In the last week, we have seen the first indications that some large money market funds may “break the buck”, i.e. because of current losses in asset-backed commercial paper, the assets of the funds will be worth less than $1.00 per share. In other words, the holders of the funds will receive a negative return on their cash investments (otherwise known as a “loss”).
Given the large investments by most money market funds in specialized investment vehicles (SIVs), which issue asset-backed commercial paper secured by mortgages and credit card debt, it is not surprising to see them beginning to take losses in the current environment. We read last week that General Electric has offered an option to buy out the outside investors in its GEAM Trust Enhanced Cash Fund for 96 cents on the dollar. In other words, these investors will lose 4% of their principle invested in the fund. The company has reported that all of those investors have taken the offer. Also, a “Wall Street Journal” article earlier in the week cited an effort by SEI Investments, a large mutual fund administrator, to “guarantee the buck” on money market funds managed for them by Bank of America.
We had been suspicious that this might happen for some time now, so we have moved all of our clients’ cash investments to U.S. Treasury money market funds (or the equivalent), thereby insuring that we will continue to receive some positive return on all of our cash investments. Even though it is widely assumed that major brokerages would support the value of their funds, a large exodus from money funds could impair their ability to do so on a timely basis. We feel it is important to be early in our decision if in fact this scenario develops.
We thought you would like to know that.
Jack and Peter Falker
Note: Jack and Peter Falker and the clients of FalkerInvestments Inc. hold positions in General Electric.
Monday, November 19, 2007
Monday, October 29, 2007
What a mess! It's going to be wild, as they say.
Here is a blog post from our friend and associate Bill Dove, a banker and financial consultant, responding to our recent posting “What’s Going On Here” and commenting on the proposed superfund conduit announced this week by Citigroup, Bank of America and J.P. Morgan.
This proposed superfund is just a Band-Aid on a gaping wound that needs major complicated surgery and a long term period of recovery. Bank of America and J.P. Morgan are in the deal to sanitize and lend credibility to what amounts to a bail-out of Citigroup, without direct government intervention. If their credibility can't raise the money for Citi, Uncle Sam may have to come in and bail-out Citi because in government regulatory banking circles Citi is “too big to fail”. As Alan Greenspan has recently pointed out, the fund delays the recognition of inevitable losses and extends the time the marketplace has to resolve the loss problem and place its negative economic consequences behind us. He believes the sooner we get this problem behind us the better and I agree.
Overall, the current residential housing disaster is probably worse than the savings and loan fiasco and could be in the magnitude of a trillion dollars or more. The savings and loan fiasco was a $500 billion dollar economic problem which ultimately cost the government $87 billion. It is estimated that the fall-out of the dot.com and high tech stock market “bubble” eventually cost our economy in excess of $2 trillion.
We are just looking at the tip of the iceberg. It will get worse before it gets better. Home buyers won't be able to obtain jumbo mortgages ($417,500) at a reasonable interest rate, unless they have at least a 20% equity cushion behind the proposed jumbo mortgage, an income of $120,000 a year, a FICO score of 700 and a stable employment history. Probably only 5% of potential first time new home buyers can meet these underwriting standards. Existing homeowners will not be able to buy a new or larger home unless they can sell their existing home and realize their cash equity, which will determine how much they can afford to spend for their next home. No one, in their right mind, will take on two residential mortgages under today's residential real estate market conditions. Lenders will insist that borrowers’ owning existing homes must sell and close on these existing homes before they will disburse a new proposed mortgage loan to purchase their next home. Buyers won't commit to buy and close with sellers until they have sold their existing homes. Residential real estate market activity will come to a "screeching halt" compared to the "hyperactive" residential buying and selling feeding frenzy of the past 15 years. The whole process of how residential real estate “changes hands” will slow down and it will be “like running in peanut butter” as buyers and sellers to go through the process.
Non-occupant residential home investors ("flippers") and second home owners, who have been a significant source of past residential buying demand, have disappeared from the residential real estate market for the foreseeable future. Inexpensive houses ($250,000 or less) in good condition located in established neighborhoods will sell relatively quickly. Very expensive houses in high-end communities will continue sell as usual to the super-rich who don’t rely on conventional mortgage financing. All homes in poor condition will sit on the market until the supply of all listed homes can be absorbed by demand within a six month period and more or less normal residential housing market conditions prevail.
Medium to high-priced homes will sit on the market until their prices are slashed 20% to 50% and will not sell until they are renovated. Prospective home buyers will not have the financial resources to make a healthy 20% down payment and also finance the cost of necessary renovations. With the cost of necessary renovations and repair completed and paid for by the seller and included in the sale price, prospective buyers, in effect, are in a position to finance 80% of the cost of these necessary renovations made by the sellers with proceeds of their new mortgage loan financing. Lenders won't lend on homes in need of necessary repairs and renovations. Gone are the days when lenders will rely on prospective home buyers to do necessary renovations and repairs after their loan closing from home-equity financing and future income resources to shore-up the value of their collateral.
Home ownership, as an important financial source of growing retirement funds, will diminish. People will be forced or will become more inclined to rent and invest their capital in securities, which is probably why the stock market and 401K type investment plans are holding up so well. Upwards to 70% of retirees currently regard the accumulation of home ownership equity as a long term savings plan. For years home ownership (because of the tax-deductibility of interest and property taxes) has been the poor man's main tax-sheltered retirement investment vehicle, which also incidentally also keeps the rain off his head while he is waiting to retire. (Securities investments don’t keep rain off his head). In the future, apartments or rental homes will keep the rain off his head without the downside financial risk of home ownership.
Sub-prime lending, rising prices and second home and non-occupant investor speculation has pushed home ownership beyond naturally sustainable limits and as a consequence, there will be an absolute downward adjustment of the incidence of home ownership from the 70 percentiles to the 60 percentiles. In the past, because of rising prices, the worst thing a home owner would likely experience is that he would make money if he were forced to sell. That is no longer the case. Home ownership for the foreseeable future will be primarily a device to just keep the rain off the owner's head and home equity will not be a reliable “risk-free” growing source of retirement savings.
Relatively, Merrill is in as bad a shape as Citi. I suspect the brokerage side of Merrill is livid about the mortgage-backed bond and investment opportunity “mess” the underwriting side of Merrill has produced. In all probability, the Merrill brokers have been pushing these "toxic waste” mortgage backs and SIV’s to their best customers.
Remember, a little number multiplied by a big number is a big number. Even a small to moderate loss experienced by a large number of home sellers is a big cumulative loss to the economy. While selling losses will be experienced on the margin by only a minority of total home owners, these selling losses will receive lots of publicity which will affect the home buying and owning psychology and thinking of all homeowners and our entire work force of 110 million people. The mobility, flexibility and spending behavior of our work force and our retirees will be greatly affected by this slowdown in residential sales. Home ownership will absolutely shrink in our society, as will home values. New home owners and existing home owners "moving up in the world" will "turn turtle" until they feel safe enough to come out of their shells and can afford the downside risk elements associated with home ownership, which could be years from now.
Historically low interest rates followed by steadily increasing interest rates, the advent of variable rate residential mortgage loan structures with beginning“ teaser rates” followed by escalating floating market rate provisions, sub-prime underwriting standards, the growth of non-occupant owner/investors and the "blind eye" of the rating agencies to the economic implications of these developments have enabled Wall Street (in its greed to acquire home mortgages to secure its popular securities and investment conduits) to franchise "fly by night" non-regulated mortgage brokers and then enable them to pursue unsound or downright fraudulent underwriting standards and practices. Large Wall Street financial institutions, not-regulated Main Street financial institutions underwriting residential mortgage loans for their own account, have been the culprits who have really screwed up the U.S. housing market for the foreseeable future by pushing the incidence of home ownership beyond economically sustainable limits.
Remember, for Joe Lunchbucket (after the basic nondiscretionary expenses for food, clothing, transportation, education and medical expenses which will always take precedence), home ownership is the biggest single discretionary expenditure he makes in his lifetime. Uncertainty about the benefits of home ownership will certainly affect Joe’s spending behavior and expectations which will significantly impact the overall economy for the foreseeable future.
Basically, our economy is going to experience an oversupply of residential dwelling units relative to demand for these residential dwelling units for a considerable period of time. Historically, our residential real estate market could support construction of an average of 1.5 million new residential dwelling units on an annual basis. Beginning in 2002 and continuing until late 2006, construction of new residential dwelling units on an annual basis approached 2.0 million dwelling units. Until the imbalance in supply and demand for residential dwelling units is corrected “chaos will reign in the residential real estate market and everyone will get wet”. It would appear that this inventory problem may be concentrated in California, Nevada, Arizona, Texas, Michigan and Florida. Perhaps we need a 24-month moratorium on the construction of new residential dwelling units in these States until supply and demand reach parity? Stay tuned.
This proposed superfund is just a Band-Aid on a gaping wound that needs major complicated surgery and a long term period of recovery. Bank of America and J.P. Morgan are in the deal to sanitize and lend credibility to what amounts to a bail-out of Citigroup, without direct government intervention. If their credibility can't raise the money for Citi, Uncle Sam may have to come in and bail-out Citi because in government regulatory banking circles Citi is “too big to fail”. As Alan Greenspan has recently pointed out, the fund delays the recognition of inevitable losses and extends the time the marketplace has to resolve the loss problem and place its negative economic consequences behind us. He believes the sooner we get this problem behind us the better and I agree.
Overall, the current residential housing disaster is probably worse than the savings and loan fiasco and could be in the magnitude of a trillion dollars or more. The savings and loan fiasco was a $500 billion dollar economic problem which ultimately cost the government $87 billion. It is estimated that the fall-out of the dot.com and high tech stock market “bubble” eventually cost our economy in excess of $2 trillion.
We are just looking at the tip of the iceberg. It will get worse before it gets better. Home buyers won't be able to obtain jumbo mortgages ($417,500) at a reasonable interest rate, unless they have at least a 20% equity cushion behind the proposed jumbo mortgage, an income of $120,000 a year, a FICO score of 700 and a stable employment history. Probably only 5% of potential first time new home buyers can meet these underwriting standards. Existing homeowners will not be able to buy a new or larger home unless they can sell their existing home and realize their cash equity, which will determine how much they can afford to spend for their next home. No one, in their right mind, will take on two residential mortgages under today's residential real estate market conditions. Lenders will insist that borrowers’ owning existing homes must sell and close on these existing homes before they will disburse a new proposed mortgage loan to purchase their next home. Buyers won't commit to buy and close with sellers until they have sold their existing homes. Residential real estate market activity will come to a "screeching halt" compared to the "hyperactive" residential buying and selling feeding frenzy of the past 15 years. The whole process of how residential real estate “changes hands” will slow down and it will be “like running in peanut butter” as buyers and sellers to go through the process.
Non-occupant residential home investors ("flippers") and second home owners, who have been a significant source of past residential buying demand, have disappeared from the residential real estate market for the foreseeable future. Inexpensive houses ($250,000 or less) in good condition located in established neighborhoods will sell relatively quickly. Very expensive houses in high-end communities will continue sell as usual to the super-rich who don’t rely on conventional mortgage financing. All homes in poor condition will sit on the market until the supply of all listed homes can be absorbed by demand within a six month period and more or less normal residential housing market conditions prevail.
Medium to high-priced homes will sit on the market until their prices are slashed 20% to 50% and will not sell until they are renovated. Prospective home buyers will not have the financial resources to make a healthy 20% down payment and also finance the cost of necessary renovations. With the cost of necessary renovations and repair completed and paid for by the seller and included in the sale price, prospective buyers, in effect, are in a position to finance 80% of the cost of these necessary renovations made by the sellers with proceeds of their new mortgage loan financing. Lenders won't lend on homes in need of necessary repairs and renovations. Gone are the days when lenders will rely on prospective home buyers to do necessary renovations and repairs after their loan closing from home-equity financing and future income resources to shore-up the value of their collateral.
Home ownership, as an important financial source of growing retirement funds, will diminish. People will be forced or will become more inclined to rent and invest their capital in securities, which is probably why the stock market and 401K type investment plans are holding up so well. Upwards to 70% of retirees currently regard the accumulation of home ownership equity as a long term savings plan. For years home ownership (because of the tax-deductibility of interest and property taxes) has been the poor man's main tax-sheltered retirement investment vehicle, which also incidentally also keeps the rain off his head while he is waiting to retire. (Securities investments don’t keep rain off his head). In the future, apartments or rental homes will keep the rain off his head without the downside financial risk of home ownership.
Sub-prime lending, rising prices and second home and non-occupant investor speculation has pushed home ownership beyond naturally sustainable limits and as a consequence, there will be an absolute downward adjustment of the incidence of home ownership from the 70 percentiles to the 60 percentiles. In the past, because of rising prices, the worst thing a home owner would likely experience is that he would make money if he were forced to sell. That is no longer the case. Home ownership for the foreseeable future will be primarily a device to just keep the rain off the owner's head and home equity will not be a reliable “risk-free” growing source of retirement savings.
Relatively, Merrill is in as bad a shape as Citi. I suspect the brokerage side of Merrill is livid about the mortgage-backed bond and investment opportunity “mess” the underwriting side of Merrill has produced. In all probability, the Merrill brokers have been pushing these "toxic waste” mortgage backs and SIV’s to their best customers.
Remember, a little number multiplied by a big number is a big number. Even a small to moderate loss experienced by a large number of home sellers is a big cumulative loss to the economy. While selling losses will be experienced on the margin by only a minority of total home owners, these selling losses will receive lots of publicity which will affect the home buying and owning psychology and thinking of all homeowners and our entire work force of 110 million people. The mobility, flexibility and spending behavior of our work force and our retirees will be greatly affected by this slowdown in residential sales. Home ownership will absolutely shrink in our society, as will home values. New home owners and existing home owners "moving up in the world" will "turn turtle" until they feel safe enough to come out of their shells and can afford the downside risk elements associated with home ownership, which could be years from now.
Historically low interest rates followed by steadily increasing interest rates, the advent of variable rate residential mortgage loan structures with beginning“ teaser rates” followed by escalating floating market rate provisions, sub-prime underwriting standards, the growth of non-occupant owner/investors and the "blind eye" of the rating agencies to the economic implications of these developments have enabled Wall Street (in its greed to acquire home mortgages to secure its popular securities and investment conduits) to franchise "fly by night" non-regulated mortgage brokers and then enable them to pursue unsound or downright fraudulent underwriting standards and practices. Large Wall Street financial institutions, not-regulated Main Street financial institutions underwriting residential mortgage loans for their own account, have been the culprits who have really screwed up the U.S. housing market for the foreseeable future by pushing the incidence of home ownership beyond economically sustainable limits.
Remember, for Joe Lunchbucket (after the basic nondiscretionary expenses for food, clothing, transportation, education and medical expenses which will always take precedence), home ownership is the biggest single discretionary expenditure he makes in his lifetime. Uncertainty about the benefits of home ownership will certainly affect Joe’s spending behavior and expectations which will significantly impact the overall economy for the foreseeable future.
Basically, our economy is going to experience an oversupply of residential dwelling units relative to demand for these residential dwelling units for a considerable period of time. Historically, our residential real estate market could support construction of an average of 1.5 million new residential dwelling units on an annual basis. Beginning in 2002 and continuing until late 2006, construction of new residential dwelling units on an annual basis approached 2.0 million dwelling units. Until the imbalance in supply and demand for residential dwelling units is corrected “chaos will reign in the residential real estate market and everyone will get wet”. It would appear that this inventory problem may be concentrated in California, Nevada, Arizona, Texas, Michigan and Florida. Perhaps we need a 24-month moratorium on the construction of new residential dwelling units in these States until supply and demand reach parity? Stay tuned.
Monday, October 08, 2007
What's Going On Here?
When we last wrote, just one month ago, we were in the thick of what had quickly become the biggest worldwide credit crisis in 37 years. For all intents and purposes, both the short-term and long-term fixed income markets had come to a virtual standstill and the stock market had dropped like a stone from a record July high, even though most non-financial companies were only minimally affected by problems in the credit markets.
Major individual players in the markets were interceding with the Federal Reserve to “wake up and do something.” (See the attached file “What Do They Know” by Bill Gross of PIMCO describing the situation: http://www2.pimco.com/pdf/IO%20Oct_07_web.pdf ) . As it turned out, they apparently were listening, and out of the blue on August 17th, took the unusual step of dropping the Fed discount rate by 50 basis points, while strongly encouraging member banks to bring asset-backed commercial paper to the Fed discount window. While that move was largely symbolic and had very little to do with problems in the housing market and ballooning defaults on sub-prime mortgages, it did pour oil on the commercial paper market waters and stopped what was becoming a rampant flight from supposedly secure money market funds by professional money managers. Subsequently, at their regularly scheduled open market committee meeting on September 18th, the Fed dropped the discount rate by another 50 basis points and lowered its federal funds rate by a larger than expected 50 basis points, which had the effect of making floating rate consumer debt of all kinds immediately less expensive.
That was all the stock market needed to see, and it immediately shifted away from discounting a recession (or worse) and returned to its all too familiar “nothing is wrong in the world” exuberance, reaching a new record high on October 1st.
So, really, what is going on here? First of all, we would like you to know that our portfolios have done just fine during this confusing time. As we have often said, our investments are designed to weather exactly the kind of environment that materialized in August, and they did, outperforming our S&P 500 benchmark during the entire downtrend and subsequently keeping right up with the market as it rocketed off its August lows to new record levels.
Despite the seemingly “irrational exuberance” of the markets, the underlying housing and sub-prime mortgage default problems have not gone away, even though some marginal home owners have been helped by the reduction in rates. The related longer-term problem that touched off the credit crisis in the first place, namely the extremely leveraged holdings by many hedge funds and financial institutions of collateralized debt obligations (CDOs), whose viability is in question because of rising defaults in the sub-prime mortgage components of these securities, has not been resolved. So there is probably more bad news to come on that front. Quoting Bill Gross’ concluding sentence in the attached article, speaking of the Fed: “What do they know? I suspect at the very least they know they’re in a pickle, and a sour one at that.”
For our part, we will conclude with the same statement we made at the end of our letter a month ago: “In summary, our portfolios are performing as expected in this environment. We think the housing and credit markets have further trouble ahead and believe that uncertainty will continue to plague the markets into 2008. This necessary (and long overdue) process will correct an inflated real estate market and eliminate dangerous consumer lending practices. While we see opportunities developing, we will continue to be careful with our investment decisions in an effort to protect capital.”
Peter and Jack Falker
Major individual players in the markets were interceding with the Federal Reserve to “wake up and do something.” (See the attached file “What Do They Know” by Bill Gross of PIMCO describing the situation: http://www2.pimco.com/pdf/IO%20Oct_07_web.pdf ) . As it turned out, they apparently were listening, and out of the blue on August 17th, took the unusual step of dropping the Fed discount rate by 50 basis points, while strongly encouraging member banks to bring asset-backed commercial paper to the Fed discount window. While that move was largely symbolic and had very little to do with problems in the housing market and ballooning defaults on sub-prime mortgages, it did pour oil on the commercial paper market waters and stopped what was becoming a rampant flight from supposedly secure money market funds by professional money managers. Subsequently, at their regularly scheduled open market committee meeting on September 18th, the Fed dropped the discount rate by another 50 basis points and lowered its federal funds rate by a larger than expected 50 basis points, which had the effect of making floating rate consumer debt of all kinds immediately less expensive.
That was all the stock market needed to see, and it immediately shifted away from discounting a recession (or worse) and returned to its all too familiar “nothing is wrong in the world” exuberance, reaching a new record high on October 1st.
So, really, what is going on here? First of all, we would like you to know that our portfolios have done just fine during this confusing time. As we have often said, our investments are designed to weather exactly the kind of environment that materialized in August, and they did, outperforming our S&P 500 benchmark during the entire downtrend and subsequently keeping right up with the market as it rocketed off its August lows to new record levels.
Despite the seemingly “irrational exuberance” of the markets, the underlying housing and sub-prime mortgage default problems have not gone away, even though some marginal home owners have been helped by the reduction in rates. The related longer-term problem that touched off the credit crisis in the first place, namely the extremely leveraged holdings by many hedge funds and financial institutions of collateralized debt obligations (CDOs), whose viability is in question because of rising defaults in the sub-prime mortgage components of these securities, has not been resolved. So there is probably more bad news to come on that front. Quoting Bill Gross’ concluding sentence in the attached article, speaking of the Fed: “What do they know? I suspect at the very least they know they’re in a pickle, and a sour one at that.”
For our part, we will conclude with the same statement we made at the end of our letter a month ago: “In summary, our portfolios are performing as expected in this environment. We think the housing and credit markets have further trouble ahead and believe that uncertainty will continue to plague the markets into 2008. This necessary (and long overdue) process will correct an inflated real estate market and eliminate dangerous consumer lending practices. While we see opportunities developing, we will continue to be careful with our investment decisions in an effort to protect capital.”
Peter and Jack Falker
Friday, August 31, 2007
Client Letter - 8/30/07
To our clients,
Here is a general update on our thinking regarding current market volatility and the impact on your portfolio.
Rapid deterioration in the housing/sub-prime mortgage and low-grade corporate debt markets has created a large amount of uncertainty in the stock market, as well as forecasts for growth in the U.S. economy. In February and again in June of this year, there were indications of problems surfacing, which created small and short-lived stock market corrections. In both cases the markets recovered within days and resumed the upward trend toward new highs. As managers, this process has been frustrating, as the opportunity to find values was short-lived; not the sign of a healthy market. Just as risk was not accurately priced into inherently risky debt securities, the stock market has also been mispricing risk. While not yet a bear market, this correction is starting to bring risk premiums back in line.
As you know, we have designed portfolios that are conservative and diversified to include only companies that meet our stringent Return on Capital and Valuation parameters. We have always used appropriate risk premiums when evaluating our holdings and consistently focused on preservation of capital in the post stock market bubble-9/11 environment. Economic expansion and global growth has encouraged us to stay fully invested, even though troubles in housing and mortgage markets have been brewing for some time. While we remain conservative, we believe there is opportunity in this market for both buying and selling. We have identified several companies we would like to own and, when appropriate, are using current cash, plus proceeds from sales, to fund purchases.
Almost all of the holdings in the portfolio at the time the market peaked on July 19th have outperformed the S&P500 during this decline, with several of our stocks moving higher. Our bank holdings, US Bank and TCF Financial, while remaining volatile, have managed to outperform the market since this correction began. TCB and USB are both very conservative banks with good balance sheets and very little exposure to sub-prime lending. When considering bank stocks over the last several years, we have intentionally avoided anything with significant residential mortgage exposure. Even so, all bank stocks have been affected due to the volatility of credit markets. Declines this year have enhanced the dividend yields on TCB to 4% and USB to 5%, which may tempt us to add to one or both of these positions at the appropriate moment. Moody’s continues to be our most volatile holding, but still appears significantly undervalued. We are keeping our options open given the “headline risk” associated with rating agencies over the sub-prime fallout. It will continue to be highly volatile as long as credit concerns remain in focus.
In summary, our portfolios are performing as expected in this environment. We think the housing and credit markets have further trouble ahead and believe that uncertainty will continue to plague the markets into 2008. This necessary (and long overdue) process will correct an inflated real estate market and eliminate dangerous consumer lending practices. While we see opportunities developing, we will continue to be careful with our investment decisions in an effort to protect capital.
Please feel free to call us with any questions.
Here is a general update on our thinking regarding current market volatility and the impact on your portfolio.
Rapid deterioration in the housing/sub-prime mortgage and low-grade corporate debt markets has created a large amount of uncertainty in the stock market, as well as forecasts for growth in the U.S. economy. In February and again in June of this year, there were indications of problems surfacing, which created small and short-lived stock market corrections. In both cases the markets recovered within days and resumed the upward trend toward new highs. As managers, this process has been frustrating, as the opportunity to find values was short-lived; not the sign of a healthy market. Just as risk was not accurately priced into inherently risky debt securities, the stock market has also been mispricing risk. While not yet a bear market, this correction is starting to bring risk premiums back in line.
As you know, we have designed portfolios that are conservative and diversified to include only companies that meet our stringent Return on Capital and Valuation parameters. We have always used appropriate risk premiums when evaluating our holdings and consistently focused on preservation of capital in the post stock market bubble-9/11 environment. Economic expansion and global growth has encouraged us to stay fully invested, even though troubles in housing and mortgage markets have been brewing for some time. While we remain conservative, we believe there is opportunity in this market for both buying and selling. We have identified several companies we would like to own and, when appropriate, are using current cash, plus proceeds from sales, to fund purchases.
Almost all of the holdings in the portfolio at the time the market peaked on July 19th have outperformed the S&P500 during this decline, with several of our stocks moving higher. Our bank holdings, US Bank and TCF Financial, while remaining volatile, have managed to outperform the market since this correction began. TCB and USB are both very conservative banks with good balance sheets and very little exposure to sub-prime lending. When considering bank stocks over the last several years, we have intentionally avoided anything with significant residential mortgage exposure. Even so, all bank stocks have been affected due to the volatility of credit markets. Declines this year have enhanced the dividend yields on TCB to 4% and USB to 5%, which may tempt us to add to one or both of these positions at the appropriate moment. Moody’s continues to be our most volatile holding, but still appears significantly undervalued. We are keeping our options open given the “headline risk” associated with rating agencies over the sub-prime fallout. It will continue to be highly volatile as long as credit concerns remain in focus.
In summary, our portfolios are performing as expected in this environment. We think the housing and credit markets have further trouble ahead and believe that uncertainty will continue to plague the markets into 2008. This necessary (and long overdue) process will correct an inflated real estate market and eliminate dangerous consumer lending practices. While we see opportunities developing, we will continue to be careful with our investment decisions in an effort to protect capital.
Please feel free to call us with any questions.
Wednesday, May 30, 2007
Thinking Like Buffett
It’s safe to say that Warren Buffett doesn’t spend much time thinking about how much the market went up or down this week. In fact, listening to him and reading his annual letters, it’s safe to say he couldn’t care less.
Buffett’s investment focus is on the quality of earnings, internal rates of return and relative valuations of the companies Berkshire Hathaway owns outright, and the common stocks of companies they own (or intend to own) within the insurance portfolios of Geico, General Reinsurance, and the several other insurance entities within the company. If you look at his shareholder letters (http://www.berkshirehathaway.com/reports.html), he never reports how Berkshire Hathaway stock performed against the S&P 500 Index. Rather, he reports the percentage change in the internal per share book value of Berkshire (i.e., the company’s net worth divided by the number of shares outstanding) vs. the percentage change in the S&P 500. Based on that measure, you can count on one hand the number of years since 1965 that Berkshire didn’t outperform the market. And isn’t that the best way to look at yourself? In other words, how am I doing internally, not how does the market value my stock this month or this year? Ultimately, in the long term, the market always values internal rates of return, the real measure of shareholder economic value added; seldom, however, does it do so in the short term.
For example, Berkshire (BRKA/BRKB) is actually down a fraction of one percent year-to-date in 2007, while the S&P 500 is up about 7% and setting new records. In 2006, it was up about 22.5% vs. about 12% for the S&P, while in 2005 it was up only a bit more than 2%, vs. about 6% for the S&P. However, looking at one of our favorite market statistics, the performance of the S&P 500 from the beginning of 2001 (i.e., just before 9/11) through May 2007, you can clearly see Berkshire’s long-term market performance. During that 6.3 year period, BRKA has produced a compound annual yield of 7.9%, while the S&P 500 has produced (believe it or not) only 2.7% compounded. If you believe, as we do, that history has a fairly high probability of repeating itself over the next five or six years, thinking like Buffett is a pretty good idea.
Interestingly, about five or six years ago, Buffett was quoted in “Fortune” saying that he expected the market to increase only about “6% to7% annually over the next decade or two”. His own performance has obviously been better than that, but the S&P 500 hasn’t done as well as he predicted, so far.
Another “Buffettism” worth noting is the statement of his two rules of investing: “Rule #1, never lose money; Rule #2, never forget rule #1”.
Not a bad way of thinking in our book!
We strive every day to think like Buffett, as opposed to the short-term market-think and hype with which we are all besieged. We know for sure that companies that generate strong internal rates of return create economic value added for their owners. We also know for sure that good companies that are overvalued by the market in the short term are not good long-term investments, regardless of how exciting they may look. There will always be a better time to own them if we are patient. This is why valuation modeling is so important to us.
While we do not imitate Buffett’s investment decisions, we do take note of what he does, because he does much the same kind of valuation analysis we do. Not surprisingly, we own several of the same companies. Here are some examples:
Berkshire Hathaway (BRKA, BRKB)
In most of our portfolios, BRKB, Berkshire’s non-voting “B” stock is one of our largest holdings, representing about 8% of our equity portfolios. In addition to its publicly traded common stock holdings, Berkshire owns a number of companies outright, such as Dairy Queen and MidAmerican Energy, which includes Home Services (Edina Realty). Also, Berkshire is able to do things with its large cash position, which most investment managers can’t even imagine, including taking large hedge positions vis-à-vis the weakening U. S. dollar.
Conoco Philips (COP)
Berkshire owns 1.1% of Conoco’s outstanding shares. We bought our COP on the basis of its ROI and valuation at about the same time as Buffett. It currently represents about 5% of our portfolios and has done very well for both Berkshire and ourselves.
Moody’s (MCO)
Berkshire owns a whopping 17% of MCO, acquired when it went public. We acquired our position much later on the basis of MCO’s extraordinary ROI and low valuation. It has grown 116% to approximately 8.5% of our holdings. See our March 23, 2006, blog posting “Happy to be Moody”.
Johnson & Johnson (JNJ)
Berkshire owns about .7% of JNJ stock and we believe we acquired most of our position ahead of them. JNJ represents about 5.5% of our holdings. It has been a slow mover over the past year, but is one of the strongest pharmaceutical and over-the-counter healthcare product providers in the world, with excellent ROI and valuation.
Wal-Mart (WMT)
Berkshire owns .5% of WMT. It currently represents about 3% of our holdings and has not been a good performer for either Berkshire or ourselves. It’s ROI and valuation fundamentals, however, are excellent.
Procter & Gamble (PG)
Berkshire is PG’s largest shareholder, with 3.2% of outstanding shares, as the result of both market purchases and PG’s acquisition of Gillette, which was one of Berkshire’s largest holdings. PG represents nearly 5% of our holdings. While it has been a slow mover over the last year, it is considered to be one of the strongest companies in the world.
US Bancorp (USB)
Berkshire reported owning 1.8% of USB’s stock in their 2006 annual report, but they have recently increased their position. We have owned USB for several years and have recently increased our position to a bit more than 5% of our holdings. Both we and Buffett apparently like their excellent ROI and the 4.7% dividend.
WellPoint Health Networks (WLP)
Berkshire is currently accumulating a position in WLP and has not as yet reported the size of their holding. WLP, which is the largest Blue Cross/Blue Shield insurer, currently represents about 4.5% of our holdings and is one of our favorites. We began acquiring positions in WLP and Aetna (AET), after taking a significant profit in United Health Care (UNH), which Buffett still holds. Both WLP and AET continue to do very well for us.
Including BRKB, approximately 45% of our portfolio holdings are also held by Buffett, so we are obviously thinking alike and doing many of the same things. While we don’t agree with all of Berkshire’s investments and believe that some of our holdings are better than theirs (for example, they own 8.6% of Coca Cola, which has been a very poor performer over the last 10 years), we strongly agree with Buffett about holding value-creating companies with proper valuations.
Most importantly, when one “thinks like Buffett”, the day-to-day ups and downs and new records of the market become largely irrelevant to the central mission of creating compounding long-term returns.
As always, we welcome your thoughts and ideas.
Jack and Peter Falker
Note: Both Jack and Peter Falker and the clients of FalkerInvestments Inc. hold positions in the companies mentioned in this article, with the exception of United Healthcare.
Buffett’s investment focus is on the quality of earnings, internal rates of return and relative valuations of the companies Berkshire Hathaway owns outright, and the common stocks of companies they own (or intend to own) within the insurance portfolios of Geico, General Reinsurance, and the several other insurance entities within the company. If you look at his shareholder letters (http://www.berkshirehathaway.com/reports.html), he never reports how Berkshire Hathaway stock performed against the S&P 500 Index. Rather, he reports the percentage change in the internal per share book value of Berkshire (i.e., the company’s net worth divided by the number of shares outstanding) vs. the percentage change in the S&P 500. Based on that measure, you can count on one hand the number of years since 1965 that Berkshire didn’t outperform the market. And isn’t that the best way to look at yourself? In other words, how am I doing internally, not how does the market value my stock this month or this year? Ultimately, in the long term, the market always values internal rates of return, the real measure of shareholder economic value added; seldom, however, does it do so in the short term.
For example, Berkshire (BRKA/BRKB) is actually down a fraction of one percent year-to-date in 2007, while the S&P 500 is up about 7% and setting new records. In 2006, it was up about 22.5% vs. about 12% for the S&P, while in 2005 it was up only a bit more than 2%, vs. about 6% for the S&P. However, looking at one of our favorite market statistics, the performance of the S&P 500 from the beginning of 2001 (i.e., just before 9/11) through May 2007, you can clearly see Berkshire’s long-term market performance. During that 6.3 year period, BRKA has produced a compound annual yield of 7.9%, while the S&P 500 has produced (believe it or not) only 2.7% compounded. If you believe, as we do, that history has a fairly high probability of repeating itself over the next five or six years, thinking like Buffett is a pretty good idea.
Interestingly, about five or six years ago, Buffett was quoted in “Fortune” saying that he expected the market to increase only about “6% to7% annually over the next decade or two”. His own performance has obviously been better than that, but the S&P 500 hasn’t done as well as he predicted, so far.
Another “Buffettism” worth noting is the statement of his two rules of investing: “Rule #1, never lose money; Rule #2, never forget rule #1”.
Not a bad way of thinking in our book!
We strive every day to think like Buffett, as opposed to the short-term market-think and hype with which we are all besieged. We know for sure that companies that generate strong internal rates of return create economic value added for their owners. We also know for sure that good companies that are overvalued by the market in the short term are not good long-term investments, regardless of how exciting they may look. There will always be a better time to own them if we are patient. This is why valuation modeling is so important to us.
While we do not imitate Buffett’s investment decisions, we do take note of what he does, because he does much the same kind of valuation analysis we do. Not surprisingly, we own several of the same companies. Here are some examples:
Berkshire Hathaway (BRKA, BRKB)
In most of our portfolios, BRKB, Berkshire’s non-voting “B” stock is one of our largest holdings, representing about 8% of our equity portfolios. In addition to its publicly traded common stock holdings, Berkshire owns a number of companies outright, such as Dairy Queen and MidAmerican Energy, which includes Home Services (Edina Realty). Also, Berkshire is able to do things with its large cash position, which most investment managers can’t even imagine, including taking large hedge positions vis-à-vis the weakening U. S. dollar.
Conoco Philips (COP)
Berkshire owns 1.1% of Conoco’s outstanding shares. We bought our COP on the basis of its ROI and valuation at about the same time as Buffett. It currently represents about 5% of our portfolios and has done very well for both Berkshire and ourselves.
Moody’s (MCO)
Berkshire owns a whopping 17% of MCO, acquired when it went public. We acquired our position much later on the basis of MCO’s extraordinary ROI and low valuation. It has grown 116% to approximately 8.5% of our holdings. See our March 23, 2006, blog posting “Happy to be Moody”.
Johnson & Johnson (JNJ)
Berkshire owns about .7% of JNJ stock and we believe we acquired most of our position ahead of them. JNJ represents about 5.5% of our holdings. It has been a slow mover over the past year, but is one of the strongest pharmaceutical and over-the-counter healthcare product providers in the world, with excellent ROI and valuation.
Wal-Mart (WMT)
Berkshire owns .5% of WMT. It currently represents about 3% of our holdings and has not been a good performer for either Berkshire or ourselves. It’s ROI and valuation fundamentals, however, are excellent.
Procter & Gamble (PG)
Berkshire is PG’s largest shareholder, with 3.2% of outstanding shares, as the result of both market purchases and PG’s acquisition of Gillette, which was one of Berkshire’s largest holdings. PG represents nearly 5% of our holdings. While it has been a slow mover over the last year, it is considered to be one of the strongest companies in the world.
US Bancorp (USB)
Berkshire reported owning 1.8% of USB’s stock in their 2006 annual report, but they have recently increased their position. We have owned USB for several years and have recently increased our position to a bit more than 5% of our holdings. Both we and Buffett apparently like their excellent ROI and the 4.7% dividend.
WellPoint Health Networks (WLP)
Berkshire is currently accumulating a position in WLP and has not as yet reported the size of their holding. WLP, which is the largest Blue Cross/Blue Shield insurer, currently represents about 4.5% of our holdings and is one of our favorites. We began acquiring positions in WLP and Aetna (AET), after taking a significant profit in United Health Care (UNH), which Buffett still holds. Both WLP and AET continue to do very well for us.
Including BRKB, approximately 45% of our portfolio holdings are also held by Buffett, so we are obviously thinking alike and doing many of the same things. While we don’t agree with all of Berkshire’s investments and believe that some of our holdings are better than theirs (for example, they own 8.6% of Coca Cola, which has been a very poor performer over the last 10 years), we strongly agree with Buffett about holding value-creating companies with proper valuations.
Most importantly, when one “thinks like Buffett”, the day-to-day ups and downs and new records of the market become largely irrelevant to the central mission of creating compounding long-term returns.
As always, we welcome your thoughts and ideas.
Jack and Peter Falker
Note: Both Jack and Peter Falker and the clients of FalkerInvestments Inc. hold positions in the companies mentioned in this article, with the exception of United Healthcare.
Friday, March 02, 2007
Lightbulbs!
A few weeks ago, I noticed an article about Wal-Mart’s initiative to convince 100 million of their customers to replace just one 60 watt incandescent light bulb with a 60 watt equivalent Compact Fluorescent light bulb, which uses only 13-watts. Here’s what they said:
“When you change to Compact Fluorescent light bulbs, you take a step in the right direction to preserve energy resources and our environment for this generation and the next. Just one Compact Fluorescent light bulb keeps half a ton of greenhouse gas (CO2) out of our air. Wal-Mart has over 100 million customers. That means if each customer bought just one compact fluorescent light bulb, it would:
· Keep 22 billion lbs of coal from burning at power plants
· Keep 45 billion lbs of greenhouse gases from being emitted
· Equate to removing 700,000 cars worth of greenhouse gases from the air
· Keep 700 million incandescent light bulbs from landfills.”
To read more about Wal-Mart’s initiative, go to their website: http://walmartstores.com/GlobalWMStoresWeb/navigate.do?catg=685 and click on the article: “Change a Light. Change the World” on the left side of their home page.
That was pretty amazing to me, but then I saw an article: “Bright Idea? Australia Pulls Plug on Light Bulbs,” saying that Australia is banning all incandescent light bulbs by the year 2010. If you would like to read about what Australia’s doing, here’s the web address of the article: http://news.yahoo.com/s/afp/20070220/wl_asia_afp/australiaclimatetechnologywarming
That was enough to convince me to go over to my local Wal-Mart and check out the Compact Fluorescent light-bulbs. I wasn’t too sure, however, if I wanted to replace the nice warm light coming out of my office and living room lamps with the icy glare of fluorescent lighting, but what I found quickly convinced me to go ahead with the change. I looked for those that are labeled “Soft White”, which are produced by Philips. They give off a very nice, warm light that is quite similar to incandescent bulbs. Another nice thing about the Philips bulbs is that they don’t look like the standard “curly-Q” fluorescents. In fact, they look just like regular light bulbs. The only difference I have noticed is that they take a few seconds to come up to full intensity, which seems to me to be a very small compromise for what these bulbs accomplish. The 60 watt bulbs draw only 13 watts, a 78 percent reduction in power consumption. I replaced all of the heavily-used light bulbs in my house with a variety of Philips bulbs, including floodlight bulbs in several ceiling fixtures. The one I’m happiest about is the little 40-watt equivalent candelabra bulb in the outdoor light post in front of my house that comes on each night at dusk and goes off at dawn. That light post is now drawing only 9 watts all night long, also a 78 percent reduction!
The only problem you might encounter is finding enough Philips bulbs on Wal-Mart’s shelves. I had to make two visits to find what I wanted and I still didn’t find 75 or 100 watt equivalent Philips bulbs. They were completely sold out both times. That led me to buy several of the “curly-Q” GE bulbs. The 75 watt GEs were labeled “natural light” and they are very nice, but the 100 watt GEs were labeled “cool white” and they are not what I wanted. So, if you decide to buy some Compact Fluorescents, it may take a little trial and error to get exactly what you want. Bottom line, however, is that you can’t go wrong with the Philips bulbs at Wal-Mart.
I think it’s great that Australia has seized the global warming bull by the horns, but we just can’t wait for our government to get on board. Each of us has to get started doing what each one of us can do. For me, it’s driving a hybrid car and replacing my light bulbs. I urge you to consider doing what you can, as soon as possible.
Let me know what you think.
Jack Falker
NOTE: At the time of publication clients of FalkerInvestments and Jack and Peter Falker had positions in GE and WMT.
“When you change to Compact Fluorescent light bulbs, you take a step in the right direction to preserve energy resources and our environment for this generation and the next. Just one Compact Fluorescent light bulb keeps half a ton of greenhouse gas (CO2) out of our air. Wal-Mart has over 100 million customers. That means if each customer bought just one compact fluorescent light bulb, it would:
· Keep 22 billion lbs of coal from burning at power plants
· Keep 45 billion lbs of greenhouse gases from being emitted
· Equate to removing 700,000 cars worth of greenhouse gases from the air
· Keep 700 million incandescent light bulbs from landfills.”
To read more about Wal-Mart’s initiative, go to their website: http://walmartstores.com/GlobalWMStoresWeb/navigate.do?catg=685 and click on the article: “Change a Light. Change the World” on the left side of their home page.
That was pretty amazing to me, but then I saw an article: “Bright Idea? Australia Pulls Plug on Light Bulbs,” saying that Australia is banning all incandescent light bulbs by the year 2010. If you would like to read about what Australia’s doing, here’s the web address of the article: http://news.yahoo.com/s/afp/20070220/wl_asia_afp/australiaclimatetechnologywarming
That was enough to convince me to go over to my local Wal-Mart and check out the Compact Fluorescent light-bulbs. I wasn’t too sure, however, if I wanted to replace the nice warm light coming out of my office and living room lamps with the icy glare of fluorescent lighting, but what I found quickly convinced me to go ahead with the change. I looked for those that are labeled “Soft White”, which are produced by Philips. They give off a very nice, warm light that is quite similar to incandescent bulbs. Another nice thing about the Philips bulbs is that they don’t look like the standard “curly-Q” fluorescents. In fact, they look just like regular light bulbs. The only difference I have noticed is that they take a few seconds to come up to full intensity, which seems to me to be a very small compromise for what these bulbs accomplish. The 60 watt bulbs draw only 13 watts, a 78 percent reduction in power consumption. I replaced all of the heavily-used light bulbs in my house with a variety of Philips bulbs, including floodlight bulbs in several ceiling fixtures. The one I’m happiest about is the little 40-watt equivalent candelabra bulb in the outdoor light post in front of my house that comes on each night at dusk and goes off at dawn. That light post is now drawing only 9 watts all night long, also a 78 percent reduction!
The only problem you might encounter is finding enough Philips bulbs on Wal-Mart’s shelves. I had to make two visits to find what I wanted and I still didn’t find 75 or 100 watt equivalent Philips bulbs. They were completely sold out both times. That led me to buy several of the “curly-Q” GE bulbs. The 75 watt GEs were labeled “natural light” and they are very nice, but the 100 watt GEs were labeled “cool white” and they are not what I wanted. So, if you decide to buy some Compact Fluorescents, it may take a little trial and error to get exactly what you want. Bottom line, however, is that you can’t go wrong with the Philips bulbs at Wal-Mart.
I think it’s great that Australia has seized the global warming bull by the horns, but we just can’t wait for our government to get on board. Each of us has to get started doing what each one of us can do. For me, it’s driving a hybrid car and replacing my light bulbs. I urge you to consider doing what you can, as soon as possible.
Let me know what you think.
Jack Falker
NOTE: At the time of publication clients of FalkerInvestments and Jack and Peter Falker had positions in GE and WMT.
Wednesday, January 17, 2007
We Have the Answer!
We now have the answer to how we can eliminate foreign oil, which, as Thomas Friedman of the “New York Times” so aptly points out, is the primary source of funding for radical Islamic terrorism. In my view, the answer is hybrid automobile technology, even as it exists today in its still rudimentary form.
A few months ago, I bought a new Toyota Highlander Hybrid SUV, which is not a small vehicle, weighing in at just over 4,000 pounds. It is rated at 33 MPG city and 28 MPG highway and I am averaging nearly 31 MPG in combined city and freeway driving. Why is it higher in the city? Because the engine shuts off every time you coast or stop at a sign or red light and, if you’re careful, you can pull away from a stop without immediately having the engine start with the always functioning motor/generator. After driving this vehicle for a few weeks, I started to realize, to my amazement, that every other car around me at a stoplight was burning expensive gasoline and mine was not! I also discovered that when I am in slow-moving rush-hour freeway traffic that my car runs almost exclusively on its battery, with the engine only coming on every few miles to replenish the battery, but not to drive the wheels. This is truly amazing when I look at the hundreds of cars around me that are blatantly wasting imported oil. Then I started to ask myself: How much gas could be saved in this country if just half of these cars were hybrids?
So, I made a few admittedly simplistic calculations, which turn out to be pretty mind-boggling.
There are approximately 250 million cars and light trucks in the United States, which get an estimated 17 MPG in fuel economy, according to the online encyclopedia, Wikipedia. I’m sure that statistic is an average of the mileage ratings of all these vehicles, so I can accept it statistically, although I believe the number must be lower if you consider the millions of cars driven in stop and go traffic daily, which get a fraction of that mileage.
Let’s assume that the 250 million cars in the United States are driven 15,000 miles annually at an average of 17 MPG. That amounts to usage of 220.6 billion gallons of gasoline annually. Now let’s see what happens if those same cars become big SUV hybrids like mine, getting 31 MPG. Fuel consumption would drop to 120.9 billion gallons, a spectacular saving of 99.7 billion gallons annually! (This number would be even more impressive if we could include the correct proportion of higher-mileage hybrid Camrys and Priuses in the fleet.)
Depending on the grade of crude oil being refined, each 42 gallon barrel of oil nets between 30-50 percent gasoline, or about 17 gallons per barrel. Therefore, a saving of 99.7 billion gallons of gasoline would eliminate approximately 5.9 billion gallons of crude oil a year, an amazing 2.2 billion barrels more than the 3.7 billion barrels we import each year, from places like Saudi Arabia, Iran and Venezuela.
But wait, that’s not all. Current E-85 alcohol technology will allow us in the near future to use only 15 percent petroleum in each gallon of fuel that we burn in our hybrids. Also, remember that hybrid technology is still in its infancy and that more efficient batteries and the addition of high efficiency diesels burning bio-diesel, as charging platforms, will likely be available within a few years. All of these things taken together convince me that we do indeed have the answer to completely eliminate our dependence on foreign oil
Now, you might think that my statistics aren’t sufficiently conservative. So cut them in half and the answer is still mind boggling. And just remember that all the technology to which I refer is currently in existence and is going to get even better over the next few years, as future hybrid generations hit the road with better and perhaps plug-in batteries, and E-85, and bio-diesel become our standard fuels.
I have spent most of my 66 years as a student of the automobile industry, first growing up in Detroit and ultimately as treasurer of Chrysler Financial Corporation, until 1977. More than 35 years ago, while working on my MBA at night and studying statistics with a Westinghouse electrical engineer, we dreamed aloud one Sunday afternoon and drew a schematic of a car that would use an internal combustion engine to charge a battery, just like the diesel locomotives being built by General Motors. I took our “hybrid” idea to some Chrysler engineers and found no interest. So much for American ingenuity, and thanks to the Japanese for seeing the light three decades later.
I am very concerned about the American automobile industry, radical Islamic terrorism and global warming. All of these problems relate to our inefficient use of oil and something has to be done about it right now. What can you do? Just go buy a hybrid car or SUV that suits your needs. Detroit will get the message, or they will fail.
Note: Neither Jack or Peter Falker, nor any of the clients of FalkerInvestments Inc. hold positions in any of the companies mentioned in this report.
A few months ago, I bought a new Toyota Highlander Hybrid SUV, which is not a small vehicle, weighing in at just over 4,000 pounds. It is rated at 33 MPG city and 28 MPG highway and I am averaging nearly 31 MPG in combined city and freeway driving. Why is it higher in the city? Because the engine shuts off every time you coast or stop at a sign or red light and, if you’re careful, you can pull away from a stop without immediately having the engine start with the always functioning motor/generator. After driving this vehicle for a few weeks, I started to realize, to my amazement, that every other car around me at a stoplight was burning expensive gasoline and mine was not! I also discovered that when I am in slow-moving rush-hour freeway traffic that my car runs almost exclusively on its battery, with the engine only coming on every few miles to replenish the battery, but not to drive the wheels. This is truly amazing when I look at the hundreds of cars around me that are blatantly wasting imported oil. Then I started to ask myself: How much gas could be saved in this country if just half of these cars were hybrids?
So, I made a few admittedly simplistic calculations, which turn out to be pretty mind-boggling.
There are approximately 250 million cars and light trucks in the United States, which get an estimated 17 MPG in fuel economy, according to the online encyclopedia, Wikipedia. I’m sure that statistic is an average of the mileage ratings of all these vehicles, so I can accept it statistically, although I believe the number must be lower if you consider the millions of cars driven in stop and go traffic daily, which get a fraction of that mileage.
Let’s assume that the 250 million cars in the United States are driven 15,000 miles annually at an average of 17 MPG. That amounts to usage of 220.6 billion gallons of gasoline annually. Now let’s see what happens if those same cars become big SUV hybrids like mine, getting 31 MPG. Fuel consumption would drop to 120.9 billion gallons, a spectacular saving of 99.7 billion gallons annually! (This number would be even more impressive if we could include the correct proportion of higher-mileage hybrid Camrys and Priuses in the fleet.)
Depending on the grade of crude oil being refined, each 42 gallon barrel of oil nets between 30-50 percent gasoline, or about 17 gallons per barrel. Therefore, a saving of 99.7 billion gallons of gasoline would eliminate approximately 5.9 billion gallons of crude oil a year, an amazing 2.2 billion barrels more than the 3.7 billion barrels we import each year, from places like Saudi Arabia, Iran and Venezuela.
But wait, that’s not all. Current E-85 alcohol technology will allow us in the near future to use only 15 percent petroleum in each gallon of fuel that we burn in our hybrids. Also, remember that hybrid technology is still in its infancy and that more efficient batteries and the addition of high efficiency diesels burning bio-diesel, as charging platforms, will likely be available within a few years. All of these things taken together convince me that we do indeed have the answer to completely eliminate our dependence on foreign oil
Now, you might think that my statistics aren’t sufficiently conservative. So cut them in half and the answer is still mind boggling. And just remember that all the technology to which I refer is currently in existence and is going to get even better over the next few years, as future hybrid generations hit the road with better and perhaps plug-in batteries, and E-85, and bio-diesel become our standard fuels.
I have spent most of my 66 years as a student of the automobile industry, first growing up in Detroit and ultimately as treasurer of Chrysler Financial Corporation, until 1977. More than 35 years ago, while working on my MBA at night and studying statistics with a Westinghouse electrical engineer, we dreamed aloud one Sunday afternoon and drew a schematic of a car that would use an internal combustion engine to charge a battery, just like the diesel locomotives being built by General Motors. I took our “hybrid” idea to some Chrysler engineers and found no interest. So much for American ingenuity, and thanks to the Japanese for seeing the light three decades later.
I am very concerned about the American automobile industry, radical Islamic terrorism and global warming. All of these problems relate to our inefficient use of oil and something has to be done about it right now. What can you do? Just go buy a hybrid car or SUV that suits your needs. Detroit will get the message, or they will fail.
Note: Neither Jack or Peter Falker, nor any of the clients of FalkerInvestments Inc. hold positions in any of the companies mentioned in this report.
Monday, January 08, 2007
2007
Happy New Year!
As we finish the holiday season and make our transition to the New Year, it’s a good time to take a look back and prognosticate a bit about what we might expect going forward. Usually we limit our investor letters to one page, but because of the intriguing issues we currently face and the ability to post our thoughts endlessly on the blog (which you have hopefully bookmarked and reread with interest) we have made this one a bit longer. So read on at your leisure and at your own pace.
Introduction
2006 ended up being a good year economically for the United States, despite persistent mixed signals, which sent perplexing and often contradictory messages to investors: (1) an inverted yield curve; (2) spiking, then collapsing, oil prices; (3) low unemployment; (4) a slowing housing market; (5) a weakening dollar; (6) a volatile, yet rising, stock market; (7) the Iraq War and all of the attendant problems of the Middle East; (8) a vote of very low confidence in our President; and (9) the persistent threat of terrorism. We consider all of these issues in aggregate when determining how to deploy our investment strategy. In this post-stock market bubble, post-9/11 world, we have chosen to step carefully, becoming fully invested at our own pace to create valuable and durable portfolios that will compound significantly over many years.
Consider the return of the market during the six-year period from the beginning of 2001 to the end of 2006. This period affords a snapshot of the market history of our country from after the bubble, but pre-9/11, to the current moment. People are always surprised to learn that the market was up only about 7.5%, in aggregate, during that entire period (i.e. only about 1.25% a year in simplified terms) despite the barrage of “new-record high” news we have been hearing almost every night for the last few months. The key in this period was to avoid the significant down market of 2002, because of the difficult recovery from such a loss, which is reflected in the above six-year statistic. We have learned a great deal in the past six years and have seen nothing to dissuade us from our belief that history could well repeat itself in the next five or six years.
The Inverted Yield Curve
Of the issues mentioned earlier, one of the most notable and interesting for the financial markets is the inverted yield curve and its implications for the economy (i.e. what does it mean when short-term interest rates are consistently higher than long-term interest rates?). There is much debate about what the curve is telling us about future economic growth versus the credibility of the Federal Reserve. By managing the federal funds rate (the rate at which banks borrow overnight to maintain their required reserve levels) from 1.00% in mid 2003 to the current 5.25% the Fed has signaled its commitment to fight inflation, while potentially slowing the growth of the economy. When considering that long-term rates are generally lower than short term rates, it would appear the Fed has gone too far. GDP growth has indeed slowed a bit recently, but still not near recessionary. In fact, in the last several weeks of 2006 the Fed has actually added liquidity to keep the current federal funds rate from rising above the target of 5.25%. This signals continued demand from banks for money and implies continued growth in the economy. Consequently, moves like this reduce the expectation in the market of the Fed lowering rates any time soon.
So it appears at this point that the inverted yield curve has less to do with predicting a recession and possibly more to do with a decrease in the volatility of inflation expectations, due largely to the persistent and, to date, successful actions of the Fed. Lower volatility creates less uncertainty, which results in a smaller inflation premium demanded by investors who own long term assets (i.e. lower long-term bond rates).
It is important to add that the demand for U.S. Treasuries has likely applied significant pressure to longer term rates as well. While most investors like ourselves don’t find 4.5% 10 year Treasury yields attractive, countries that carry enormous dollar reserves from their trade surpluses with the U.S., namely China and Japan, need a safe place to park their cash. As you can guess, many of the dollars we use to buy products from China turn right around and come back to us via the United States Treasury, adding to our ever-growing national debt.
We consider the current structure of interest rates to have been a net positive to the U.S. economy, the stock market, and the prospect for continued growth, for several reasons. First, the Fed has demonstrated its effectiveness in moderating core inflation and inflation expectations, thereby creating generally lower risk premiums for investors, as well as gaining credibility from the markets. Second, lower long-term rates have enhanced corporate profitability and allowed for continued capital spending. Third, the housing market has avoided a destabilizing decline due in part to the persistence of historically low fixed mortgage rates. Fourth, the Fed has ample room to lower rates and create liquidity in case of recession or an external shock such as terrorism.
As for the shape of the yield curve in 2007, we really can’t say for sure. It’s our guess, however, that the economy will sputter sometime late in the year as the economic cycle and the Fed will hit the tap for more liquidity by lowering rates. As long as we are not facing a severe recession, we would expect the markets to respond positively, as the Fed would be seen as promoting economic growth, while gaining credibility by controlling inflation. In particular, we would expect bank stocks to do very well, as they resume the business of borrowing short and lending long profitably. We are looking to add to our bank holdings and capturing some very attractive current dividend yields. Consider US Bank (USB) yielding 4.4%, Bank of America (BAC) at 4.2%, and TCF Financial (TCB) at 3.4%.
Housing and Employment
We feel it is important to look at jobs and housing together. The single most important factor in a healthy housing market is a healthy jobs market. Much has been said about the collapse of the housing bubble and the shock to the economy. Having significant experience with residential and investment real estate ourselves it is painfully obvious that housing has endured a significant correction that has yet to fully run its course. For those homeowners looking to sell, the pain has generally been felt in reduced expectations of what they can get for their property, rather than actual loss of initial investment.
The greatest risk is the leverage used against overzealous return expectations and the consequent fallout of foreclosure and bankruptcy. The fastest growing and highest risk segment of the mortgage market is sub-prime loans. Recently the New York Times addressed a report from the Center for Responsible Lending claiming that 1 in 5 sub-prime mortgages made in the last two years are likely to see foreclosure in the coming year, as adjustable rates are ratcheted up. Although possibly a worst-case scenario given the subjectivity of foreclosure models, with these types of loans accounting for 25% of the mortgage market the potential negative fallout is obvious.
We have always felt the consumer/homeowner has been vulnerable in the past several years with rising oil prices and higher short-term interest rates. However, the unemployment rate has remained at historically low levels of about 4.5% and workers have seen a recent rise in real wages due largely to the year-end decline in energy prices. Always aware of the certainty of economic cycles, being at a trough for so long in unemployment makes us nervous about its duration. We are certainly not out of the woods and the risk definitely gives us caution in making our investment decisions.
Oil and Energy
2006 saw us invest in the oil and gas sector for the first time. With the rise in oil prices and the expectation for continued global demand, we are seeing companies in this segment finally meet our return on capital criteria. We believe that $50 per barrel oil prices allow for sufficient returns on capital, while not overburdening the consumer.
We are among those who believe in increasing global demand with tighter supplies (supporting higher prices) of both domestic and foreign oil and natural gas over the next several years. Those in the opposing camp believe that oil demand will lessen as the world economy (read primarily China) slows down and perhaps recesses from its current growth pattern. In that case, we would probably have an even bigger problem of world recession, but we see that as quite remote at the moment. China, in particular, is creating growth to support its massive employment base while aggressively acquiring oil assets.
According to a report in 2006 from the Energy Information Administration (the statistical arm of U.S. Department of Energy) world oil demand will increase 47% from 2003 to 2030. 43% of this increase is projected to come from developing Asian countries, including China and India. A commensurate rise in output is needed to maintain stable oil prices and favors companies involved in exploration and production, as well as oil services. We are looking to invest approximately 10% of our assets in these areas over the next year or two. We have currently chosen ConocoPhillips (COP) and Noble Corporation (NE) as initial investments. COP gives us global exposure for exploration and production and a stake in the largest supplier of natural gas in North America. Noble Corporation is engaged in global deepwater drilling, where demand is currently outpacing the supply of equipment. We expect these holdings to be quite volatile and move with the short-term speculation in oil futures, which may take some short-term patience. However, we believe the underlying value and cyclical forces in the oil and oil services sectors will prevail.
Within the energy sector, we also believe there will be a massive move toward hybrid automotive technology over the next 3-5 years, as we try to reduce our reliance on foreign oil and attack the sources of global warming. We have run the numbers ourselves and can see how conversion of approximately half of the U.S. automotive fleet to hybrids would virtually eliminate foreign oil dependency, particularly if “plug-in” hybrid technology comes to pass, resulting in 50 mpg SUVs burning alternative fuels, such as E-85 gasohol or bio-diesel.
Many people have made the choice to drive a hybrid but cost and vehicle selection have inhibited wider use. With Toyota entering production of their 4th generation hybrid technology and U.S. auto makers making future production announcements of 5th generation hybrids, based on a consortium of General Motors, Daimler and BMW, it is only a matter of time before substantial portions of the U.S. fleet are converted. We have identified Johnson Controls (JCI) as the front runner in U.S. automotive hybrid battery development, as they have received significant contracts to develop next- generation, lithium-ion batteries.
If that sounds like we are playing both sides of oil demand, that would be correct. Oil exploration and production and offshore oilfield services should see significant gains over the next 2-3 years, while hybrid battery development will be very important in the longer term.
Healthcare
We increased our exposure to the healthcare segment this year with recent acquisitions of Aetna (AET) and Wellpoint (WLP). This adds to our healthcare related holdings of Medtronic, Johnson & Johnson, and Abbott Labs. For the year, this segment has underperformed the S&P 500 and continues to persist as undervalued in our model. Much of this underperformance relates to the sell- off in the weeks prior to the election, as the market discounted the possible change in legislation from a shift in control in the Congress. Even though Medicare Advantage will likely be scrutinized, significant change is unlikely, especially in the next two years. We feel comfortable that the return on investment and growth incentives for healthcare companies will remain attractive as the U.S. population ages and innovative products for the uninsured become a focus for the private sector.
Summary
For our part, we ended 2006 fully invested in all but our newest accounts. Our emphasis has continued to be defensive, with the notable exception of positions we took during the year in the oil industry, both in exploration and production, and offshore oil-field service. As always, our outlook is long-term, with particular attention toward capital conservation. This results in low-beta portfolios, which can be expected to do well (but not quite as exciting) in a frothy market, and decidedly better than the market in downturns. Our only objective is to outperform the market in the long term, which we are very proud to have accomplished during the period of our management experience.
In general, our other investments include major banks, consumer product companies, and medical technology and biotechnology companies, which, as always, must meet our criteria of generating internal rates of return on invested capital that consistently exceed the companies’ costs of capital, and are undervalued based on our EVA/DCF modeling technique.
We also have a core holding in Berkshire Hathaway, which is primarily a casualty insurer, but has broad portfolio holdings not unlike our own, including oil and gas and consumer products, among several others. We strongly subscribe to Warren Buffett’s current thinking about the markets and keep always before us his prediction of several years ago that he expects 6-8% returns in the markets over the next “decade or two”. So far, he has been fairly accurate, if not a bit generous. Most importantly, Warren Buffett is totally unconcerned about the short term and the current gyrations and records set by market averages. His two rules of investing are always worth repeating: Rule #1, Never lose money; Rule #2, Never forget Rule #1. We believe our portfolios have significant room for appreciation while limiting our risk of loss.
As always, we welcome your thoughts and comments.
Peter and Jack Falker
Note: Jack and Peter Falker and the clients of FalkerInvestments Inc. hold positions in the companies mentioned above, with the exception of General Motors, Daimler, BMW and Bank of America.
As we finish the holiday season and make our transition to the New Year, it’s a good time to take a look back and prognosticate a bit about what we might expect going forward. Usually we limit our investor letters to one page, but because of the intriguing issues we currently face and the ability to post our thoughts endlessly on the blog (which you have hopefully bookmarked and reread with interest) we have made this one a bit longer. So read on at your leisure and at your own pace.
Introduction
2006 ended up being a good year economically for the United States, despite persistent mixed signals, which sent perplexing and often contradictory messages to investors: (1) an inverted yield curve; (2) spiking, then collapsing, oil prices; (3) low unemployment; (4) a slowing housing market; (5) a weakening dollar; (6) a volatile, yet rising, stock market; (7) the Iraq War and all of the attendant problems of the Middle East; (8) a vote of very low confidence in our President; and (9) the persistent threat of terrorism. We consider all of these issues in aggregate when determining how to deploy our investment strategy. In this post-stock market bubble, post-9/11 world, we have chosen to step carefully, becoming fully invested at our own pace to create valuable and durable portfolios that will compound significantly over many years.
Consider the return of the market during the six-year period from the beginning of 2001 to the end of 2006. This period affords a snapshot of the market history of our country from after the bubble, but pre-9/11, to the current moment. People are always surprised to learn that the market was up only about 7.5%, in aggregate, during that entire period (i.e. only about 1.25% a year in simplified terms) despite the barrage of “new-record high” news we have been hearing almost every night for the last few months. The key in this period was to avoid the significant down market of 2002, because of the difficult recovery from such a loss, which is reflected in the above six-year statistic. We have learned a great deal in the past six years and have seen nothing to dissuade us from our belief that history could well repeat itself in the next five or six years.
The Inverted Yield Curve
Of the issues mentioned earlier, one of the most notable and interesting for the financial markets is the inverted yield curve and its implications for the economy (i.e. what does it mean when short-term interest rates are consistently higher than long-term interest rates?). There is much debate about what the curve is telling us about future economic growth versus the credibility of the Federal Reserve. By managing the federal funds rate (the rate at which banks borrow overnight to maintain their required reserve levels) from 1.00% in mid 2003 to the current 5.25% the Fed has signaled its commitment to fight inflation, while potentially slowing the growth of the economy. When considering that long-term rates are generally lower than short term rates, it would appear the Fed has gone too far. GDP growth has indeed slowed a bit recently, but still not near recessionary. In fact, in the last several weeks of 2006 the Fed has actually added liquidity to keep the current federal funds rate from rising above the target of 5.25%. This signals continued demand from banks for money and implies continued growth in the economy. Consequently, moves like this reduce the expectation in the market of the Fed lowering rates any time soon.
So it appears at this point that the inverted yield curve has less to do with predicting a recession and possibly more to do with a decrease in the volatility of inflation expectations, due largely to the persistent and, to date, successful actions of the Fed. Lower volatility creates less uncertainty, which results in a smaller inflation premium demanded by investors who own long term assets (i.e. lower long-term bond rates).
It is important to add that the demand for U.S. Treasuries has likely applied significant pressure to longer term rates as well. While most investors like ourselves don’t find 4.5% 10 year Treasury yields attractive, countries that carry enormous dollar reserves from their trade surpluses with the U.S., namely China and Japan, need a safe place to park their cash. As you can guess, many of the dollars we use to buy products from China turn right around and come back to us via the United States Treasury, adding to our ever-growing national debt.
We consider the current structure of interest rates to have been a net positive to the U.S. economy, the stock market, and the prospect for continued growth, for several reasons. First, the Fed has demonstrated its effectiveness in moderating core inflation and inflation expectations, thereby creating generally lower risk premiums for investors, as well as gaining credibility from the markets. Second, lower long-term rates have enhanced corporate profitability and allowed for continued capital spending. Third, the housing market has avoided a destabilizing decline due in part to the persistence of historically low fixed mortgage rates. Fourth, the Fed has ample room to lower rates and create liquidity in case of recession or an external shock such as terrorism.
As for the shape of the yield curve in 2007, we really can’t say for sure. It’s our guess, however, that the economy will sputter sometime late in the year as the economic cycle and the Fed will hit the tap for more liquidity by lowering rates. As long as we are not facing a severe recession, we would expect the markets to respond positively, as the Fed would be seen as promoting economic growth, while gaining credibility by controlling inflation. In particular, we would expect bank stocks to do very well, as they resume the business of borrowing short and lending long profitably. We are looking to add to our bank holdings and capturing some very attractive current dividend yields. Consider US Bank (USB) yielding 4.4%, Bank of America (BAC) at 4.2%, and TCF Financial (TCB) at 3.4%.
Housing and Employment
We feel it is important to look at jobs and housing together. The single most important factor in a healthy housing market is a healthy jobs market. Much has been said about the collapse of the housing bubble and the shock to the economy. Having significant experience with residential and investment real estate ourselves it is painfully obvious that housing has endured a significant correction that has yet to fully run its course. For those homeowners looking to sell, the pain has generally been felt in reduced expectations of what they can get for their property, rather than actual loss of initial investment.
The greatest risk is the leverage used against overzealous return expectations and the consequent fallout of foreclosure and bankruptcy. The fastest growing and highest risk segment of the mortgage market is sub-prime loans. Recently the New York Times addressed a report from the Center for Responsible Lending claiming that 1 in 5 sub-prime mortgages made in the last two years are likely to see foreclosure in the coming year, as adjustable rates are ratcheted up. Although possibly a worst-case scenario given the subjectivity of foreclosure models, with these types of loans accounting for 25% of the mortgage market the potential negative fallout is obvious.
We have always felt the consumer/homeowner has been vulnerable in the past several years with rising oil prices and higher short-term interest rates. However, the unemployment rate has remained at historically low levels of about 4.5% and workers have seen a recent rise in real wages due largely to the year-end decline in energy prices. Always aware of the certainty of economic cycles, being at a trough for so long in unemployment makes us nervous about its duration. We are certainly not out of the woods and the risk definitely gives us caution in making our investment decisions.
Oil and Energy
2006 saw us invest in the oil and gas sector for the first time. With the rise in oil prices and the expectation for continued global demand, we are seeing companies in this segment finally meet our return on capital criteria. We believe that $50 per barrel oil prices allow for sufficient returns on capital, while not overburdening the consumer.
We are among those who believe in increasing global demand with tighter supplies (supporting higher prices) of both domestic and foreign oil and natural gas over the next several years. Those in the opposing camp believe that oil demand will lessen as the world economy (read primarily China) slows down and perhaps recesses from its current growth pattern. In that case, we would probably have an even bigger problem of world recession, but we see that as quite remote at the moment. China, in particular, is creating growth to support its massive employment base while aggressively acquiring oil assets.
According to a report in 2006 from the Energy Information Administration (the statistical arm of U.S. Department of Energy) world oil demand will increase 47% from 2003 to 2030. 43% of this increase is projected to come from developing Asian countries, including China and India. A commensurate rise in output is needed to maintain stable oil prices and favors companies involved in exploration and production, as well as oil services. We are looking to invest approximately 10% of our assets in these areas over the next year or two. We have currently chosen ConocoPhillips (COP) and Noble Corporation (NE) as initial investments. COP gives us global exposure for exploration and production and a stake in the largest supplier of natural gas in North America. Noble Corporation is engaged in global deepwater drilling, where demand is currently outpacing the supply of equipment. We expect these holdings to be quite volatile and move with the short-term speculation in oil futures, which may take some short-term patience. However, we believe the underlying value and cyclical forces in the oil and oil services sectors will prevail.
Within the energy sector, we also believe there will be a massive move toward hybrid automotive technology over the next 3-5 years, as we try to reduce our reliance on foreign oil and attack the sources of global warming. We have run the numbers ourselves and can see how conversion of approximately half of the U.S. automotive fleet to hybrids would virtually eliminate foreign oil dependency, particularly if “plug-in” hybrid technology comes to pass, resulting in 50 mpg SUVs burning alternative fuels, such as E-85 gasohol or bio-diesel.
Many people have made the choice to drive a hybrid but cost and vehicle selection have inhibited wider use. With Toyota entering production of their 4th generation hybrid technology and U.S. auto makers making future production announcements of 5th generation hybrids, based on a consortium of General Motors, Daimler and BMW, it is only a matter of time before substantial portions of the U.S. fleet are converted. We have identified Johnson Controls (JCI) as the front runner in U.S. automotive hybrid battery development, as they have received significant contracts to develop next- generation, lithium-ion batteries.
If that sounds like we are playing both sides of oil demand, that would be correct. Oil exploration and production and offshore oilfield services should see significant gains over the next 2-3 years, while hybrid battery development will be very important in the longer term.
Healthcare
We increased our exposure to the healthcare segment this year with recent acquisitions of Aetna (AET) and Wellpoint (WLP). This adds to our healthcare related holdings of Medtronic, Johnson & Johnson, and Abbott Labs. For the year, this segment has underperformed the S&P 500 and continues to persist as undervalued in our model. Much of this underperformance relates to the sell- off in the weeks prior to the election, as the market discounted the possible change in legislation from a shift in control in the Congress. Even though Medicare Advantage will likely be scrutinized, significant change is unlikely, especially in the next two years. We feel comfortable that the return on investment and growth incentives for healthcare companies will remain attractive as the U.S. population ages and innovative products for the uninsured become a focus for the private sector.
Summary
For our part, we ended 2006 fully invested in all but our newest accounts. Our emphasis has continued to be defensive, with the notable exception of positions we took during the year in the oil industry, both in exploration and production, and offshore oil-field service. As always, our outlook is long-term, with particular attention toward capital conservation. This results in low-beta portfolios, which can be expected to do well (but not quite as exciting) in a frothy market, and decidedly better than the market in downturns. Our only objective is to outperform the market in the long term, which we are very proud to have accomplished during the period of our management experience.
In general, our other investments include major banks, consumer product companies, and medical technology and biotechnology companies, which, as always, must meet our criteria of generating internal rates of return on invested capital that consistently exceed the companies’ costs of capital, and are undervalued based on our EVA/DCF modeling technique.
We also have a core holding in Berkshire Hathaway, which is primarily a casualty insurer, but has broad portfolio holdings not unlike our own, including oil and gas and consumer products, among several others. We strongly subscribe to Warren Buffett’s current thinking about the markets and keep always before us his prediction of several years ago that he expects 6-8% returns in the markets over the next “decade or two”. So far, he has been fairly accurate, if not a bit generous. Most importantly, Warren Buffett is totally unconcerned about the short term and the current gyrations and records set by market averages. His two rules of investing are always worth repeating: Rule #1, Never lose money; Rule #2, Never forget Rule #1. We believe our portfolios have significant room for appreciation while limiting our risk of loss.
As always, we welcome your thoughts and comments.
Peter and Jack Falker
Note: Jack and Peter Falker and the clients of FalkerInvestments Inc. hold positions in the companies mentioned above, with the exception of General Motors, Daimler, BMW and Bank of America.
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