The Ultimate Dividend

Much is talked about dividend investing. But few know of one particularly type of dividend that I think is very powerful if employed appropriately and honestly (that is, if it's not abused by unscrupulous managers): stock dividend.


Because stock dividend:
  1. Lets the investor control how much in taxes he/she wants pay.
  2. Lets the investor decide whether to reinvest in the company or cash out and buy another investment.
  3. Is tax free.
Here's how it works. Suppose company A has X in earnings. It can choose to issue a fraction of X as dividends and retain the rest. If dividends are paid, say Y% of X, investors face an automatic dividend tax hit and then need to make a decision whether to buy something else, reinvest the proceeds in the company or let it sit somewhere, such as in a money market account.

But company A could elect to issue a stock dividend instead, in the same amount as before (Y%). The stock price should go down proportionally, like what happens when companies pay out a cash dividend. But then the investor has extra shares, that make up the same total he had before. The only difference is that he now has a few extra shares, which he can keep or sell for cash as before -- the difference is having the choice.

If stock dividend is more flexible than cash dividends but otherwise equal, why don't companies choose to do it all the time?

I think it has to do with the fact that many investors don't understand it well and also due to the danger of companies being perceived as being in a weak financial situation.

As it happens, companies typically issue stock dividends when they need to conserve cash. Two recent examples are Sunstone Hotels (SHO) and Lloyds Bank (LYG). Sunstone not only paid out in stock, but it raised its dividend -- using money that it did not have. Its payout ratio is a whopping 216%. So, in this case, the stock dividend is nothing more than a stock split. It does nothing for the shareholders.

Similarly, Lloyds paid out 339% of its "earnings" in stock, also using money it did not have.

These are examples of when not to pay a dividend -- in cash or stock.

Now, going back to why stock dividends are useful if employed properly by honest companies.

Let's go back to our company A above. It has X in retained earnings, it could issue 2X or 3X (or any number) in shares and declare as large a "dividend" as it wants, like SHO and LYG. But let's say they're responsible folks and won't pay out more than say 0.5X. If the company pays out cash, the share price is automatically reduced by 0.5X divided by the number of outstanding shares -- to reflect that X dollars are now no longer part of the company's assets.

On the other hand, if company A chooses to pay out in stock, the share price will also decrease by an amount proportional to the new shares issues, which is exactly 0.5X divided by the share count. But now investors have 0.5X in extra stock certificates. They can elect to maintain their claim on the entire share they had, or sell the extra shares for income, just as if the company had paid out in cash. Either way, the result is the same.

Here's an illustration:

With stock dividends, the default behavior is to reinvest the money in the company (without incurring transaction costs nor taxes) while in the cash dividend case, the investor had no such choice -- he had to pay taxes and then take an action to deploy his new cash.

I think all companies should consider using stock dividends more often. All else being the same, investors should be given more control over their tax and reinvestment situations.

However, to avoid the situation where share counts increase but no cash ever exchanges hands, I'd like to see a hybrid approach: companies should pay out a quarterly cash dividend, and yearly they should issue a special stock dividend with the unpaid part of their earnings -- like they do with bonuses for their employees. This special stock dividend would fluctuate in value over time, to reflect the company's ups and downs as it goes through good and bad times.


Desperate Credit Card Companies Pulling New Tricks

It's amazing how sneaky credit card companies are and have been. It doesn't even surprise me much anymore. But they do manage to catch us off-guard every now and then and create new headaches all the time.

People who don't check their statements carefully might be paying extra fees for everything without knowing.

The newest trick on their book is the following: if a company has headquarters in another country, but conducts business in the US as usual, they now apply their special foreign transaction fee even on transactions generated in the US and in US dollars.

That's just insane.

I just got a bill today with a three percent surcharge because the company that billed me, called "British Airways, USA", located in Florida, US, is an arm of UK-based British Airways. The charge was originally in USD and still the three percent fee applied.

(BTW: I called British Air and a representative told me there are lots of complaints like mine, and that the card was charged in the US, in US dollars, by their american subsidiary, and that we should not pay these abusive fees)

Of course, I'm disputing the charge with the credit card company. But it goes to show how sneaky these people are.

This, of course, wasn't the first time I had to dispute charges with credit card companies. In all cases though, I take them to the Better Business Bureau if needed and close the account. I've only lost once, but the company lost a good customer of 8 years. And I'll never return to it.

The supply is large for someone with good credit, so being faithful to any single company is pointless.


Are "generics" a threat to drug companies?

Every time I read something about a drug company it always comes with warnings about fierce competition and the threat of generics. Fierce competition I can understand. There are many drug companies out there. But the threat of "generics" is something I started questioning recently.

The theory is that when patents expire, opportunistic drug companies will step in and produce the same drug for less and bring down the nice margins enjoyed by the original manufacturer of the drug. The nice margins were nice because the drugs were protected by patents. When this is no longer the case, goodbye profits. Or so goes the theory.

But does this really happen and is it really that bad?

Why can't drug companies lower their prices and compete head-to-head with generics when their patents expire? Are the big drug companies that inefficient that they can't lower prices enough to compete? They surely have better financial position than the generics. Given that they compete with other drug companies, I'd expect them to be reasonably efficient and be constantly lowering their cost structures.

Wouldn't some customers even pay a small premium to get a branded drug as opposed to a generic one? Of course some will, just look at sales of Tylenol compared to other generic cold and fever drugs. Anyone can mix paracetamol and acetaminophen cheaply. But Tylenol still sells more than others and people do pay a premium for the brand. Why wouldn't people pay a small premium for Plavix or Lipitor, two of the cholesterol-lowering drugs that are coming off-patent soon, the former by Bristol-Myers Squibbs and the latter by Pfizer?

Plus, is it really the case that big pharma companies cannot lower costs enough to compete with those like Teva, the israeli-based generic maker?

I simply don't believe that.

Assume the worst: big pharma is inefficient at running their drug factories (the plants that mix the powders and packages the pills -- all that is needed for a generic manufacturer). In this case, they could: 1) sell their "assembly line" and let a more competent operator run it, 2) buy one of the generic makers or 3) don't even bother with production and sales and worry only about development of new drugs. Many biotechs and smaller drug makers operate in the latter mode.

Now, suppose that this is not the case, that big pharma companies can lower their prices upon patent expiration enough to compete with generics. Then what happens? They now must compete on who has the most efficient sales channel, distribution and marketing teams, just like they had to do against their bigger rivals to begin with.

So, what does really happen? Let's see.

Let's look at three big-pharma: Bristol-Myers Squibb (BMY), Pfizer (PFE) and Merck (MRK) and compare them with generic giant Teva (TEVA), Watson Pharmaceutical (WPI) and Mylan (MYL).

What do they have in common?

BMY, PFE and MRK are all 3-star stocks as rated by S&P currently. Their analysts all "caution" us against "generic competition".

TEVA, WPI and MYL are all 5-star stocks as per S&P.

And yet, BMY, PFE and MRK trade between 9 and 12 price-to-earnings ratio, sport a 4 to 6% dividend yield and have return-on-equity that averaged from 22 to 34% over the last 9 years.

Compare these with TEVA, WPI and MYL trading between 14 and 43 price-to-earnings ratio, having dividend yields of zero to 1.29% and return-on-equity that averaged from 5 to 15% over the last 9 years.

The table below summarizes the comparison:

Note on methodology: I picked BMY and TEVA due to my own interest in them and then I randomly selected two others from each group. The big-pharma group I selected based on the first two names that came to mind and for the other two generics I picked the top two by capitalization. Of course, there are probably counter-examples to this situation too. P/E and div. yield from Google Finance. Avg 9-year ROE courtesy of S&P.

Conclusion: I don't buy the argument that generics are better investments (3 versus 5 stars), nor that generics create such a large threat. Sure, they eat into profits just like any competitor would. But the fear of generics does not justify, by itself, the low valuations of big-pharma nor a 5-star rating for the generics.

Disclaimers: None (no securities mentioned held long nor short at the time of writing -- though I'm considering starting a position in BMY, pending further analysis).

The Dire State of Commercial Real Estate in the Silicon Valley

A few hours driving around in the Silicon Valley in California are enough to have an idea of the oversupply of commercial real estate buildings for lease, if only as anecdotal evidence of the precarious condition of CREs in the region.

I now leave you with 50,000+ words describing the situation.


Ben "Nostradamus" Graham

The markets and the economy are cyclical beasts. We all know that. But from time to time we all (or almost all) forget about it. That's part of the cycle too.

Nothing new so far, right?

What amazes me the most, though, is how predictable these cycles are. No, not the timing of them. Just how they happen and that they will happen. The same mechanisms, over and over again.

Just to illustrate one, consider this short passage from Security Analysis, by the legendary Ben Graham, from 1934. Regarding real estate assets:

During the great and disastrous development of the real estate mortgage-bond business between 1923 and 1929, the only datum customarily presented to support the usual bond offering -- aside from an estimate of future earnings -- was a statement of the appraised value of the property, which most invariably amounted to some 662/3% in excess of the mortgage issue. If these appraisals had corresponded to the market values which experienced buyers of or lenders on real estate would place upon the properties, they would have been of real utility in the selection of sound real estate bonds. But unfortunately they were purely artificial valuations, to which the appraisers were willing to attach their names for a fee, and whose only function was to deceive the investor as to the protection which he was receiving.

The method followed by these appraisals was the capitalization on a liberal basis of the rental expected to be returned by the property. By this means, a typical building which cost $1,000,000, including liberal financing charges, would immediately be given an "appraised value" of $1,500,000. Hence a bond issue could be floated for almost the entire cost of the venture so that the builders or promoters retained the equity (i.e., the ownership) of the building, without a cent's investment, and in many cases with a goodly cash profit to boot.
(Security Analysis, Second Edition, 1940, Ben Graham and David Dodd, pages 139-140. All emphasis are theirs).

Recap: inflated, self-serving appraisals. Check. Zero money down investment. Check. Greater fool's theory. Check. Did he allude to bonds having high credit ratings due to inflated asset prices ("deceive the investor ... of the protection he was getting")? Check again.

Sounds familiar?


Jamie Dimon's Shareholders Letter

In Berkshire Hathaway's recent annual shareholder's meeting, Warren Buffett highly recommended Jamie Dimon's letter to shareholders. So I read it. Indeed, it's very interesting. In it, Dimon summarized a few interesting things, besides how JP Morgan did in 2008:
  • Critical Events (purchase of Bear Stearns and WaMu and acceptance of TARP funds).
  • "Blame" for the crisis (possible root causes for it).
  • Future and regulation.
He also touched upon executive compensation and social responsibilities, but only briefly.

Summarizing his letter here would be pretty hard, since it contains a lot of topics and is highly summarized already. So I will focus on two interesting aspects and possibly the most controversial ones: assigning blame and more regulation.


He starts with a caveat/disclaimer:
The causes of the financial crisis will be written about,
analyzed and subject to historical revisions for decades.
Any view that I express at this moment will likely
be proved incomplete or possibly incorrect over time.
And then proceeds to enumerate them:
• The burst of a major housing bubble
• Excessive leverage pervaded the system
• The dramatic growth of structural risks and the unanticipated damage they caused
• Regulatory lapses and mistakes
• The pro-cyclical nature of virtually all policies, actions and events
• The impact of huge trade and financing imbalances on interest rates, consumption and speculation
The Burst of housing bubble
Poor underwriting standards (including little or
no verification of income and loan-to-value ratios as
high as 100%) and poorly designed new products (like
option ARMs) contributed directly to the bubble and
its disastrous aftermath.
Excessive leverage

He cites hedge funds, banks (and their SIVs), private-equity firms, investment banks, CDO managers, some bond funds and even pension plan funds were highly levered, due to conditions made possible from rising prices, thus fueling even higher prices. He concludes:
Basically, the whole world was at the party, high on
leverage–and enjoying it while it lasted.
The dramatic growth of structural risks and the unanticipated damage they caused

He starts with short-term, illiquid assets:
Some banks, hedge funds, SIVs and CDOs were using short-term financing to support illiquid, long-term assets. When the markets froze, these entities were unable to get short-term financing. As a result, they were forced to sell these illiquid assets.
And goes on to money market funds:
After Lehman collapsed, one money [market] fund in particular, which held a lot of Lehman paper, was unable to meet the withdrawal demands. As word of that situation spread, investors in many funds responded by demanding their money
And then on to repo financing (daily borrowing between banks):
[I]n those markets where financial companies financed their liquid assets, financial terms had become too lax. For example, to buy non-agency mortgage securities, financial institutions only had to put up 2%-5% versus a more traditional 15%-25%. The repo markets also had begun to finance fairly esoteric securities, and when things got scary, they simply stopped doing so. [...] Once again, financial institutions had to liquidate securities to pay back short-term borrowing.
Regulatory lapses and mistakes

Again, he starts with a disclaimer:
With great hesitation, I would like to point out that mistakes also were made by the regulatory system. That said, I do not blame the regulators for what happened.
Then, on to lack of regulation or poor regulation throughout the system:
Much of the mortgage business was largely unregulated. While the banks in this business were regulated, most mortgage brokers essentially were not.
He continues:
Basel II [...] was highly flawed. It was applied differently in different jurisdictions, allowed too much leverage, had an over-reliance on published credit ratings and failed to account for how a company was being funded (i.e., it allowed too much short-term wholesale funding).
And on Fannie and Freddie regulators:
Perhaps the largest regulatory failure of all time was the inadequate regulation of Fannie Mae and Freddie Mac. [...] Both had dramatically increased their leverage over the last 20 years. And, amazingly, a situation was allowed to exist where the very fundamental premise of their credit was implicit, not explicit.
The pro-cyclical nature of virtually all policies, actions and events

This is possibly the most interesting part of Dimon's recount of why the crisis unfolded. The high-level view here is that when things are bad, regulation and accounting rules force increased loan-loss reserves (thus consuming capital), mark-to-market accounting distorts the fair value of illiquid assets, rating downgrades can force some insurers to post more collateral (thus also burning through capital), financing arrangements (loan covenants, etc) force deleveraging at the worst possible times, while allowing higher leverage in good times, and with increased volatility Basel II accounting rules demand more capital be held.
In a crisis, pro-cyclical policies make things worse. I cannot think of one single policy that acted as a counterbalance to all of the pro-cyclical forces. Although regulation can go only so far in minimizing the impact of pro-cyclical forces in times of crisis, we still must be aware of the impact they have.
The impact of huge trade and financing imbalances on interest rates, consumption and speculation
Over an eight-year period, the United States ran a trade deficit of $3 trillion. This means that Americans bought $3 trillion more than they sold overseas. Dollars were used to pay for the goods. Foreign countries took these dollars and purchased, for the most part, U.S. Treasuries and mortgage-backed securities. It also is likely that this process kept U.S. interest rates very low, even beyond Federal Reserve policy, for an extended period of time. It is likely that this excess demand also kept risk premiums (i.e., credit spreads) at an all-time low for an extended period of time. Low interest rates and risk premiums probably fueled excessive leverage and speculation.
And this ends his summary of the root causes and main fuel to the great financial fire in history. The next part is his proposal for how to avoid another one going forward or at least how to minimize its scale and impact. It is probably a very controversial topic as it hinges on more and better regulation, which is typically a double-edged sword.


He starts:
The extent of the damage and the magnitude of the systemic problems make it clear that our rules and regulations must be completely overhauled.
And cautions:
Political agendas or simplistic views will not serve us well.
Often we hear the debate around the need for more or less regulation. What we need is better and more forward-looking regulation.
The plan:
The first goal should be to regulate financial institutions so they don’t fail. If they do fail, a proper resolution process would ensure that action is swift, appropriate and consistent. The lack of consistency alone caused great confusion in the marketplace. For example, when some of the recent failures took place, there was inconsistent treatment among capital-holders (preferred stock and debt holders were treated very differently in different circumstances). It would have been better if the regulators had a resolution process that defined, a priori, what forms of aid companies would get and what the impact would be on capital-holders. The FDIC resolution process for banks provides a very good example of how a well-functioning process works.
And on fragmentation of the many regulators and their limited scope:
If [...] similar products were overseen by a single regulator, that regulator would have much deeper knowledge of the products and full information that extends across institutions. [...] Everyone agrees that the existing system is fragmented and overly complex. We have too many regulators and too many regulatory gaps. No one agency has access to all the relevant information. Responsibility often is highly diffused.
And hedge funds:
[Hedge funds] could be required to show their regulators (not their competitors) any concentrated “trades” that could cause excessive systemic risk.
Mortgages are the largest financial product in the United States, and while we do not want to squelch innovation, the entire mortgage business clearly needs to be regulated.
No one was responsible for the actual quality of the underwriting. Even mortgage servicing contracts were not standardized such that if something went wrong, the customer would get consistent resolution. We cannot rely on market discipline (i.e., eliminating bad practices) alone to fix this problem.
On fixing mark-to-market (or "fair value accounting") he says:
We generally like fair value accounting.
But provides a caveat when times are bad, which requires companies to use synthetic benchmarks and judgment on "comparable" securities:
In many instances, cost is the best proxy for fair value. We would rather describe our investments to our shareholders, tell them when we think these investments might be worth more and, certainly, write them down on our financial statements when they have become impaired.
Which is interesting if it's not abused. But when there's leeway for good faith estimates, it's bound to be abused. I've commented on closed-end mutual funds estimating the value of treasuries based on other methods besides market values.

He essentially agrees with Charlie Munger on what I called "voodoo accounting":
Essentially, we now have to mark to market credit spreads on certain JPMorgan Chase bonds that we issue. For example, when bond spreads widen on JPMorgan Chase debt, we actually can book a gain. Of course, when these spreads narrow, we book a loss. The theory is interesting, but, in practice, it is absurd. Taken to the extreme, if a company is on its way to bankruptcy, it will be booking huge profits on its own outstanding debt, right up until it actually declares bankruptcy–at which point it doesn’t matter.
And then goes on:
It is becoming increasingly more difficult to compare mark-to-market values of certain instruments across different companies. [...] [D]ifferent companies may account for similar mark-to-market assets differently. This needs to be addressed by ensuring that companies adhere to consistent valuation principles while applying the rules.
Not all illiquid assets need special treatment (such as real estate, plant and equipment), but some others do. He cites examples:
Fair value accounting does not and should not apply to all assets. [...] [F]or example, a farm would be worth more when corn prices go up, and a semiconductor plant would be worth less when semiconductor prices go down. [...] [M]arking the aforementioned assets to market every day would be a waste of time. Under this scenario, it would be quite hard for companies to invest in anything illiquid or to make long-term investments.
And now perhaps the most interesting part is what this new regulation and accounting method should do, to counter what he previously called "cyclical policies". He cites three good ideas:
  1. Loan loss reserving can easily be made counter-cyclical
  2. Repo and short-term financing can easily be made counter-cyclical
  3. Banks should have the ability to implement counter-cyclical capital raising with rapid rights offerings
Loan loss reserving
As things get worse and charge-offs rise dramatically, one must dramatically increase loan loss reserves, thus depleting capital rapidly. This problem would be solved if banks were allowed to estimate credit losses over the life of their loan portfolios. Reserves should be maintained to absorb those losses. This would enable banks to increase reserves when losses are low and utilize reserves when losses are high. Transparency would be fully preserved because investors and regulators would still see actual charge-offs and nonperformers. This would require a rational explanation about the appropriateness of the lifetime loss estimates. It also would have the positive effect of constantly reminding CEOs, management teams and investors that bad times, in fact, do happen–and that they should be prepared for such events.
Repo and short-term financing
If an institution provides financing to clients in excess of what the Fed would lend to the bank for the same securities, it would have to be disclosed to risk committees and the company’s Board of Directors. The Fed then would have two major tools to reduce leverage and in a way that is counter-cyclical–it could charge higher capital costs to a bank when the bank is lending more than the Fed would lend or the Fed could reduce the amount it would lend to the banks.
Rapid rights offerings
Banks and possibly other companies would be aided by having the ability to effect rights offerings at a moment’s notice. Regulations should facilitate such offerings–with the proper disclosure–in a matter of days rather than weeks.

Final Words

All told, it was a very interesting read. The summary of the historical facts paint a very complex picture. Saying it was regulators' fault or the banks' fault or even subprime borrowers' fault is too naive. It was a combination of all these things over a long time that led to excesses that had to be undone. We're now paying the price for letting it happen.

Perhaps the most controversial points were his proposed solutions. More regulation can be a bad thing. I'm a believer that "free" markets are one of the most powerful forces in nature. On the other hand, I don't believe that free means "free of regulation". I believe free means without government intervention in prices and the free exchange between market participants.

For this free market to happen, however, there needs to be a healthy dose of rules -- regulation, if you will. Markets without rules and penalties for those who violate it are bound to be exploited by evil participants, which will cause others participants to take measures that will defeat the benefit of the free market and impose too high a cost to smaller participants. Ultimately, unregulated markets will fail.

Striking a reasonable balance is necessary. Dimon's suggestions did not seem unreasonable. But at the same time, they didn't seem to be that powerful. I don't think they would resolve the problem going forward, though they would certainly help. I'm still undecided about the idea of letting banks tell us what the fair value of their assets are. I'd be more convinced when I knew what the details and guidelines were and what kind of punishment was there for those who abuse it -- and how regulators plan to audit and detect abuses.


Reaching the castle island

We are born in the ocean. Almost all of us are at least. But the ocean is not a very hospitable place. It's dangerous, full of sharks. We can't really eat in the ocean nor sleep adequately.

Luckily for us, there are islands all around us in this big ocean. Thousands, millions of islands, actually. Most are small, 2-by-2 islands with single coconut trees on them. But the coconut tree gives us water, food and minimal shelter against the sun. These islands are usually taken by other people. But it doesn't matter. There are so many of them that one can quickly swim to another, deserted coconut island.

There are bigger islands too. Ones with castles on them. Some with big castles, some with little castles. But castles, nonetheless.

Everyone says they want to live in the islands with a castle. But few do. Mostly because they're far, far away -- it's a big ocean we live in, after all. Many people are afraid of taking the plunge and swim to one of the castle islands. We hear stories about those who made it there, and we all know the stories of those who tried to get there but never made it.

The sad stories are of all kinds. Some folks tried to swim all the way, non-stop, but they simply swam in the wrong direction. Others got tired along the way and stopped at slightly larger coconut islands.

Some adventurous ones built sail boats or even motor boats to get to the castle islands, but didn't build a good enough structure and their boats sunk along the way, causing a lot more damage than if they had chosen to stay on the coconut island. Some who took other people's motor boats ended up exploding their engines and causing even more damage. Now they spend all their time building new boats for those who lent them the boat initially.

Some fail spectacularly, with explosions and boats, but failures can also be almost non-events too. There are those who swim a little, spend a little time in the coconut island and then swim some more, never really getting any closer to the castle islands.

On the other hand, the success stories we hear are of very few kinds. In fact, they all sound very similar. Excluding those who got a lift from a relative who happens to have a helicopter, most others who live in the castle islands now would describe their stories as the following.

Swim to the coconut islands strategically for a few years. Always in the direction of the castle islands. Take that time on the coconut islands to learn how to orient oneself, how to swim efficiently in case of an emergency (swimming fast is not desirable -- very few get to a castle island that way) and how to build a flotation device. Then build it -- slowly if one has to. Use the flotation device to go in the direction of the castle islands. Stop along the way in the larger coconut islands to build bigger and faster flotation devices. Some will sink. But as long as one keeps building them and floating in the right direction, day after day after day, the goal gets closer and closer.

Eventually, one makes one's way to a fake castle island. Everything looks real, but those who throw their flotation devices away and choose to stay will eventually be disappointed as the castle will vanish. The success stories though, tell us to enjoy the castle for a little bit, while taking the time to build a real boat.

That last boat is the one that will take us to one of the real castle islands.

How big your castle and island depend on many factors, such as the wind and the turns you took. But the biggest determinant is the power of your boat. Nonetheless, every castle island has a permanent castle on it. And it's yours forever. You can only lose it if you find a stupid way of imploding it. Some people do it, but it's not as common as those in the coconut island who build sand castles that later crumble on their own.

The common thread among the success stories though, is that it took having a plan to get there. And it required time and effort. There are really no honorable shortcuts.

What is your plan to reach the castle island?


Berhkshire Hathaway Shareholders Meeting

This weekend was Berkshire Hathaway's shareholders meeting. This is one of the few times when Buffett goes out to the public to let his shareholders and fans openly question him. This time the meeting format was a little different: half of the questions were vetted by financial journalists Carol Loomis, of Fortune; Becky Quick, of CNBC; and Andrew Sorkin, of the New York Times.

Warren and his not-so-well-known partner Charlie Munger fielded questions for over 6 hours. The most interesting ones had to do with the economy, Berkshire holdings, value investing, and accounting rules.

Economy and Inflation

On the economy front, Buffett answered to an 11-year-old boy who asked about what to expect for his future. Buffett told him the usual honest answer that he can't predict the future, but he doesn't see how it could be possible for the US to avoid inflation: "we're doing things now that will inevitably lead to inflation in the future", Buffett told the boy (as I recall him saying -- not a verbatim quote). Munger complemented that he still remembers the 2-cent stamp and the 5-cent 6 ounce bottle of Coca-cola and that inflation has always been with us, and it will continue to be, and as long as it's not massive and uncontrolled, we will be okay.

Berkshire holdings and activism from Buffett

A very interesting question and perhaps one that exposed one of Buffett's weaknesses in my opinion was about Moodys, the rating agency he owns 20% of. The question asked why he did interfere with Moodys inflated valuations of housing and mortgage-related securities. The question pondered, if he saw it coming -- which it wasn't clear he did -- why didn't he take an active role in telling Moodys (and perhaps S&P) about it. His answer was disappointing, but nonetheless honest. He said he's not an activist and has never been. He buys companies for their value and net worth and not with the intention of changing them. He thought and still thinks that Moodys is a very good company with good prospects, but his role is to allocate capital, not to manage companies, especially ones he doesn't own 100%.

I was disappointed because being such an honest person and so good in what he does, the normal thing to expect is that he would take a more active role in "fixing" mistakes, wrongdoing and excesses. I think I probably expect him to be a hero too, despite being the most successful investor of all times. Perhaps that's asking too much of him. It could even spoil him. Corporate activists have fame of being raiders and acting in self-interest. I disagree with this simplistic view by the media and I respect the famous activist Carl Icahn's position. But that's subject of another post.

Also, it wasn't clear whether or not Buffett really knew the housing excesses were really about to pop or not, so maybe it wasn't just that he didn't say or do anything, but that he, like most of us and most big banks, didn't see it coming.

Executive compensation and shaming mutual fund managers

Another question touched upon changes in executive compensation, and why he didn't take a more active role there, in the public companies he owns. He mentioned he had been on the board of 19 companies and that he didn't believe he could affect them much. He recalled being vocal about compensation when he was part of the compensation committee at some company I don't recall, but being kicked out of the compensation team ever since. Out of 19 boards, he was on only this one compensation committee and was never invited again.

His solution to exuberant executive compensation is to have large institutional investors -- the big mutual funds managers -- be more vocal about it. And that all it takes is for the public and the media to shame them into taking this active role on compensation. He said it would take only 3 to 4 big mutual funds to synchronize an attack on CEO and executive compensation to kick-start the process.

Fair enough. Here's my part of the bargain. Because of all of you, my four faithful readers, I can be considered part of the media too. So I'm now publicly embarrassing the managers of the top 3 mutual funds (by assets) for not taking a more active role in executive compensation. According to this article and others, the top 3 companies managing equities are American Funds, Fidelity and Vanguard. And according to Marketwatch the top 3 funds by assets are: AGTHX, FCNTX and VTSMX. Their manager's names are: Gordon Crawford and team, of American Funds; Will Danoff, of Fidelity Contrafund; and Gerard C. O Reilly, of Vanguard Total Stock Index. Shame on you!

Value Investing

Regarding value investing, a woman from Omaha asked how Buffett does it and whether it was true he didn't need a calculator or a computer to crunch the numbers. Buffett confirmed that he didn't do spreadsheets nor used calculators and that it doesn't make a difference whether the discount rate is 9.1% or 9.2%: "the numbers should jump at you", Warren said.

He repeated Ben Graham's words that too much IQ can actually interfere with good financial results in the markets. He pointed out examples of Long-Term Capital Management (LTCM), a hedge fund that blew up a few years back due to manager's exaggerated confidence in their abilities, given their 150 IQ, PhD and sophisticated computers (here's a video of Buffett commenting on this at a meeting with students).

Buffett repeated what he's said many times before, that investing is simple and one should only focus on their circle of competence and when in doubt throw wild ideas and complex companies in the "too hard" file and forget about them.

Voodoo Accounting

As part of a question I don't recall now, Munger made a bold remark about some Generally Accepted Accounting Principles (GAAP) having some rules that are bogus. The one he cited is a company being able to increase its equity because the price of their bonds went down and the company being able to report buying their debt at a discount as a "profit". Citibank recently did just that and the difference between the market value of their bonds and par was recorded as a profit. Of course, this is just a paper profit, since no cash flows to the company. In fact, there's an outlay of cash by the company, to purchase its debt back. So, if anything, this should be an expense, not a gain.

But the debt reduction is real, and hence why GAAP indicates this should be recorded as income. I don't know how to reconcile this fact with what Munger pointed out, that there was no cash being generated to the company. How should this be treated under a proper accounting system? Perhaps it should be booked now as an expense (the outlay of cash to repurchase the debt) and when the debt formally matures it should be treated as a capital gain. But if the entire amount of debt was repurchased, then it's hard to justify waiting many years for the now nonexistent debt to mature.

I've commented on other voodoo accounting practices being adopted by closed-end mutual funds for apparently no good reason.

Dividend Policy

An elaborate question given to the journalists asked whether Berkshire had changed the rules of the game. Its owner manual states that a dividend shall only be paid if for each dollar of earnings retained Berkshire does not accrue at least a dollar in share price over time. The manual says that so far that test has been met. The question points out that for the last 5 years, the retained earnings were not reflected in the share price nor in the book value of the company and that perhaps it would be time for Berkshire to pay a dividend after all.

Buffett answer poorly in my opinion. It was mostly a non-answer about 2008 being a bad, one-off year and that Berkshire did better than the S&P 500. I would have been satisfied if he had said he prefers to exclude 2008 and that he would re-think his decision by end of 2009. That would have been decent. But the comparison with the S&P 500 has nothing to do with whether or not $1 of retained earnings are reflected in the stock price or not. This seems to me like a change in the rules of the game.

I personally think that Buffett will face this question again and again and more strongly every time, given that the amount of growth everyone, including himself, expects from Berkshire is diminishing dramatically, given its size. I wouldn't be surprised if BRK paid a special dividend in the next 5 years and instated a permanent dividend policy within 10-15 years.

Other Things

Berkshire is not immune to corporate activism. This year some shareholder brought to our attention possible employee mistreatment in Fruit of the Loom's factories in Honduras. A former employee, speaking in Spanish, commented on inhumane treatment, threats and other allegedly excesses of management in Honduras. A Fruit of the Loom manager spoke about the third party investigations, actions taken and firing of the people responsible. He said how things have improved since then, commented on some exaggeration by the woman reporting the facts and the closing of the factory since then, due to the downturn in the economy.

On the succession front, Buffett fielded questions about who would take over upon his death. This has become a trite subject by now and is not very interesting, since Buffett won't comment who the candidates are. The same 3 internal candidate remain for the CEO position and the same 4 internal/external candidates also remain for the position of Chief Investment Officer (CIO). When asked how the possible future CIOs did this year, Buffett said they did a little worse than the S&P, but that this didn't bother him, as over the long run, they should outperform the S&P.

Judging from Buffett's voice and some coughing, and Charlie falling asleep a few times during the meeting, their health is not what it used to be (whose is?). Despite that, if Buffett stops drinking five cans of Cherry Coke per day and eating burgers, he might live another 20 years.

Buffett also mentioned a few times about the 2008 letter to shareholders of JP Morgan Chase, by Jamie Dimon. I have not read it yet, but I will. Perhaps I'll have something to say about it here. Stay tuned.


Among the celebrities present, I saw Pat Dorsey, from Morningstar, author of books I highly recommend for the beginner investor: The Five Rules for Successful Stock Investing (the very first book on stock investing I bought) and The Little Book that Builds Wealth (next year I'll be sure to bring my copies of these books for Pat to sign and I'll hope he brings along his colleague Josh Peters, author of another book I like, The Ultimate Dividend Playbook).

Also present who I believe was Monish Pabrai, author of The Dhandho Investor (a popular book I have not read myself yet, except for a few excerpts). Of course, Bill Gates as a Berkshire director was there too as was Susan Decker, ex-Yahoo.

Pat Dorsey, from Morningstar.