Investment Manager’s Letter June 2010
Mr. Market seems to have lapsed into one of his periods of depression, and while this has brought out the prophets of doom on CNBC that may not be an entirely bad thing. The market has been going up for 15 months and the values were definitely getting stretched. The only way to prolong the bull phase that started in March 2009 was with a correction. Losch Investment Management Company current correction has the S&P selling at 13 times this year’s earnings, and 11 times the estimate for next year. This latter figure is not far from the levels reached at the market lows in March of last year, particularly if one compares the earnings yield on stocks to the yield on long term treasuries.
As long as there are markets, there will be bubbles; and all bubbles end with a crash. Economics is the study of human behavior and markets are a product of that behavior. So, Markets are not efficient and often not very rational. In October of 2007, the Dow and the S&P were making all time highs at a point when disaster was inevitable. Housing prices had been falling since late 2006 and subprime loans were defaulting at record levels. Everything was in place for the Great Crash, and the fuse had been lit. All that was left to be done was to wait for the boom. Yet the stock market was totally blind to the coming disaster. CDO’s like those that Merrill Lynch had just purchased for $30 billion were carried on books all over Wall Street for one hundred cents on the dollar. Eight short months later, Merrill would liquidate this position for $7 billion, realizing a loss of a cool $23 Billion as Wall Street found itself in the midst of a valuable learning experience about the nature thermo-nuclear finance.
It is a great mistake to think of the markets as efficient. What they are is a reflection of the current emotional state of the people participating. If the market had it so wrong in October 2007, then why is it any more likely to be right today? Regulation will neither prevent the next down cycle nor guarantee the next up cycle. As long as there are humans in charge there will be cycles. It will always happen again. Yes, next time will be different, but the basic causes (short term greed, arrogance, stupidity, panic, etc.) will always emerge, being essential parts of the human condition.
The good news is that at the end of every bear market there is a bull market, and that the benefit from the next bull will likely be in direct relation to the pain suffered during the crash. In politics and economics, pain is the mother of wisdom, and the amount of pain experienced will be directly proportional to the acquired wisdom (the more pain the better). So we can posit that just as the thirties provided a foundation for the economic growth that followed in the Forties, Fifties and early Sixties, then also the trauma of the seventies gave way to growth in the Eighties and Nineties. The lessons learned from the Great Recession are likely be the driving factors for the world economy for the next twenty or thirty years. Recovery follows the crash for the same reason that a crash follows the bubble, because this is the pattern of human behavior. The human economy is like the donkey that just does not pay attention until the 2×4 is carefully applied between the eye balls. While the long bull markets feel better because most people are getting richer, the economic contractions are more important to our counties long term growth, so if you can learn to enjoy the pain.
What we do know at this point is that the market has experienced what is probably a generational bear market, and that this correction, like the bear markets of the thirties and the seventies, will provide lessons that will eventually propel an economic expansion. What is not clear is the timing of that recovery. If I had to guess, I would bet that the current corrective process has a way to run. We are not going to solve our debt problems overnight.
Years ago, when Goldman Sachs was still a partnership, Senior Partner Gus Levy used to counsel his traders to be long term greedy, not short term greedy. This is certainly the best advice for investors in today’s market. Don’t worry about short term losses, if you are right about the long term there will be a positive result. “In the short term the market is a voting machine (think November 2007); in the long term it is a weighing machine.” You do not have to know what is going on with the market in the short term if you a right about the long term.
All this is not to say that there is no role for regulation. There are lots of things that can be done to help the donkey improve his behavior and to make the markets and the economy work better for the next twenty to thirty years. Financial institutions must be required to reduce leverage, and must be forbidden to pay obscene eight figure compensation for antisocial behavior that has no redeeming social value. No company should be too big to fail, failure must always be an option, or we invite disaster. Credit default swaps are insurance, and as such they must have rules that treat them like insurance. All derivatives trading should be subject to as much visibility as possible.
These are a few of the things which could be helpful to future investors. As for my personal opinion, as investment manager, I’m with Charlie. If I were in charge, I would make Paul Volker look like a pussycat.
When it comes to our investment strategy, it is likely what has worked for the last ten years will continue to be the best approach for preserving capital. We have been able to beat the Market consistently by focusing quality stocks and religiously avoiding the mania de jour. We intent to stick with this plan, secure in the knowledge that history tells us that things will get easier in the not too distant future.
As part of the deal to purchase a $5 billion Goldman Sachs preferred, Berkshire Hathaway received warrants to purchase 43.478 million shares of Goldman Sachs’s common stock. For the trailing 12 months, Goldman Sachs earned $23.97 per share, so Berkshire Hathaway’s look-through earnings on this position, if the warrants had been exercised, would have been $1.042 billion. This compares to $2.180 billion which was the Berkshire Hathaway’s total look-through earning for its 51 stock positions in 2009. So, the Goldman Sachs purchase can definitely be classified as a needle mover, at least when it comes to its eventual impact on look-through earnings. It also looks as though Berkshire Hathaway’s return on this investment, instead of being limited to the 10% dividend paid by the preferred could be closer to 20% if you consider the earnings of the underlying security. The only other convertible whose earnings are greater than the dividends paid on the convertible is Dow Chemical. If we take per share earnings on these two issues and subtract the dividends paid to Berkshire Hathaway and the tax that would be due if all earnings were paid out to Omaha, then Berkshire Hathaway’s undistributed investee earnings would increase from $1,262 per share to $1,658 per share. If we add this figure to Berkshire Hathaway’s reported earnings per share for the last four quarters, the total is $10,109, which gives Berkshire Hathaway a PE of 10.4 at today’s close, and of 13.55 at munofitch’s conservative intrinsic value figure of $137,000. With the assumption of 17 times earnings as reasonable valuation for a stock of this caliber, you could arrive at an intrinsic value of $172,000.