% of the company, then the company as a whole should be worth $15 billion minus the breakup costs, assuming of course EDF is not overpaying. With 178 million shares outstanding, this would be about $84/share minus breakup costs.

At its current price, CEG has a market cap of $4.3 billion. In other words, it is about to sell part of one of its units for more than you could buy the entire company for today. Were you to buy CEG today you would (theoretically speaking) get all your money back upon the consummation of the EDF deal, leaving you with half of the nuclear unit and all the rest of CEG as gravy, but also with the obligation to pay MidAmerican $500 million in cash (about $3/share) as well as shares equal to 10% dilution of the stock (if we assume intrinsic value before dilution is 84 – $3 = $81 then this would be $8.10/share).

So what do we have? CEG should be worth $84 – $11.10 = $72.90? Is this right?

I think it may be, but that doesn’t make it a buy. Not in this market anyway. I mean, the stock soars when the EDF deal was proposed, then tanks when the deal was confirmed. This is just nutty.

The logical explanation for CEG’s fall yesterday is that investors simply will not buy anything in this environment that does not have an identifiable and imminent catalyst. There is value all over the place right now, so CEG is not alone with its unfairly low valuation. Because of this, and because the market is so nutty anyway, investors just don’t want to put up with owning the stock now that they know they won’t be getting their $26.50 cash payout.

These are amazing times. Ben Graham is smiling from the heavens I am sure.

Thoughts on a Big 3 "Bailout"

With so much talk, debate and controversy over the idea of “bailing out” the Big 3 automakers, I find it amazing that so little of this discussion has been on the topic of bankruptcy. The media, congress and the Big 3 CEOs seem to accept as a foregone conclusion that a bankruptcy filing would be a bad thing. This is completely absurd and I would like to discuss why.

Businesses fail in this country (and across the globe in fact) all the time. Because of this, and because chaos might ensue among creditors otherwise, we have this nifty section of the U.S. Code called Title 11 entirely devoted to the idea of the federal court system dealing with failing businesses (or individuals) and aiding in equitable distribution. This is not new – the power to codify such a thing was written in our constitution. What is new is the idea that in some instances we ought to abandon this time-tested framework and instead let Congress directly and deliberately affect the outcome of financial distress for a limited and specific group of companies. Reminder: Congress is not in the business of running businesses. (We need to remind ourselves of this these days.)

I will, for the purposes of this essay, assume that it is in the best interest of the nation to see the Big 3 survive. However, I do think very strong arguments can be made that they ought to be competed out of existence. Nonetheless, let’s assume that the job losses that would result from an outright liquidation of the automakers would be permanently catastrophic to our economy.

Under this scenario the solution is simple: File Chapter 11 like every other company that runs in to difficulty. Many pundits seem to be equating bankruptcy with corporate death, which is just not the case. Chapter 11 primarily allows a firm to restructure its capital. In the end the company comes out of bankruptcy with less financial burden. Operational changes usually occur, but that is not the point. It is a financial maneuvering first and foremost. Filing Chapter 11 does not necessarily mean any factory-line autoworker need lose his job. However, one caveat: If your job is not needed, it may (and should) be put on the chopping block as part of the plan of reorganization. Perhaps this is reason for the UAW’s opposition to bankruptcy?

What Chapter 11 does usually mean is that the CEO will get fired. With very rare exception, the existing CEO gets canned between the time the bankruptcy petition is filed and the plan is confirmed (for empirical support of this contention see Hotchkiss (1995)). This, I think, is why we saw the three CEOs fly their corporate jets to Washington to beg for help. All of them are probably not long for their posts, save perhaps for Mr. Nardelli, who could probably make the strongest argument he is not to blame for his firm’s woes. Thus, the CEOs clearly would rather not go the Chapter 11 route. And so they go before Congress to testify in front of a group of politicians that desire to be seen as the saviors of the auto industry, and who know that the majority of the American public doesn’t really understand what bankruptcy is. It’s a win-win for the powers that be. Not so much for the millions of other stakeholders.

There are two reasonable arguments against a Chapter 11 filing for the Big 3. The first is the weakest, but also the one that has been cited the most by the ignorant media. People won’t buy cars from a bankrupt automaker. Sounds bogus to me, I mean people fly on bankrupt airlines every day. But maybe it is true if potential customers are legitimately worried about the soundness of their warranty. Perhaps. But there is a logical solution that does not include writing a $14 billion check: Have the government guarantee all Big 3 car warranties for a period of time sufficient to restore confidence in the companies. Maybe until confirmation of a Chapter 11 plan of reorganization when the company will have more firm footing?

The other argument against Chapter 11 is more legitimate. This is that, once in bankruptcy, the automakers won’t be able to find the necessary debtor-in-possession financing to keep them afloat through plan confirmation. One reason bankruptcy works as well as it does is that, once the petition is filed, all subsequent debts are given priority over pre-petition debts. This is called debtor-in-possession (DIP) financing. With the credit markets tightening, it is not unlikely that the Big 3 would find DIP financing scarce. No problem! The government can't wait to lend these companies money. Problem solved.

If the government is going to provide lending to the Big 3, it ought to be under the oversight of the bankruptcy court. Congress could tell them to go ahead and file, while assuring them that DIP financing will be available from the government if needed. It seems unnecessarily arbitrary to extend a loan to a troubled company outside of bankruptcy for no other reason than that they employ many people. By structuring government involvement within the framework of bankruptcy (through a government-backed DIP loan and/or guarantee of manufacturer warranties), at least the many other existing creditors will have a voice in the direction of the companies by allowing them to vote on the plan of reorganization.

I don’t like the term “bailout” because it implies that whatever problem exists will be fixed. Congress' proposed bailout promises a great deal of bailing, but not much hope for a bail-out. I mean seriously, blindly throwing money at businesses that are losing billions of dollars every year with no real guarantee that anything will change is an awfully foolish idea for anyone, but especially the government.

Merger Arbitrage Mania!

I haven’t heard a lot of discussion about this, so I thought I would put my thoughts down on this blog, because to me the phenomenon is pretty obvious. There is some serious value out there right now, and for the last two months the market has been more inefficient than I have ever witnessed in my lifetime. Many stocks, especially small caps, are selling at valuations FAR below their intrinsic value, even after accounting for the possibility of severe and prolonged recession. I am convinced the reason for this is not fundamental, it is institutional.

Hedge funds make up a huge portion of the market and the vast majority of them are levered, many highly levered. By “hedge fund” mean simply the plain-vanilla, independent equity long/short type (not the arcane structured-product investing kind like Bear Stearns’ that got us in to this mess in the first place). By “highly levered” I mean anything from 400% gross exposure (this would be 200% long and 200% short) to infinity.

These are the types of investors that buy up small value stocks. Well, when liquidity dries up brokers have to boost margin requirements. Couple this with falling stock prices and the resulting margin calls and what you have is a situation where everyone is selling. This is basic stuff. But compounding the problem is even more selling as the result of investor redemptions. All hedge funds have different redemption periods, but my guess is that as the year closes we will see even more hedge fund selling as investors dissatisfied with this year’s performance cash out.

I still think it is this delevering phenomenon that explains much of the disparity between price and value that we are currently seeing in the market. But where it seems most obvious is in the merger arbitrage arena. This is where I am focusing currently because a) the value of the stock is much less ambiguous and b) the delevering effect is likely especially pronounced among stocks heavily invested by hedge funds who must leverage up substantially to take advantage of what are typically small discounts.

The first case-in-point is a long-time favorite company of mine, Anheuser-Busch (BUD). InBev settled with BUD back in July to purchase the company for cash of $70/share by calendar-year end. The stock hovered around $68, representing a reasonable merger arb discount, until the market blew up in September. At this point the stock, like all others in the market, fluctuated wildly and momentarily got as low as $56. This $14 discount implied a 25% raw return, or 240% annualized! Investors immediately assumed this was because the deal was in limbo because of the state of the European credit markets. But InBev soon issued a press release reiterating that the cash offer was still a go and still expected to close by the end of the year.

I was lucky enough to load up on BUD around $58. Since I don’t mind owning it as a standalone company (in fact I had for many years anyway), my rationale was simple since the expected value of the purchase was enormously positive. That is, there was a high probability of the deal going through, resulting in a large gain, and only a small probability of it not going through, which would result in only a small loss.

The second case-in-point is an even bigger no-brainer. Remember back in September when Berkshire Hathaway announced that MidAmerican Energy would acquire Constellation Energy (CEG) for $5 billion or $26.50 per share? Did you know the stock is currently trading at $23.50? This doesn’t make any sense, but yet the cigar butt is right there in front of us. With this deal, although not expected to close until sometime in Q2 of 2009, there is absolutely no danger of the acquirer failing to find financing. We are talking about Warren Buffett and his war chest!

I believe that the only reason these situations are occurring is because of the deleveraging effect. It certainly does not seem to be a function of risk so far as I can tell. Highly levered hedge funds MUST sell off their BUD or CEG stakes simply to meet higher margin requirements or investor redemptions. This leaves the individual investor with some great opportunities. But these types of opportunities are unlikely to ever be repeated, which is why I am placing large bets on them.

A couple of other merger arb plays to consider: HPC and MVCO

Ashland Inc.’s acquisition of Hercules Inc. (HPC) is a deal that has been approved by all shareholder constituencies and is expected to close next week. I don’t know much about these companies but I can find no indication anywhere that the deal is in trouble. If it is, someone please let me know. The shareholders will get $18.60 plus 0.093 shares of the acquiring company. With Ashland currently around $20, this puts the value of HPC around $20.50. HPC stock is currently at $18.

Meadow Valley Corporation (MVCO) agreed to be acquired back in July for $11.25/share and the deal is still expected to close by the end of the year. With the stock currently under $8, we are looking at a 26% return in two months.

Another intriguing thing about these merger arbitrages is that even if our return is small, the market in general does not look good in the near term anyway. We could play the safest mergers and still come out ahead, since the standard discount out there right now seems to be in excess of 10% annualized.

FD: I am long BUD, CEG, HPC and MVCO

Victory for Wooden Arrow Advocates

It was a glorious evening yesterday when the U.S. Senate passed its version of H.R. 1424, the package of legislation representing Congress’ half-hearted attempt to stabilize the economy. It was glorious for all those of us who have striven so hard in our lives to ensure the proliferation of wooden arrows designed for use by children.

I was ecstatic to see that, upon passage of this legislation, wooden arrows (with shafts consisting of all wood and containing no laminations or artificial means of enhancing the spine of such shaft) will be exempt from excise tax. Importantly, this provision allows for wooden arrows with shafts measuring 5/16 of an inch or less! The heck with all those wooden arrow manufacturers who intend for their product to be suitable for use with a bow. Who needs ‘em? I am talking about arrows with natural spines. What a landmark victory in the history of wooden arrows!

In times of crisis, I am still able to rest assured that our elected officials are able to reach meaningful legislative consensus.

PS - Where's the hedge funds' bailout?

As the day has worn on, I am getting convinced this is political because here is what I've been told. Hedge funds are evil. Short sellers are evil. Even the SEC is evil - and that was before it decided to ban short selling. (I am referring to McCain's comment that Cox should be fired for not regulating the markets sufficiently in the last few years. ?? Cox should be fired, but not for what he did last year or the year before...)

Ever notice how every time the media mentions short selling that mention is accompanied by an explanation of what short selling is. You know how it goes. "Short sellers take bets that a stock price declines, hoping to profit from its fall." Why does this need to be explained every flipping time? Because they think we are idiots. Actually, that's not right. They are idiots and assume we are idiots as well. This works well for politicians, because they can run around blaming everything on hedge funds and short sellers and Mr. Dumbass American Joe won't know any better. Isn't that about right?

Oh, so now it's the shorts' fault?

Nothing surprises me these days. But that doesn’t mean it doesn’t concern me. This short selling ban is, without question, the scariest thing to come out of the whole mess.

And it is not that I don’t have perspective. The meltdown of three bulge bracket I-banks and the largest insurer in the world is pretty damn scary. But at least it wasn’t the government’s doing. You see, I have a far-fetched and unfashionable faith in this whole free-market thing. I realize the effective shutdown of credit and resulting lack of liquidity would have been devastating to the economy, possibly sending us in to depression. But how in the world does the banning of short sales on the stocks of these financial companies promise resolution? (answer: it doesn’t, but makes the politicians look good)

Here are a few things I know for sure. First, hedge funds now dominate a huge portion of the stock market in this country. In order to hedge, they use short selling. Without the ability to do so – even if only for a limited number of stocks – their portfolios will be in chaos and this is not right.

Second, short selling is not evil. It is necessary. Typically the only ones who ever gripe about it are the ones frustrated their stocks aren’t going up. But even if it were evil, it was the way the game was played up to this point.

Third, if the bulls really were right, they would eat the shorts’ lunch. The shorts would drive the price down and at some point, I, the fundamental value investor, would say holy cow this stock is cheap and buy it up. But we can’t do that with the financials because there is a good chance they really are worthless.

Fourth, the act of the government telling me these stocks are not worthless does not change their intrinsic value.

Maybe there is a legitimate reason. The most logical one is that some short sellers are spreading false rumors. Well, this is called fraud and is already illegal. If the SEC wants to go after any idiot that may be doing something like this, they can have at it. But banning short selling across the board is not an appropriate reaction. Jim Cramer articulated a different possibility yesterday, that short selling is being used as financial terrorism. I guess the theory is that some middle-east terrorist syndicate is coordinating a series of shorts, knowing that it was cause chaos in our markets. I guess that’s plausible.

Most important, though, is that the SEC itself has yet to justify the attack on shorts. While it is still early in the day, I have yet to hear anyone explain how it is the stock prices of the financial firms that threaten the stability of our economy. I would argue that the stock prices, while reflective of the underlying firms, are not the cause of their troubles. The cause of their troubles lies in the credit market, credit default swap market and/or the mortgage backed securities market. But NOT the stock market. In light of this observation, the only conclusion I can draw is that Washington doesn’t want to see stock prices fall, regardless of the underlying fundamentals of the companies behind them. This is not a free market attitude.

Call me ivory-tower, but it was my understanding that short selling helps in this process we call price discovery, the driving force behind the efficiency of the capital markets. Without shorts, one must own the stock to take a bearish position. With it, the bears and the bulls can battle it out and reach a consensus called the market price. The sad truth is, the financial companies whose stock prices are getting hammered have financial statements that nobody trusts, giving the shorts as much justification in betting against them as the longs would have in betting in favor of a stronger company.

Moreover, the inability to short leads to market bubbles – the very problem (albeit in a housing market) that got us in to this mess to begin with. Short sale constraints are the classic limit to arbitrage. If bearish investors can’t take bets to offset the bulls, prices get completely out of whack. For an example of this see my old posting about the Palm/3Com situation from several years ago.

Herein lies the biggest hypocrisy of all; the SEC seeks to thwart stock market manipulation by short sellers, yet by interfering with investor’s ability to short the SEC is itself manipulating stock prices far more than any hedge fund could ever hope to. It should be obvious the market’s rally late yesterday was not “hope for a bailout” as the headlines read, but shorts covering before it was too late. Well here it is Friday morning and it already is too late. The logic behind forcing investors to purchase stocks (cover shorts) at grossly inflated prices could only be understood by Karl Marx himself. These investors can’t even ride it out.

Of course there will be unintended consequences of this nonsense, but there is no excuse for the SEC not anticipating them. For one, hedge funds will be forced to cover their short positions in certain financials, so will they sell the other financials in their portfolio not among the 799 on the list since those positions may no longer be hedged? Is it fair to force investors to abandon an investment just because its strategy is now prohibited by the SEC?

Chairman Cox says “The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets.” Well if changing the rules for basic functioning of the market is one of the weapons in his arsenal, perhaps we need to re-think the language of the SEC Act of 1934. While I don’t have this portion of the code committed to memory, I have yet to hear anyone cite the section explicitly giving him this authority.

Cox’s most hilarious quote of the day is probably the following, “The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets.” Gimme a break. Tell me its terrorists, tell me its market manipulators, but don’t tell me this will bring equilibrium.

Thoughts on Anheuser Busch and InBev

I have always had warm feelings towards Anheuser Busch. Growing up in the St. Louis area I couldn’t help it – afternoons at Grant’s Farm, countless Cardinal games at Busch Stadium and the occasional brewery tour. AB is all around you in that town. And it is a good kind of omnipresence. In spite of the differences and segregation with which the city constantly battles, everyone can be proud living in the home of the largest brewer in the world.

So with the proposed acquisition of AB by InBev, St. Louisans are in a complete tizzy. I was contacted by a reporter from St. Louis Post Dispatch on Tuesday wanting my opinion on what role Buffett might play in the deal, given Berkshire's 4.8% AB stake. I wish he had waited a few days to ask because I hadn’t given it much thought (thus missing out on another opportunity to get quoted) other than my initial gut reaction which was sadness that our town could lose yet another large corporate headquarters. But since then I have done a lot of thinking about the deal.

I own AB shares. In fact I bought at $48 them just before Berkshire’s stake was disclosed a few years ago. So it is great that we now have a nice 30% gain, but in the same way I had mixed feelings about the acquisition of Wrigley, I am uncertain of my opinion on this one. It is a great company generating enormous returns on equity - in no year since 1994 has it returned less than 25%. Unfortunately the company has found ways to destroy value just as quickly as it is created – book value per share has also remained flat over this time. But the company does have an extremely valuable brand that rivals the strength of Coke and this has kept price-to-book as well as PE’s pretty lofty. So perhaps, just maybe, InBev could come up with better places to deploy the shareholders’ capital. It wouldn’t seem it could do any worse.

But these are AB concerns, not InBev-AB concerns. And when considering what InBev can bring to the table I don’t see Warren Buffett resisting. His only objection might be the terms of the deal, which is currently all cash. Just as he did with the P&G acquisition of Gillette, he would be wise to negotiate a stock swap instead, deferring the taxes on his gains and also giving him continued exposure to this fantastic business. I am fairly sure he could care less about the extra $2.3 billion in cash that would end up on Berkshire’s balance sheet and would much rather have a few million shares of InBev, a good company in its own right, instead.

Nevertheless, rest assured that if Buffett backs this deal as he should, it will sour his popularity among the fools that know nothing else about him. But remember what they say about a fool and his money.

To see what type of irrationality St. Louis is currently dealing with consider the following as evidence.

Politicians are generally pretty stupid I think, at least when it comes to business and economics. Ordinarily this doesn’t bother me, but when they try to speak as an authority I can get pissed. An example is the genius that our state sent to Washington a few years back, Democratic Senator Claire McCaskill. Not surprisingly she came out screaming when the InBev deal was proposed. Check out the following from an article in the Post Dispatch (original here) on Wednesday:

McCaskill blasted the deal as one designed to give "premium profit for hedge fund investors." She said A-B is a strong company that has provided thousands of good middle-class American jobs. "This is not a company that's in stress." Addressing concerns about a foreign firm taking over an American icon, she added: "We do not have a 'For Sale' sign on our front lawn in America."

There is so much ignorance in that paragraph I really can’t even believe the paper printed it. Or maybe I can.

The first statement about hedge funds is just completely baseless - total political pandering. The largest shareholder of AB is Barclays, at a mere 5.1%, after that is Berkshire then the Busch family. Even if all of Barclays’ stake is held through hedge funds, I wonder where she thinks the remaining 94.9% of the premium profits are going. Clearly this woman thinks she is speaking to a very ignorant constituency whom she probably assumes a) is not invested in AB themselves and b) doesn’t even know what a hedge fund is.

While she is correct that “A-B is a strong company that has provided thousands of good middle-class American jobs,” this fact is not threatened by the takeover. If jobs are to be lost as a result of this deal they will be the upper-level management jobs, not the blue-collar factory jobs I am sure she is worried about. InBev has made no indication it plans to move stateside breweries overseas – nor would this seem to be a wise business decision.

McCaskill also seems to need a lesson in M&A. A company need not be “in stress” to be a takeover candidate. How dumb would InBev need to be to pay that “premium profit to hedge fund investors” if the company were in stress? AB’s strength is the very reason it is a target! Duh!

Finally, and most hilariously, McCaskill claims "We do not have a 'For Sale' sign on our front lawn in America." Oh really? I got news for you lady. That is exactly what we have on our front lawn. For decades now we have been shipping our dollars overseas, effectively selling off small pieces of the farm to finance our overspending. What do you expect other countries to do with all those greenbacks, stuff their pillows? As a result of this trade imbalance, of course, InBev’s euros are at an all time high against the dollar.

What I gather from all this is that, at least locally, there is too much sentimentality at play and far too little rational business deliberation. Further, people are dumb. And when you mix sentimentality with ignorance you are left with a lost opportunities.

Full Disclosure: I own shares of BUD, BRK.B and WWY. I have no position in InBev, KO or PG.

USA Today

There was a good article recently in USA Today about Warren Buffett that quotes me, among others. http://www.usatoday.com/money/markets/2008-06-04-warren-buffett_N.htm

RBP Investing

As some readers may know, I recently started writing a couple of new blogs. One is called RBP Investing. RBP stands for Required Business Performance and was developed by a company in New York called Transparent Value.

RBP is a proprietary stock analysis methodology that, although not something Warren Buffett himself would use, is completely consistent with all of his ideals. It looks at companys in reverse, by starting with the stock price and deducing what the market expects of the company, in terms of both revenue as well as actual product sold. From this, the investment question becomes something more like "Does the market valuation make sense?" or "Can this company actually deliver what the market expects?" They call this reverse discounted cash flow analysis.

This made perfect sense to me, being someone who believes DCF analysis is the only legitimate way to value a stock. The RBP method is a pretty ingenious way of looking at things and has the potential, I think, to become mainstream now that Dow Jones has started publishing the RBP Index Series. I encourage readers to check out out the blog at www.rbpinvesting.com.