Bubble Backlash

We try to make our investment discipline as clear and concise as possible. If you are a client you’ve heard us say it many times over (Jack has a tendency to lecture at length during our meetings), but here are our two guiding principles again.

1. Only own companies that generate returns on capital that exceed the cost of capital.
2. Never overpay for an expected future stream of cash flows.

These principles can be adapted for particular circumstances, but are too often ignored or forgotten by business owners and managers, households, and financial market participants. Because of this, our country finds itself in a serious economic predicament, as we go through the second post-bubble backlash in seven years.

As the financial markets have declined due to fears of recession, foreclosures, deflation, inflation, etc., etc., it is important to look across the valley for a path to higher ground. In the meantime we can use our guiding principles to help us find better investment returns along the way. So let’s take a brief trip down into the valley and look at the “crisis” facing the US economy. First, a look at how the US Dollar Index illustrates, literally, the road map we have been on.

This decline in the dollar can be summed up easily: the demand for dollars is significantly less than the supply available. Many believe this reflects the relative direction of our global economic position.

At risk of oversimplifying, we all know that US consumers have an insatiable appetite for “stuff”, and their eagerness to borrow (often against their houses) to buy that “stuff”, has created a growing disparity between what we use and what we produce in this country. This was greatly enhanced in recent years by the Greenspan rate cuts to 1% after the fallout from the tech bubble, and by financial markets deploying creative and complex ways of aggregating global capital that was starving for return. The perfect marriage of a fiscally irresponsible consumer, and capital invested at a reduced, or most likely false, expectation of return, created the potential for widespread destruction of value. Our clients and those familiar with our investment discipline will recognize this as similar to the reason we invest only in companies that are fiscally responsible and respect the cost of the capital they are using.

For most of the last century, the US has enjoyed the position of being the global economic leader and producer of goods. The reality is that economies previously labeled emerging (a fairly non-threatening term) have now emerged and are competing globally. While competition is healthy in a free market system, it also requires efficiency and discipline with respect to capital investment. Our consumption patterns, lack of saving and willingness to over-leverage are all weaknesses that are being highlighted and exploited by our newfound competitors (think China, India, etc.). The resulting fallout from this behavior, seen specifically in the highly leveraged housing and financial markets, has lawmakers and the Federal Reserve ready to intervene.

Government has been mastering the art of the bailout since at least the early 1900s and, therefore, the markets have high expectations for a rescue. While our capitalist, market-driven economy benefits from regulation and occasional targeted intervention, the focus on a rescue when things go awry can distort the market mechanism of finding equilibrium asset prices and flushing out bad financial decision making. The headlines of a looming recession and realized losses on financial investments coupled with constant rhetoric from politicians and central bankers, stoke the uncertainty and volatility present in markets today. Given that we are unwinding possibly the greatest credit bubble this country has ever seen, the proportionate response from the Federal Reserve and lawmakers may be quite large in absolute terms.

So, let’s look at what the geniuses at the Federal Reserve are up to. After several months of uncertainty, the Fed has clarified its position: Offset the deflationary and recessionary effects of deleveraging on the economy and worry about inflation later. To be clear, the greater risk in the very short run is deflation, as the rapid unwinding of credit and credit availability limit capital investment, consumption, and overall aggregate demand in the economy. Declining credit availability is similar to a decline in the money supply, which is exactly what the Fed is trying to offset.

The unwillingness (in some cases inability) for banks to lend, as well as the difficulty of credible borrowers to obtain capital, is at the forefront of the Fed’s concern as it continues to use the blunt force of lower short-term interest rates by injecting money into the banking system. As the Fed was apparently late in assessing the risks of the situation (or possibly ignorant as was much of Wall Street), the short end of the yield curve is currently indicating the need for substantially lower rates to induce capital flows. For much of the past two years, banks have faced weak net interest margins (interest received less interest paid) due to short-term rates equaling or exceeding long-term rates. In addition, some of the largest banking institutions and brokers (the best examples being Citigroup and Merrill) have sought massive capital infusions to bolster bloated balance sheets loaded with “toxic” loans that are subsequently being written down in value (in accordance with some debatable accounting standards). The Fed is attempting to allow banks to earn money at all maturities of the yield curve by lowering the Federal Funds Rate. As seen in past rate reductions, the target Federal Funds Rate may be somewhere below the two-year Treasury yield, a proxy for the short end of the yield curve. Currently that rate is close to 1.6%, but it can fluctuate greatly day to day.

Even though the banking system as a whole is well capitalized, restriction of the flow of capital is a real and destabilizing threat to the economy that the Fed needs to address. The risk here is being too aggressive for too long. By inflating our way out of this problem with an increasing supply of money, a substantial portion of those “extra” dollars unfortunately will be used to consume imported goods, which will expand the difference of what we use versus what we produce as a nation. By forcing dollars into the hands of our foreign competitors and essentially asking for them back as a loan to fuel further consumption and government spending, we give away ownership interest in our national assets, as well as the discretion over how those dollars are invested. For example, when we use dollars to buy toys with lead paint from China, they can use those dollars to invest in US Treasuries, which helps keep our long term interest rates low but also makes us dependent on them to finance our deficits. Or they can reallocate and buy other stores of value. If they choose to do the latter because the returns here are insufficient (i.e., practicing principle number one from above), it will raise our interest rates, exacerbate tight commodity markets (commodities are already expensive due to global demand and ethanol subsidies), and raise the cost of imported goods. These are all symptoms of inflation. Worse, it is inflation with very little real growth, or “stagflation”.

The key here is this: no pain, no gain. Deleveraging and the revaluation of asset prices (e.g. houses, mortgage backed securities, leveraged loans) is taking place right now. So far the Fed’s action can be seen as attempting to stabilize defunct credit markets. We should expect (or hope for) the Fed to take back anything extra that has been put on the table, as soon as markets have had time to heal. Healing might require going into a recession, but it is often the best remedy. Consider how the Fed inflated its way out of a surprisingly mild recession in 2002. Possibly the credit bubble we face today could have been avoided with less aggressive monetary policy and a deeper, more effective slowdown. As Stephen Roach, chairman of Morgan Stanley Asia, opined in the New York Times recently, “The greater imperative is to avoid toxic asset bubbles in the first place.” (click here to read his op-ed, after you finish this blog post of course)

Additionally, right or wrong, the government will bail out many people who made poor financial decisions (by the way there is some real evidence of fraud in mortgage lending being uncovered). At the very least, Congress and the Treasury will attempt to facilitate a workout of the mortgage problem to get people back on their feet. There are many pitfalls along the way, but the real challenge is to moderate assistance, so those that get help learn to stay on their feet. Some ideas that are being floated include reform (or possibly a bailout) of Government Sponsored Enterprises known by their chummy nicknames Fannie Mae and Freddie Mac, expansion of the FHA, and a public awareness campaign called The Hope Now Alliance, which is sponsored by the Treasury Department. In the end, free markets guided by the boundaries of sound laws and the efficient transfer of capital will eventually get it right and money will flow when returns are appropriate. Lessons will be learned (possibly to be forgotten as history suggests) and we will make progress.

There is a path that leads us to higher ground and there will continue to be opportunities to invest profitably. Since it is difficult to say it any better, here is a quote from Warren Buffett’s 2007 letter to shareholders: “Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce evergrowing prosperity for its citizens.” This is the belief in our country to get it right. The realities of a global economy have revealed our weaknesses and it will take time to adjust and correct our errors and imperfections. Now is the time to focus on fiscal discipline, sound capital management, sound free trade policy, and innovation to compete and export in a global marketplace.

It is very important to look across the valley at future growth and investment returns. The U.S. economy continues to increase productivity, more companies are focusing on return on capital (we see it most in working capital management), and many U.S. corporations are well positioned internationally to take advantage of the rapid growth of infrastructure and technology on a global level. Those opportunities are most prevalent today in China and India, which are voracious consumers of resources and goods, as they build out to accommodate a surging urban population.

No matter how long the duration of the credit crisis, we stick to our principles of investing, which are serving our clients well. Many well run businesses will feel minimal effects from a slowdown. Stock market values may go down, but as long as businesses continue to create value and preserve capital, intrinsic values will rise. While by no means the beginning of a long term bull market, current levels are presenting opportunities to invest. We continue to be conservative in our choices and maintain our current theme of preserving capital by maintaining some defensive positions. We will continue to add undervalued names that will benefit from global expansion and the general level (not just the rate of change) of commodity prices. We are closely watching some financial companies that have been significantly discounted in the market. Retail is not as interesting quite yet as consumer spending and employment will likely be under pressure through much of 2008. We will also take full advantage of opportunities to take profits when appropriate. Finally, as a reminder we will:

1. Only own companies that generate returns on capital that exceed the cost of capital.
2. Never overpay for an expected future stream of cash flows.

These should not simply be treated as truisms, but should be discussed and practiced in all matters of economic consequence.

We welcome your questions and opinions.

Peter Falker, CFA

Selling a Long-Term Holding

Selling a stock we’ve held for quite a while, and which has done well for us, is always a difficult decision. We are often asked how and why we do that, and it’s always a good question.

Here’s a good example: We just sold WellPoint, Inc. (WLP), one of the largest healthcare insurers in the country, which we had held for the last 13 months. We bought WLP, along with Aetna (AET), to maintain our position in the healthcare insurance segment, shortly after taking our profits in UnitedHealth (UNH). That proved to be a good decision, since both WLP and AET have outperformed UNH, as well as the S&P 500 Index, since we bought them. (See our blog post “Back to Healthcare” dated December 6, 2006.)

So why sell WLP now? The most important reason is that the company no longer meets our investment criteria. Their current stock price is just below an all-time high and it now exceeds what our valuation model tells us the company is worth. Secondly, they are no longer an EVA company, meaning that their return on capital has drifted below their cost of capital while we have held the stock. That’s reason enough when we can book an 18 % long-term gain, even though we think there could be some appreciation in the stock over the next year, based on what the company has recently said in an analysts’ meeting.

However, there was another rather compelling reason for us to sell WLP here. We recently had access to a somewhat obscure, but very well done, piece of research that said that WLP has approximately $300 million in sub-prime, mortgage-backed securities on their books, which they probably will have to substantially write-down, as of the end of 2007. While $300 million is a relatively small portion of their investment portfolio, it is still a lot of money, and the write-down would come at a time when no one wants to hear about another company losing money on sub-prime mortgage investments. If this happens (and we can’t say for sure it will), we think the stock could trade down for a period of time, thereby impairing our gain.

So, this combination of factors (i.e., the company becoming overvalued, as well as not meeting our EVA criteria, plus the desire to protect our 18 % gain in a difficult market) gives us our sell signal. Of course, we can’t know for sure what will happen after we’re gone. But one thing we do know is that we beat the market with this holding and we are quite sure we’re going to have other places to deploy our cash, as the market continues to give up the meager gains it made in 2007.


Note: At the time of this posting, Jack and Peter Falker and the clients of FalkerInvestments Inc. were long Aetna (AET).

Breaking the Buck (Not!)

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.

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.

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