Berkshire Ruminations

Friday, March 21, 2008

A few thoughts on the Bear Stearns situation

The first lesson that came to my mind when I heard about this debacle was straight from Buffett: Don’t buy what you can’t understand. Was Bear a simple and understandable business? Of course not. Their investments were so complex that it is not unlikely that no single individual at the firm understood them all. If this is true, then it is even less likely that ordinary investors understood them.

But the lesson for the Bear employees heavily invested in Bear stock should have already been learned. Remember Enron? Remember the sketchy (ultimately fraudulent) ways they seemed to be making money out of thin air? The Enron employee didn’t understand how the company was making money. If he had he would have known it was all a farce. But nonetheless many, many hardworking people put their faith in their employer’s stock and in many cases invested their entire retirement in it. Big mistake.

But it need not have even be an issue of understanding the company. From a pure diversification standpoint any employee is better off keeping his investments out of company stock since his human capital (read: income) is already 100% invested in the company. Instead, these folks have lost not only their jobs but also their savings.

I don’t mean to take the high road, nor do I mean to downplay the tragedy that this has caused families. Indeed, it is not even their fault. It is their employer’s fault for encouraging them to invest their retirement in company stock, since I assume most of them are not financially sophisticated enough to understand the diversification argument while an investment house like Bear certainly should be, and for creating the illusion that the company was strong enough to warrant their investment. It’s a rotten situation all around.


Much has been made about Bear’s current stock price, which is 200% higher than the JP Morgan acquisition price. It could be that investors are betting that either the bid will get raised before the deal goes through (a highly unlikely notion in my opinion given the Fed’s involvement) or that they think the deal will be delayed long enough for the company to right itself so that it eventually survives as a standalone.

Even considering these possibilities, it remains somewhat puzzling. But I think the explanation is a bit more academic than it might seem at first glance. Specifically, this is a textbook example of behavioral finance. According to theory, there are two requirements for irrational investors to drive prices from intrinsic value and, consequently, for the market to inefficiently price securities. Those two things are a) psychological biases and b) limits to arbitrage. In this case I think both are met.

The probability that the bid will get raised or that Bear will actually survive is not zero. But I think it is low. How low exactly I am not sure, but it is certainly not high enough to justify a stock price three times that of the most likely outcome – that the JP Morgan deal goes through as planned. Rather, the stock price is three times that of the bid price because there are irrational investors betting on the aforementioned possibilities and there is no arbitrage opportunity for more level-headed investors who would otherwise correct this blatant mispricing. At least that is the way it seems to me. Has anyone been able to successfully place a large short sale on BSC shares within the last week? I tried and I couldn’t. The lack of shares available for short is a natural limit to arbitrage and, according to behavioral finance theory, opens the door for irrational investors to control prices.

The investors willing to pay $6 a share for Bear seem to me to be falling victim to the following psychological biases:

Overconfidence – These irrational investors are overconfident in their own assessment of the situation, so much so that they are willing to pay a price far in excess of what would seem logical. They are also likely overconfident in Bear’s ability to weather this storm. This is understandable since big storied companies like this typically don’t just vanish overnight. But that doesn’t mean that can’t.

Endowment Effect – The investors who already have an equity interest are valuing their shares at a price much higher than the $2 bid. This too is understandable. Most people are reluctant to sell a stock for next to nothing when it was worth $150 as recently as a year ago, even if a price of $2 seems reasonable given today’s information set.

Disposition Effect – If these investors give in to the current offer, they will feel a tremendous amount of regret. Regret for not selling at $50, regret for having ever invested in a company with subprime exposure. To mitigate this regret, they are willing to increase their stakes by buying more shares, all while convincing themselves that since they liked the stock at $60, they should really like it at $5.

These biases create the environment in which mispricing might occur and the inability to short sell creates the limit to arbitrage that allows it to persist. So behavioral finance should explain the bizarre mispricing we are witnessing. Unfortunately, inherent in a situation like this is the inability for the rational investor to take advantage of it. Said differently, the stock would never have become mispriced if it could be arbitraged, so clearly there is no way for us rational investors to arbitrage it now. What a bummer.

Friday, March 07, 2008

Empirical Finance Research Blog

If you are interested in financial research you may want to check out a new project I am starting with a friend of mine who is a PhD student at the University of Chicago. It is called Empirical Finance Research:
Our goal is to review for the non-academics any literature that may be of practical use to the investor. There still isn't much on the blog yet but expect more in the coming weeks.

Thursday, March 06, 2008

Bullish on TMA

I captured the following screenshot from Yahoo Finance shortly after the market closed today:

This was kind of surprising to me given the performance of TMA stock:

Wednesday, March 05, 2008

Thoughts on the 2007 Chairman's Letter

As usual, Mr. Buffett touches on both classic and contemporary issues in this year’s letter. Two stand out to me as worth quickly addressing.

The classic issue most interesting to me is his discussion of See’s Candies (see page 7). It lends support to an argument I made on this blog last spring that it is return on equity, or in some cases return on capital, that is the crucial ratio to the value investor. See’s exemplifies this perfectly, since it requires hardly any invested capital. As Mr. Buffett notes, See’s needs only $40 million to continue to operate, yet in 2007 the company earned pre-tax profits of $82 million. Since it was acquired in 1972, See’s has reinvested only $32 million to maintain its operational growth. The rest of its earnings, about $1 billion, has been deployed elsewhere. Earning huge returns on little capital investment is the definition of a good business. Yet investors rarely consider it.

Returns on capital are, in my opinion, horribly underrated by the investing public. Evidence of this can be found in the public’s fascination with companies like AT&T, GM or any airline. These are businesses that, while they may generate large earnings, do so only after investing large amounts of capital. Why not skip over these businesses whose hurdle is so high that only the most outstanding performance will yield the investor a decent return? That is what Berkshire has done over the years.

The contemporary issue that interests me is the one everyone has been talking about. Much has been and will be made of Berkshire’s derivative positions, but little was said in the letter about them. Personally I think Mr. Buffett is missing out on a see-I-told-you-so opportunity. It was in the 2002 letter that he, noting the role they played in LTCM’s implosion, warned derivatives were “financial weapons of mass destruction,” at which time he began to wind down the derivative business of the newly acquired General Re.

Since then I think he earned the right to boast a little about recognizing this fact but he did not in this year’s letter. For instance, this year he only mentions in passing the key aspect of Berkshire’s derivatives that set it apart from other companies drowning in credit-default swap failures and such. “In all cases we hold the money, which means that we have no counterparty risk,” he says. This is huge and deserves more attention. After all, it is the reckless and poorly capitalized bond insurers that have contributed the most to this mess.

The new bond insurance arm of Berkshire, Berkshire Hathaway Assurance Corp, was established in December which probably means the letter was already complete at that point. But I must assume the creation of BHAC had been planned for some time before that and thus it seems like a missed opportunity that Buffett doesn’t point out in the letter how well positioned Berkshire is to pick up where the MBIA’s and Ambac’s of the world failed. Especially with those companies’s refusal to grab Berkshire’s lifeline, I think responsible underwriting in this area will prove to be a big opportunity for Berkshire.