Berkshire Ruminations

Monday, November 27, 2006

The real reason for lemon laws.

On a day when the market is tanking, here is an economic observation to get our minds off the shrinking value of our stocks. While shopping for a new car, I noticed a Toyota Avalon with only 1000 miles that was selling for about $5000 less than a comparable new one would cost. That got me thinking. Why do cars depreciate so quickly, anyhow? Well here is my explanation, as it pertains to so-called "lemon laws."

When economist George Akerlof introduced the “Market for Lemons” in 1970 he revolutionized economists’ understanding of uncertainty. A lemon is a product of poor quality that is sold among other good quality products. But to the buyer, whether or not a product is a lemon is not apparent. Akerlof showed that these types of products can come to dominate the market and can even cause the entire market to collapse.

This is because uncertainty can result in “adverse selection” and that the bad drive out the good. This is extremely important to economic theory as it implies that informational problems can cause, at the least, only bad products to be sold and, at the most, the collapse of the entire market.

Because buyers of, for instance, used cars are uncertain about the car’s true quality, they are only willing to pay less than the expected true value of the car. The owner/seller of the car has information the buyer does not, namely, whether or not the car is a lemon. But since the buyer cannot tell the difference between a good car and a bad car, the buyer must offer the same price to sellers of both types. Realizing that the buyer will offer less than the true value of a good car to account for the uncertainty of the transaction, owners of good cars will not be willing to offer them for sale. Only owners of bad cars (lemons) will. Hence, the bad have driven out the good.

Another good example of the market for lemons occurs in the market for health insurance. Substantial informational asymmetry exists between an individual and his health insurer, as the individual clearly has an advantage when it comes to assessing his own health. Generally, riskier policyholders must pay higher prices. But as the price of an insurance policy rises, only higher risk individuals will choose to insure themselves. Thus, an element of adverse selection will have manifested itself. Insurers, because of their informational disadvantage, will raise premium rates to account for the increased risk of insuring very sick people. And as this price rises, only more and more risky people will choose to purchase the policy. Again, the bad have driven out the good.

This phenomenon has obvious and important governmental policy implications. For one, government programs such as Medicare may be necessary to prevent the bad from driving out the good in markets such as health insurance for the elderly, particularly given the life-or-death nature of health care.

For another, perhaps we need "lemon laws" to overcome these problems. So although lemon laws purportedly exist to protect consumers, such laws really just guarantee the stability of the market. Since government cannot overcome the information asymmetries in some markets, it instead guarantees that the buyer will be compensated should his purchase prove to be a lemon. As a result, the buyer is willing to pay much closer to the true value of a good product, and the market can be sustained. The seller is still permitted to sell lemons, but has little incentive to prefer lemons, as he may be forced to buy back the product if it proves to be a lemon.

Thursday, November 16, 2006

Sears Holdings - Part 1

I was excited to see that shares of Sears Holdings (SHLD) were down yesterday on lower same-store sales in the third quarter. This is a beautiful reaction to one of my favorite companies, as any pullback tempts me to plow more money in to it. The company is still seen as a retailer and, as such, retail analysts insist on evaluating it based on their favorite metric, same-store sales. But SHLD is much more than that now and, moreover, sales don’t put money in your pocket. Earnings do. And the company’s operating earnings were actually up, by more than 58%, after adding back in a large restructuring charge reflected in last year’s Q3 earnings.

To put is simply, although the stores’ sales may not be rising, their profitability is. This is due to two things: higher gross margins (from 27.4% in Q3 2005 to 28.3% in Q3 2006) and reduced expenses as a percentage of sales (from 24.4% to 23.7%). In English, this means that Chairman Eddie Lampert, et al have stopped selling unprofitable products, focusing on high margin products, and have also cut out a lot of costs.

But don’t fool yourself in to thinking that the retail operations of this company are of complete concern. SHLD has started engaging in many other investment activities unrelated to Sears and Kmart. In fact, these “investment activities” contributed a third of its Q3 earnings. The company attributes this to the investment of its “surplus cash,” of which it held about $2 billion of at the close of the quarter. Sound familiar? To some this sounds a lot like a certain New England textile operation that floundered in the late 1960s.

Eddie Lampert’s ESL Investment Management currently owns 41% of SHLD. But to many people, including me, it is clear that Lampert intends to turn SHLD in to something similar to Berkshire Hathaway. That is, Kmart and Sears may hang around for a while and produce decent cash flow, but the growth of the company will come from its other investments.

I owe a great deal to my friend Chad at the Peridot Capitalist for turning me on to this stock about a year ago. He has a ton of great insights in to the company as well.

FD: I own shares of Sears Holdings.

CNBC Buffett Special

On Monday evening, November 20, at 7:00 central time, CNBC will be airing "Warren Buffett: The Billionaire Next Door." As part of the special, there should be a segment about the Warren Buffett Class at MU. A few weeks ago a crew from the network visited our college and interviewed several people, including me. I would have been excited about any hour-long Warren Buffett special, but to be included it in myself is a real thrill. I suppose there is no guarantee they will use the footage of my interview, but it should be a worthwhile watch regardless.

The show will be re-run throughout the weekend:
Thursday, November 23 7:00 am and 5:00 pm EST
Friday, November 24 3:00 pm and 11:00 pm EST
Sunday, November 26 10:00 pm EST