The (Really Long) Road to Perdition

This past week presented more signs that, at least with respect to common stocks, the great liquidation sale of 2008 is winding down. Knock on wood, but since December 2 (the day after that precipitous end to the prior week’s holiday-muddled rally), the volatility isn’t what it used to be. “18% either way in three or so days” so typical since mid September seems to be over, and really outsized moves by individual stocks (like 25%+ in a day) are quite predominately to the upside.

What was really striking about the week is the reaction to the unremitting stream of lousy news. The geniuses at the news wires and the chronically-insecure-about-their-future in the business sell-side analysts keep shoveling out the despair, but the Market is having none of it. Tech is up nicely in the face of all kinds of news about inventory glut and reduced guidance. Friday morning was especially instructive in this respect. We were greeted not only with the usual litany of lay-offs and the prospect of Chicagoland scandal sapping the effectiveness of the new Administration before it even gets started, but two hammer blows of uncertainty. Once again, but on an apparently unprecedented scale, a number of wealthy individuals learned in an up close and personal sort of way that if an investment advisor’s returns seem too good to be true, they are probably aren’t. And the futures market flinched mightily at the inability of the US Senate and the United Auto Workers to come to terms. These developments probably account for why the Market seemed to have a relapse on Thursday afternoon. But after a familiar gap down opening on Friday, it quickly found its feet again, and with Tech leading the way (despite a peculiar funk creeping into MSFT) moved nicely higher for the day.

One hopes that the number of families who entrusted all or even most of their savings to an apparent Ponzi schemer operating under the halo of Wall Street respectability is only a fraction of the apparent total. There is tragedy in this that is not to be made light of, widows and orphans suddenly rendered into poor widows and orphans. That said, this unfortunate episode does illustrate the limitations of applying the “wealth effect” to economic prognostication. I am big believer that perceived changes household wealth will affect consumer behavior above and beyond changes induced by changes in income. As with any principle, though, it is easy to stretch it beyond usefulness and unto distortion. Many, if not most households in the US are more affected by things like fuel prices than by the value of real estate or stocks. To the extent wealth destruction affects them, it is income related, the loss of employment as more affluent (though less affluent than they used to be!) households opt to take back tasks they used to outsource (lawn care, child care, food preparation, auto detailing, etc.) This is not to say that there are not tens of millions of households cutting back their expenditures because their declining home equity and/or 401 makes them feel poorer, but that there are tens of millions more for whom asset bubbles are a spectator sport probably not worthy of their attention. But what about that million or so households that make up the “upper crust”, the sort of folks who get invited into a deal like this Wall Street luminary apparently offered? If someone had $10MM and it all got lost in a “by invitation only” Ponzi scheme, their spending behavior would certainly change. But what if only half of their $10MM was in the scheme, would they really start living all that differently? Eating any less? Taking the bus? One supposes that there might be a few putative heirs reconsidering early retirement (or considering the possibility of a J-O-B in a whole different light) but as far as moving the needle on what shows up in the accounts of economic activity, it doesn’t seem likely that the instantaneous immolation of several $B in savings of this sort will be a system-rocking event. We hear a lot about wealth effects, and these effects are real, but to the extent that the changes in wealth are concentrated in relatively few (out of 100MM+) households, they are likely to be over estimated, both on the way up and when the “wealth” is finding its way back into the “thin air” from whence it came.

The stand-off over life support for the US auto industry brought to mind that this “day of reckoning” has been a very long time coming. Much of what is going on here is so wrapped up in posturing and politics that it is not worth commenting on. I remember some 35 years ago, when cars and the inconvenient reality of having to go to work were very much on my mind. OPEC was just starting to reorder a few economic assumptions, and the Japanese were showing up with little Hondas, Toyotas and Datsuns that ran like tanks and didn’t need much gas. They were leveraging their success with reasonably priced “rice rocket” motorcycles (ad jingle c. 1968 “..and the world’s biggest seller is priced about two-fifteen. And don’t you know, you meet the nicest people on a Honda!”) There weren’t a whole lot of jobs around, but some of the best paying and least demanding jobs were in unionized industries. Trouble was, you had to know someone in the union. Everyone who gave it a minute’s thought understood that the US automakers had inherited a strong position, but were saddled with higher cost labor and structural inefficiencies imposed by union work rules. As the Seventies wore on, there was much anxiety about whether Detroit could compete with the Japanese. So point #1, this crisis that dominated the week’s headlines did not exactly sneak up on us. Even a callow youth could see way back then that if there was anything at all to the notion of a more global economy, it was only a matter of time before the Detroit model would take its place in the proverbial ashcan of history.

That said, it’s not like Detroit and the UAW sat and did nothing and hoped things would get better. The industry certainly came up with a number of compelling products along the way, and the quality gap (as one recollects, say, Ford Pinto versus Toyota Corolla) has been relegated to the realm of the subjective, if it exists at all. Whatever blame might be heaped on senior management has to reckon with the fact that two of the Big Three have CEOs who only very recently came to the auto industry. (I got to know Alan Mulally when he was at Boeing, and if anyone can fix Ford, it’s him.) I think what has happened is that a long time ago union leadership defined its mission as being a “prudent parasite”, extracting as much nourishment from the host as it can without actually killing it, exercising just enough restraint and cooperation so that, hopefully, it lives until “after we’re gone”. Up until very recently, they were doing a good job at this. Those fellows who graduated high school (sans academic effort, as “the job” was waiting for them) and started at Ford or GM at about the time I was trying to decide on a major and Honda Civics were starting to roll off of ships are probably retired by now (if their lifestyle choices haven’t put them in the grave). If it was all just a delaying action, give them high marks.

As I look at the global auto industry, there is no reason there could not be a couple of successful US based companies producing lots of vehicles close to their markets, which would include right here in the US. I believe the problem can be boiled down to unwillingness on the part of union and political leaders to recognize the “understanding” between capital and labor has one foot rooted in a bygone era. That era was Pax Americana. Like much of American industry, the auto industry of sixty years ago found itself astride a world still smoldering from world war. The US industrial heartland was about the only place on earth that had not been bombed halfway to the Stone Age (or never got more than about halfway out of the Stone Age). Given the rising economic tide and dearth of competition, it was not irrational for management to share the fruits of prosperity with all of the stakeholders. Trouble is, as the decades slip by, things change. This was apparent only thirty years along, when Japanese imports meant little cars made far away. It started getting obvious when Chrysler had its near death experience. In the mean time, other industries either disappeared from the US or evolved away from what only made sense before Pax Americana gave way to globalization. And one of the most salient aspects of this evolution was around post retirement benefits, especially medical. Not every industry, and certainly not the municipalities and such that have the rate payers by the collective short hairs, but by and large, survival has dictated that very deliberate steps be taken to limit or eliminate this seemingly bottomless source of liability.

I am a bit concerned that what is really going on with the high drama of “saving Detroit” is that you could fix the whole thing, for another business cycle or two anyway, if you could make the retiree health care liability “go away”. Actually, I suspect that if you could rationalize some work rules, ditto the dealer networks and “contain” the retiree obligations, and not muck it up with overly ambitious mandates a la solar powered cars, you could probably end up with a couple of reasonably profitable entities. These are big, no, make that humongous, “ifs”. The mischief afoot is that this dire situation de jour is “Exhibit A” as to “why health care needs to start being handed over to the government”. We can argue it to death, like we have with human caused global warming, but if we take action in the form of a government program that would make “break the log jam” and allow the auto industry to recover, then our stocks will start to go up again and everything will be alright. Like the man said, “Never let a crisis go to waste”. How this plays out over the next couple of months will have much to say about the ever evolving relationship between the government and the governed.

What Time is It, Really?

These past few weeks have found us looking way back at Market history, and savoring the imminent undoing of what has become yet another “only game in town.” Disparate times seem to lead us to take disparate measures. The extent to which the past couple of months have seemingly undone what a couple of decades might have taught us about gauging Market sentiment, we find ourselves feeling as if we have been looking for something really important through the wrong end of the telescope. This causes many of us to start reading more widely than usual, or at least tuning in differently. In my case, the idea of being in “a cyclical market within a secular market trend” struck a chord. In the past, I have from time to time found the study of longer cycles to be an interesting diversion, but insights thus gained have tended to slip way into the background, if not all the way out the back door. There is something there, be it the “seven fat years, seven lean years” alluded to in the Bible, or sixty year Kondratieff wave theory or any number of not totally implausible ideas about the Tao notion that “every extreme condition contains the seeds of its opposite”. Most likely, it is about immutable human propensities to forget past lessons and the pains they inflicted. Every generation must learn anew, and all but fatal wounds turn into scars, which fade with time. The events since September, an interlude wherein palpable fear of the unknown supplanted mere anxiety about the health of the economy as the mental state of that all important investor at the margin, has caused many of us to revisit our understanding of “what time it might be” in terms of Market cycles that tend to be “too big to see”.

Over the course of the Twentieth Century, the Market (as measured by the DJIA) went through three cycles we can call “secular”, or The Market Cycle That Matters. Each of these cycles was characterized by a long and fairly steady rise that ran something on the order of 16-17 years and culminated in a manic phase, a long term Bull Market. This was followed by a very unpleasant undoing of the wretched excesses (in terms of both capital allocation and investor expectations) that accumulated during that rise, a Bear Market. What is less evident to the casual observer is that rather than making an obvious and quick transition from Bear to Bull and then back, there tends to be an era of “going nowhere in a hurry”, lots of fluctuation but little to change over several years. (Eight or so years of carnage followed by eight or so years of apprehensive psychological recovery) The 1930s was really three distinct Bear Markets, the first of which only lasted about 70 days. Likewise, the Bull Market that can be dated from 1949 essentially peaked in early 1966 and then experienced three bear Markets, the most memorable being 1973-74 within an eight year span. The years that followed are remembered as “going nowhere”, but in fact the Market rose dramatically from late 1974 until well into 1976, then experienced another decline before settling into a funk that would not be relieved until August 1982.

If one looks at the past Markets closely, there is a clear tendency after a severe downturn for it to make a very strong recovery and then settle back and be somewhat range bound for several years. It did so from 1938 (when the New Deal quit “working” and the economy relapsed) until 1949, with the range being 100 to 150 until 1945, as the outcome of the war was becoming obvious). At this point the range shifted to 175 to 225. (It was the interjection of a World War, that dreadful "consumer of consumers", that stretched out the aforementioned “eight or so years of… healing” to about eleven.) It broke out of this range in the midst of a recession and never looked back, experiencing its most meaningful downturn shortly after the son of a purported bootlegger became President. The Market would again be range bound after 1966, but this time the range was 650 and 1050 and would encompass several serious bear markets. It would be 1982 before the Market rose decisively above 1000. What followed was an extended rise not unlike the ones that ended in 1929 and 1966, and ending in early 2000. What strikes me now, as we approach nine years since the Tech Boom fizzled out, is that considering how long it took for the Market to “find its feet” after the prior secular Market peaks, it was unrealistic for us to expect the excesses that accrued over 17 or so years would be wrung out by a single Bear market that ran for two or so years. As the past fifteen months have made abundantly obvious, that downturn was no more efficacious in resetting the cycle for another Bull Market than were the Crash in 1929 (the 70 day sell-off that was followed by a brisk recovery and then the Mother of all Bears that lasted into 1933) or the two Bear Markets in 1966 and then from late 1968 to 1971.

My conclusion is that investors will do well to look to the latter half of the 1970s for a clue as to what the next few years are likely to look like. As in 1974, we are now about eight years into the Bear Market That Matters. In the previous BMTM, the first eight or years (1966-74) were characterized by the worst declines since the 1930s, punctuated with brief but spirited recoveries. The next eight (1975-82) differed insofar as the price movement became somewhat more muted and with less of a downward skew. There was money to be made, but it wasn’t easy. If “buy & hold” worked (and it certainly did in many instances) it probably had to be “buy & hold & forget about it for awhile”. As in that era, there will be great opportunities in the months and years just ahead, but only for the strong-of-stomach. Having spent the last eight years living through two Bear Markets of epic proportion (especially if one considers the carnage in the NASDAQ (2000-02), which arguably evolved into a more representative index than the thirty stocks that make up the DJIA), we can probably get to a decent answer to the “What time is it with respect to the market cycle that matters?” question. It sure looks to me a lot like early 1938 (in a weak and slowing economy, with three big sell-offs in the past eight years and world war looming) or 1974, in the wake of three sell-offs in the past eight years, in the midst of a struggling economy, with Jimmy Carter, the Ayatollah and disco looming in the future. I expect that in the very near term, we will see a rally in stocks not unlike that which characterized the 16 or so months that followed December 1974, which will be fueled by yet another undoing of yet another “only game in town”.

The only game in town? Repeatedly over the course of my investing career, from real estate and energy stocks at the end of the 1970s to, oh my, real estate in 2005 and energy stocks in 2007, some asset category or industry emerges at a time when nothing else seems to be working. Tech stocks enjoyed similar status at the end of the millennium, when stocks of what I was then referring to as the Real Economy were stagnating toward 1982-like valuations. For a season, but only for a season, something becomes what seems like “the only game in town”. Invariably, it ends ugly, like a party that started out nice but then there were far more guests than were actually invited and soon the actual invitees are long gone and the thing finally sputters to an end with much pain, indigestion, ruined reputations and strained relationships.

So what is TOGIT as 2008 draws toward a close? Seldom has the phrase “no place to hide” been more apropos than in the last ninety days. TOGIT has either been US Treasuries or being a short seller. In both cases, the well-remarked progression from innovators to imitators to idiots is very well advanced, but for the moment, the quiet exit of what remains of the innovators is being masked by frenzied inflows from the latter category. At some point, it will become evident that the game is over. In the case of the UST, one of the broadest and most liquid of securities markets, the rush for the exits will be interesting but not likely to resemble Wal-Mart on the morning of Black Friday. Such is not the case for many heavily shorted stocks in the equity market. There is a lot of money sitting on the sidelines (e.g., the big hedge funds that got very liquid over a year ago and so are not the ones making the financial obituaries we are treated to almost every day) These guys are always looking for the next game, and when it comes to games traders play, squeezing the shorts is an old standby that comes back into vogue as soon as it gets obvious that the prevailing bias is no longer turf-ward.

There really is smart money out there (smart enough it cash out and sit and wait, that is) and one of the things that defines smart money is the ability to recognize when seekers of “easy money” have overdone it and then find a way to take advantage of it. We have already seen a few instances of stocks (HIG & TLB come to mind) that doubled almost instantly in response to some development that, charitably speaking, did little more than make them “not such great short ideas after all”. The same smart traders who make a business out of knowing who is being forced to sell and then aggravating the situation with some sales of their own also make it their business to know what stocks have high short ratios (number of trading days worth of volume needed to cover the short interest). This game got a lot easier when they took away the 'uptick rule in back on more or less the same day the fun started in July 2007. No sane observer believes that short selling “caused” the mess we are in, and there can certainly be honest differences of opinion about the degree to which false rumors passed along by short sellers might have been the difference between life and death for the likes of Lehman Brothers, Merrill and Bear Stearns, as well as how such actions should be punished, if at all. However, only a nut cake free market ideologue or an “operator” with a guilty conscience (or more likely, an urge to cling to some pretense of respectability) would deny that short selling does exacerbate volatility during the season when fear crowds out rationality. (It was not puritanical spite that, at the suggestion of the aforementioned rum-runner, who apparently was a bit of a market “operator” as well, imposed the “uptick” rule in the first place. Its removal was encouraged by academics who, based on data from an era of record low volatility, assured us was a meaningless hindrance to free and efficient markets.) Up to a point, the short interest performs an important and healthy function, but like seemingly everything else about the Market, it can and does find a way to get overdone. This is especially true when it starts to seem as if it were the only game in town and the "easy money" crowd piles in. These things end predictably, so predictably that a 50%+ rise in the Market over the next year or so, with very little if any improvement in the economic or earnings outlook, would not surprise this grizzled old observer of human fatuity one bit.

The Geithner Factor? Ha!

This edition of HRVA finds us, once again, none too thrilled about living through a moment of historic import. We are not referring to what some are calling 11/4, when the “the seas stopped rising” and all that, although that does play into this morning’s funk in an indirect sort of way. No, this past week took the Market indices to depths that will rank this Bear Market somewhere between “73-74” and The Big One in the 1930s. (Apparently, there were at least three distinct Bear Markets in that era, a 48% drop in just over two months in the fall of 1929, a similar drop over a one year period starting in 1937, and the Granddaddy of them all, the 86% drop between April 1930 and July 1932.) As of the morning of November 21, no Bear Market except the 1930 debacle has been worse than what we have now gone through (Those who were long the Tech Bubble going into 2000 and didn’t get out might beg to differ.) The spirited rally that marked the last hour on Friday might have lifted our spirits a bit. It was the media explanation that this time-worn observer of human folly found exasperating.

There are two explanations for why the media informed us that the Market broke loose from a pattern of meandering uncertainty and ripped about 6% in an hour or so. The one I would prefer to believe is that, as always, certain peoples’ meal tickets are dependent on coming up with reasons why inscrutable activities happen. Apparently consumers of information and insight expect an explanation for whatever is happening in the moment, and if one wants to keep their snout in the trough from whence investment insight is generated, they sure better come up with an answer. So like when the sun comes up its because the geese just flew by (or in another time and place, that first born male child got passed through the fire), the fact that the name of the likely Treasury Secretary was leaked around the time the Market took off was a slam dunk in the great game of spurious cause & effect. Never mind that having been crumbling the way it had all week it was as oversold as it ever gets. The media and the Street do this all the time, as if there was a possibility that if just once they did not have a glib answer for the day’s fluctuation, we might tune them out and not come back.

A less palatable explanation might be that the news media is still smitten with our newly arrived Savior and eager to do their part in helping Him make history. The announcement of the name of a likely Cabinet member does clear up a bit of uncertainty, but only a small bit. How much might this glimmer of clarification account for, say, the 12% rise in the value of Microsoft that afternoon? As a conservative (one who is squeamish about the prospect of squandering what the Founders bequeathed to us) it has been disconcerting to watch the institutions that have are supposed to hold the political class accountable show such abject adoration for any public figure, let alone one who has shown strong sympathy toward the thoroughly discredited ideologies that brought so much human misery to the Twentieth Century. It will not be a good thing if even the financial media is in the tank for the Anointed One and his crew of nice folks from Chicago. One is left to hope and pray that the opposition can buy time, rebuild and rise again as voters recognize life starting to resemble the aftermath of the Great Society again. In the very near term, though, there could be a silver lining in this. To the extent that the Market is very over ripe for some kind of rally, and “needs an excuse to go up”, this sort of cheerleading could prove helpful in weeks and months just ahead.

Most likely, what transpired Friday was that the Market got a just good enough “excuse to go up”. Any excuse would have done. The Nasdaq had traded down nearly 55% from its year earlier peak as of Friday, the S&P 500 about 52%, the DJIA just shy of 50%. The whole week had been disheartening, the final hours of the two preceding days in particular. The economy, which has been slowing for quite some time (the global purchasing managers index peaked over two years ago), got pole-axed by the shock waves emanating from financial markets in September. It might not start to recover until well into next year, and when it does start to recover it could be a very tepid recovery for quite some time. That said, it is important to never lose sight of how short term pricing activity almost invariably exaggerates what is actually going on in the world of commerce. And we have got the illustration of a lifetime of this from the recent price of petroleum.

Recently, when called upon to try and be helpful to younger colleagues, I find myself encouraging them to think of investing as the reconciliation of two distinct realities. There is the reality of the enterprise that underlies the stock, which I call Commercial reality. We need to devote most of our time, effort and thought to understanding this reality; to being assured that the enterprise we are investing in has a strong commercial position and can hang on to it. It works itself out in intrinsic value, which can be quantified, but only approximately so. The other reality is what I call Price Reality. It is about fear and greed, momentum and sponsorship, and while it can be precisely measured in whatever the price is in a moment of time, it can only understood for what it is, a manifestation of the mood of an ill-informed and emotional crowd. I try to encourage colleagues to view what they do this way, as an alternative to succumbing to the Analysis Delusion. This is a tendency to build models and then treat those models as somehow real in a way that exists outside the mind of the person who made the model. Models are useful tools, but not much more, and in the hands of someone who disregards what really real, they become implements of destruction.

With this in mind, consider what has happened over the last year or so to the price of something that is much more a part of how nearly everyone on the planet goes about their daily business than those abstractions that, figuratively speaking, change hands every day on the NYSE. It is hard to remember just where a barrel of oil was priced a year ago, but $60 in 2007 would not be off the mark. Indeed, I have dim recollections of $60 seeming kind of “out there” no more than two years ago. Somehow, it found its way up to $147. Then, perhaps ninety days later, it’s breaking through $50. Somehow, the stuff that makes the trucks run and the planes fly and puts the ester in your polyester, among about a zillion other things we don’t want to think about living without, lost two-thirds of its value in about a dozen weeks. It is true that many of us have found ways to drive a bit less, and likely that economic activity will continue to slow to an extent that some price retrenchment might be in order. Any fool could tell you as much. Many of us “knew” there was something in the realm between fishy and ridiculous about it going to $147, that the “speculative interest” was acting in a way that was contrary to the interest of the rest of us. Studies were made and experts hauled before committees, but the outcome was the familiar “I didn’t do it, nobody saw me, you can’t prove anything!”

Thus it will always be. Markets are peculiar things. People want explanations, as if they were as forthcoming as what the research of the past 200 years has rendered in fields like chemistry or astronomy. Such answers about why stock prices do what they do are not forthcoming, and never will be. Part of the reason is that most people seem to so prefer answers that merely seem substantive and they reject answers that leave that matter in the realm of mystery. (Mystery in the sense of how so much else, like weather or the workings of the body remained mysterious, until science provided a bit of illumination. Despite being much more understood, these matters also retain a bit of mystery.) Markets act the way they do because humans are, to varying degrees, speculative creatures, endued with an impulse to better their lot in life by making guesses about an inscrutable future. Speculation is always with us (as long as there is freedom, and even in oppressive states there will be covert markets). Most of the time, it is benign, even useful activity. Occasionally it takes on a life of its own and becomes a raging beast. We have just lived through such a time. This will be remembered as one of those times when speculation became the “tail wagging the dog”. Actually, this is the time when the natural consequence of that abnormal state, a painful unwinding of excess, takes place. Hopefully, this unwinding has found impetus from the rapidly approaching New Year. If it is things like tax loss selling and client redemptions that have kept the selling interest so much greater than the buying interest, we are now only a couple dozen trading days away from when that is no longer the case. Let us hope so.

Fish In a Barrel Time

This first week in November finds us taking exception with one of our oldest journalistic rules. Since the beginning of “ruminations on things that matter for thinking investors”, I have assiduously avoided “naming names”, i.e., writing about the specific investment merits of a particular stock. One does not want to degenerate into a “tout sheet”, and on among the safeguards against degeneracy, as with many other of life’s hazards, is remember that there are not only lines one does not want to cross, there are lines one does well to not even go near. This exception is being made because it is the best way to illustrate something that has become almost too obvious too see: stocks are ridiculous, stinkin’ cheap right now, the kind of bet against the end of the world one only gets once or twice in a lifetime (if it happens twice in your life, you were probably too young and didn’t have the proverbial two-nickels- to-rub-together the first time, or too old and world weary the second time.) So I am going to include a few thoughts about some (but not all) of my favorite (most beat up?) stocks.

This past week shook my conviction, but just a bit. No one should have been surprised that the Market needed to pull back after ripping about 18% in just six or so days. The first -5% day (Wednesday) had the feel of a normal pullback, with a concentration on the stuff in the indices. It had a nice orderly feel to it. Thursday was another matter, likewise down about 5%, but had all the gentility of Hutus meeting Tutsis on a moonlit road. That day’s carnage brought the indices down to within about 6% of their 10/10 lows, and sent us home wondering if Friday might not end up being the day “the center did not hold”. Friday brought wretched news (GM running out of money, unemployment up more than expected, hedge funds still have lots to liquidate, President-elect Obama appointing some memorably loutish alumni of the Clinton Administration). The Market popped up like a prairie dog with a tail full of fire ants anyway. This is a healthy sign. The urge to purge is still there, but not nearly as urgent. The hedge funds are still there, but their ranks are thinning. The unwinding of the 2 and 20 business model has been painful even for those of us who got nowhere near it, but it is most decidedly a finite process. The bad news will keep coming, but Big Dump I wrote about on 10/19 is likely getting down to the late innings. It matters much less to investors that GM might go through a reorganization (unless of course they are owners of GM securities) than that of a class of investors, apparently bereft of the humility that was considered virtuous before the self-esteem movement ran amok in the education system, thought they were immune to the ill effects of leverage gone bad and now are reaping the consequences. This liquidation will probably keep the Market moving sideways for a few more weeks or even months, but it will run its course.

We are at a point much like late 1987 or 1990 or 2002, only more so. I can’t speak for 1974 or 1932, but you would think it was 1932 to listen to some people. Heck, if you are working in “the business” and living in a money center, where most the people you know are contemplating big time life style changes, it is 1932, in the same way it was in Seattle in 1972 when Boeing was said to be down for the count. The Street is a scary and depressed place right now. That does not mean that the challenges are not real. What it does mean is that the messengers are traumatized, a herd a scalded cats ready to bolt up a tree any time anyone reaches for anything resembling a pasta pot. The events of the past year have been unsettling to a degree that nothing we went through in 1987 or 1990 prepared us for them. However, I do believe we have reached the point where one has to make the same bet I did back then, the Bet Against the End of the World. Valuations are such that for a bet on the stocks of reasonably secure enterprises to not work out much better than money market rates, we would have to be at something akin to the end of the world. It would be an outcome so bad that however much money you have would be the least of your worries. I would not recommend that anyone put all their money into stocks. Some kind of rainy day (or year) cash reserve is still in order, but there will not likely be another opportunity like the one that is at hand for another couple of decades at least.

I would encourage readers to look at that dismal time that was the 1970s, the (as my Company Commander at the time put it) “peanut poppin’ redneck” in the White House, the Ayatollah, the gas lines, disco, Whitewater, double-knit pant suits and double digit inflation. The Market had a swoon of similar magnitude to what we just endured in 1973 and for most of 1974. It, too, was the worst downturn since the Depression. Then a funny thing happened. From its nadir in late 1974, the S&P rose 54% in a year. If you look at the records of value investors, as lousy as the second half of the 1970s were for the rest of us, well-situated investors had a splendid four years. You can look it up! But they had to be there, and not wait for a theme (like energy, which worked great until about 1980 and then gave it all back and then some) to appear to them on the pages of USA Today.

The bargains are everywhere, even among the some of the most stellar of “blue chips”, stocks that haven’t been cheap in decades, if ever. A good example would be Intel. (INTC - $14.63 ) At less than 12 times current year EPS, with a couple of dollars per share more cash than debt and a franchise (leadership in the advance of microprocessor power & functionality) that will never be matched, it has been the sort of a “no-brainer” that I don’t mind recommending to strangers I meet at parties who want to talk about the Market (another rule being bent for the first time). I have spent the last couple of years studying Intel and its place in the world and have concluded that “the end of the line” for Moore’s Law is well beyond the far edge of my three to five year investment horizon. I reckon the appreciation potential to be something on the order 20 times EPS of $2+, well within that timeframe. Earnings might flatten out or even decline a bit in the year ahead if the global economy slows enough, but it would little more than a speed bump considering all of the life changing innovation that Intel’s own innovation is still unleashing around the world.

That said, if you forced me to make a short list of “best ideas”, INTC would not be on it. As compelling as two points of downside and 20+ points of upside, with a decent dividend yield (Yes, INTC has a well covered 3.5% yield!) no less, there are plenty of situations offering significantly more appreciation potential without significantly more risk. While I presently own more INTC than I ever would have imagined owning even a few years ago, I would be more focused on other stocks with much more upside that are arguably riskier (based on comparison of attributes) but as practical matter the downside is not all that different (they’ve all been crushed to valuations that could not have been imagined a year ago). So without further ado, here are five stocks that I am particularly pleased to suggest and to go “on the record” with”:


Seagate Technology (STX: 485MM shares @$6.60) As the world’s leading and low-cost producer of hard disk drives (HDD), STX has both facilitated and benefited from the burgeoning (40%+) growth in demand for data storage. It has also played a hand in the consolidation of what for most of its three decade history had been a frightfully competitive market. Seagate will probably earn about $1 this (June) FY. In a more normal period, FY 04 to FY 08, grew EPS from $1.41 to $2.63). Based on $1 EPS, gross CF will be just under $3: Free Cash Flow will be $1.45. The company has net debt of a little under $1B, or less than two (trough) years of FCF. With $0.48/year in dividends, the stock has an attractive yield. Unless the “growth in data storage” thesis has run its course, STX has earnings power well above $3 per share. I still expect the Market to accord a low teen multiple once this downturn proves that the HDD business is less cyclical (doesn’t give it all back in the downturn) than in the past. $40 within three to five years would not surprise me.

USEC (USU:110MM @ $4.05) is one of four companies in the world that enrich uranium for electric power production and the only one that is US based. As a provider, under long term contracts, of the fuel that provides 20% of what keeps the lights on, it is in a stable and low risk business. They will likely earn something like 30c this year and 70c next year while spending close to $1 per share developing a next generation technology. The reason the stock trades at a huge discount to a $12 book value, which consists largely of very fungible inventory, is lingering uncertainties about the funding and construction of a new plant, the American Centrifuge Project. The funding issue was signed into law earlier this year in the form of a loan guarantee by the Department of Energy (which used to own USEC and has a royalty interest in the production of ACP). Once the DOE loan guarantee is finalized sometime before the present Administration departs, the only remaining “issue” will be their ability to construct the American Centrifuge Program on time and on budget. This is not without risk (it is similar to the risk in a new aircraft engine program, but my estimation more contained, as if the new engine had millions of hours on it already, which the ACP does), but it is out there in time, as in two or so years from now. Once the financing question that goes away (they will be borrowing on an as needed basis through the Federal Finance Bank) there will be no good reason for the stock to trade at a discount to book value. I believe the earnings power from the ACP is such that USU could be $30+ in the next five years.

Hutchinson Technology (HTCH: 22MM @ $5.08) the world’s leading (of three) producer of suspension assemblies for hard disk drives. The stock traded off the map because they have been losing money on a GAAP (but not cash) basis. Earnings will recover as volume builds in the “additive” plant they started up last summer (to support the next step-change in suspension design; having this plant makes HTCH the only fully integrated provider to a customer base that needs rapid design, prototype and delivery) and they rebuild their share in the biggest the Seagate desktop. This is by far the largest SKU in the industry, went to zero for HTCH last year and is programmed to grow over the next several quarters. They have also been generating an operating loss on their BioMeasurement startup, to the tune of $5MM+/Q, or nearly $1 per share pre tax. This start-up has developed InSpectra, a device that non-invasively measures tissue oxygenation (StO2), a drop in which is a precursor to “going into shock” (is there an ancillary market putting these in brokerage offices?). It was approved by the FDA last year and continues to progress well ahead of expectations in terms of getting into hospitals, protocols and additional indications. Given what they have going for them, worst case I see the stock narrowing the discount with tangible book value (about $19). Alternatively, with a moderately profitable BioMeasurement division and the suspension business reaping the benefits of that investment in “additive” technology, it is no stretch at all to get to $5/share and, considering the potential of the StO2, which is already being regarded in some quarters as a standard vital sign, a P/E of 20+.


Mohawk Industries (MHK 68MM @ $39) is a leading producer of floor coverings, including carpet, tile, wood and laminate. The company earned $6+ per share in both 2006 and 2007, a period of declining housing activity and rising energy and raw material costs. These pressures got even worse in 2008, especially in H2. MHK will only earn about $3.60 this year and will probably see weak demand in the few months of next year. However, raw material and energy costs will be lower, and the company has been working very hard to otherwise reduce cost and emerge from the downturn an even stronger company. They should be able to continue to generate free cash flow and reduce the borrowings that funded their acquisition of Unilin in late 2005. (They paid down $128MM in Q3, and $1.4B since the acquisition.) This has been a splendidly well run company, a low cost provider of a basic need (predominately replacement). It is presently selling for less than eight times trough free cash flow and five times a more normal year’s free cash flow. I anticipate EPS of $10+ within the next five years and decent, mid-teen multiple on that.

The Dixie Group (DXYN 12.2MM @ $4.15) is another, albeit much smaller producer of floor coverings. In 2003, DXYN transformed itself by selling its commodity operations and using the proceeds to pay down debt, focus of it high-end brands (Masland and Fabrica) and develop Dixie Home, a new better-priced brand. Reaping the fruits of this transformation has been postponed by the housing downturn, but the company has remained profitable and continues to develop new product. This recent extension of its lending agreement to May 2013 put to rest any concerns about financial flexibility. The stock is trading well below its tangible book value of roughly $12. I believe DXYN has earnings power a couple of years into a recovery of something closer to $2 than to $1 per share.

Obviously there are many other bargains to be had, some of which are no doubt even more compelling. Only time will tell. These are but a few of the stocks that I expect future investors to say “Dang! Did it really get that cheap?” when they pick up a Value Line. The important thing is not to pick “the best of the best of the best”, but to heed the maxim, attributed to Woody Allen, that 90% of success is just showing up. It’s been hard enough just to show up lately, especially if showing up means stepping up and buying. So show up, and try not to throw up. We’ve lived through worse.

The Evil Eye, Virtual Crowds & The One

Halloween finds us contemplating a ghoulish spectacle: the smoldering ruins of a portfolio laid low by Bear Market forces of once-in-a-generation magnitude, and an electorate seemingly determined to plunge the nation into a two to four year bout with that retrograde conceit that calls itself Progressivism. These two developments have something in common, something besides making some of us want to curl up in a safe corner and wait for the dry heaves to subside. They were helped along by what seems to have become the Ubiquitous Evil Eye.

Actually, as painful as it is to see how far some of our stocks have fallen from where we thought they were really, really cheap and so doubled (or tripled) down, the way the Market has been acting these past few days is quite encouraging. I am seeing the return of at least a modicum of confidence on the part of bargain hunters, and a diminution of the “get me out!!” liquidation that has taken so many stocks to such unbelievable discounts to their intrinsic worth. It was encouraging to see the Dow Industrials and the S&P 500 test the 10/10/08 intraday lows so successfully on Monday, trading to within 3.3% and 0.8% of the major low before commencing a rally of nearly 11% through Thursday. Whereas the weeks leading up to this “test” have been characterized by waves of liquidation selling being interrupted by feeble recoveries, and dramatic losses of heart (as in last minutes-of-the-day meltdowns), whatever ongoing selling that has continued is now being met with buying interest of at least equal vigor. It also matters that the short side is proving to be a much more perilous place to place one’s bets, and that the vast herd of hedge hogs, which grew so fat feasting on easy money, is well along in the process of being thinned out down to a level the range can actually support. The Market is acting as if the “urge to purge” has spent its fury. I can see the possibility of another test of the low, which is now defined by 10/10 and 10/27, if the election ends up being close and contested enough to unleash another wave of uncertainty, but otherwise I strongly suspect that prevailing bias is in the process of turning upward.

It has been my experience that election outcomes tend to get discounted well in advance, and that there is not much value in trying to handicap likely Market trends based on them. Elections, or rather, the campaigns leading up to them, are quirky things. It is best to keep in mind the fortunes of war. As in war, unpredictable things happen. As the loss of a nail caused the horse to lose its shoe, and so on, tiny, quirky events can change things dramatically, shifting the final score the way an aberrant bounce of a football late in close game might. That said, I have a distinct recollection of the Market figuring it out last time, in 2004. The trend shifted from a weak drift to a distinct upward bias on the morning after the Democratic Convention tried to pass their man off as a war hero. I remember thinking that this charade, so unlike the demeanor of any other warrior I have ever known or met, was simply not going to fly. The Market did a very good job of discounting a victory by the incumbent, completely neutralizing what we as individuals saw as a great source of uncertainty. The remainder of 2004 was very much a validation of the maxim “Buy the rumor, sell the news”.

As I ponder the questions of why this Market got as whacked out as it did, why 2008 turned into the downturn of a lifetime, and why we are facing an election outcome favoring vague promises about “hope” and “change” over proven leadership in facing the world’s evils for what they are, I find a common thread of understanding. It is the ubiquity of that Evil Eye, that flat panel of light that shouts out at us everywhere we go unless we take deliberate steps to avoid it. It seems that most people have become overwhelmingly dependent on visual stimuli, unable to suffer more than a few minutes without soaking up a dose of whatever it is that comes to us out of a big screen TV or a monitor. I, for one, have chosen to be an exception. For the last decade or so, the television in my home has been used as a monitor to play tapes, and more recently, DVDs from Netflix. Consequently, not being as inured to the bombardment as I imagine most people to be, I find TV to be unbearably shrill, an annoying and obtrusive absurdity. One of the marks of being a mature person is recognizing that there are some people whose demeanor or character has some negative aspect that we do well to avoid, lest something “rub off”. It is a recognition that we are more malleable than we would like to think, and that attitude is contagious. Can nonstop interaction with digital personages, especially given the “amplification” that seems to be intended for dramatic effect (watch the faces with the sound off, as I have founded myself doing on many an airplane, to see what I mean) be any better for you? I think not!

When I am asked about how this Market downturn differs from 1987, one of the first things that comes to mind is that back then, we only had a handful of channels to choose from. People who owned stocks were plenty scared, but the fear mongers could not ply the multitudinous digital channels to seek them out and agitate them even further. You would find it instructive to compare the Wall Street Week episode from that week in October 1987, which included the reflections of Sir John Templeton, (available on You Tube) with what we are subjected to today if we find ourselves in the presence of a TV tuned to a financial or “news” channel. And how unlikely is that? Go to a tennis club to burn off some stress by whacking away at some fuzzy balls, and there’s the Evil Eye, filling the lobby with its prognostications of doom. Head out for an offbeat lunch, ethnic fare tucked away in a strip mall, and that same eye is staring at you, with its inducements to try a new kind of birth control or asthma relief or the services of some pit bull of an ambulance chaser. In the mall, in the airport, in the doctor’s office, it is as if it simply has to be there for us. But it doesn’t, really.

The blessings of technical progress are not unalloyed with invidious consequences. Besides facilitating a bombardment of information that if allowed to will overwhelm one’s capacity for critical thought (or is just me, with my underwhelming-to-begin-with capacity?), the tsunami of digital content, however it is delivered, also seems to have the ability to create virtual crowds. It was instructive to read Fouad Ajami’s 10/30 editorial in the WSJ about the role of crowds in this election. He spoke to literal masses of people in close physical proximity, but thanks to big screen TV, wall-to-wall coverage by far too many “news” channels, and Web communities where like-minded individuals can go and reinforce each other into a frenzy, we seem to have arrived in the Age of the Digital Crowd. That the idea of Crowd has taken on a new and more pervasive meaning is not the only reason that this Market downturn got so out of hand , but it is a big part of the equation. Likewise, the candidate leading in the polls, despite many lingering questions about who he really is, where he actually came from, who is putting up all that money for him and what he really believes, is perfect for the part if one is trying to cast the One who will lead a Digital Crowd.

My guess is that while some fear as to the outcome of the election is in order, the worst fears are all but certainly overblown. (They usually are, but good grief, we have been watching Worst Case go to Even Worse for months now already!) Le Bon commented that crowds lose their heads as one, and then men regain their senses one at a time. The crowd whose members have been allowing their fears to add fury to the forced selling of others is already starting to thin out. Let’s assume for a moment that the polls, though persistently problematic, are “close enough” this time and the front runner wins. The Crowd that has projected their hopes for nebulous change onto the cipher that is BO will inevitably dissipate as each individual comes to the realization that The One is not who or what they allowed themselves to believe he was. Scandal will linger past Election Day, much like Whitewater did twelve years ago, like so much sand poured into the gas tank of the Engine of Change. Bereft of a promising abstraction, as opposed to a very human leader, to focus them, the litany of grievances that defines the Democratic Party will succumb to centrifugal forces and start to come asunder. Meanwhile, that 40%+ of the electorate that is not on board with Progressive ideology has gotten its wake up call. A Progressive president will find himself between the rock of multifarious ideologues for whom he cannot move fast enough and the hard place of tens of millions who will be agitated by all but the most subtle moves down the Progressive path. And these are the people who are much more likely than those on the other side of the cultural divide to reproduce, to volunteer their time and money, to serve in the military or to own guns and know how to use them. Some of them, when faced with dire enough circumstances, have even been known to call on aid of the Almighty, the One who not only made them all but has also seen it all, and who answers such calls in ways that are sometimes later than we would wish, often beyond our understanding, but always to suit His good purposes.

I see a slowly clearing financial storm, followed by economic recovery in fits and starts, helped along by the same sort of political gridlock that made the last years of the Twentieth Century a relatively benign era for investors. The years ahead might see a quickening of the entropic forces that send all human edifices down the way of all flesh, but then again, they might not. In any case, it looks like 2009 will be a great year to have owned stocks.

The Scrutability Test

The recent Market Panic finds most of us in a soul searching mode, revisiting investment rules and principles that if better adhered to might have saved us some pain. In this vein, there have been some heated discussions at “the day job” about companies that might be “too big or too complicated” to truly understand. This, in turn, has gotten me thinking about an important principle, or better yet, presupposition, which could be called Scrutability. In this edition, I will attempt to define this concept and illustrate it with some examples from my own recent experience. I will also suggest some criteria by which one might avoid getting on the wrong side of this principle, and conclude by applying this principle to GE, a very prominent recent example of the perils of inscrutability.

We can start with the premise that investors, indeed, thinkers of all stripes, have differing notions as to what it means to “understand” a situation. For some of us, “understanding the business” is a non-negotiable starting point. What do I mean by this? We get a couple of important clues from the likes of Warren Buffett, as seen in his ability to “pass” on most ideas he hears after just a few minutes of discussion, and Peter Lynch with his egg timer rule. It is the ability to honestly say, “Yes, I understand how these guys make their money, why their ability to hold their own against competition should remain intact if not improve, and how they are more likely than not to be able to do more business with more customers over time”. One needs to determine that the company in question is either a great business at a decent price, or a decent business at fire sale price, or a business in an industry that has just changed in a way that it can finally be a decent business but its still priced like its always going to be just a decent business in a terrible industry. If it is not clearly one of these, it is simply something that shouldn’t be bothered with, an opportunity cost versus time well spent. The ability to make these judgments entails at least a bit of knack (business sense) and no small amount of hard work accumulating a body of supporting data that is both “experience” and a good grasp of relevant present and prospective conditions.

We confuse the issue when we talk in terms of “complexity” being the issue. Complexity, which is the opposite of simplicity, is not necessarily a problem. Indeed, it is a source of opportunity, if it is amenable to being reduced by intellectual effort down to something simple, and there is rarely much investment opportunity in that which is both obvious and simple. I would argue that one of the hallmarks of a truly great investor is the ability to recognize a simple understanding of a seemingly complex enterprise. A more accurate term than complexity would be the slightly arcane “scrutability”. To be scrutable is “to be capable of being understood by study and observation”. Another hallmark of an at least mature investor is the ability to recognize when the answers to the central questions about an enterprise are excessively inscrutable. If Warren and Charlie can say that some businesses are “too tough” to understand, why can’t we? It doesn’t mean that there aren’t businesses where just because they wouldn’t try we shouldn’t (they have a much different pallet of opportunities to work with), but we do need to exercise the same sort of humility. If the question of “exactly how do they make their money…?” is at its core inscrutable, just don’t go there!

A couple of points of clarification are in order before I start illustrating with some of my recent misadventures. I think we all understand that no one has 100% clarity about everything there is to know about a situation, especially when entering a new position. It is not an either/or between total ignorance and omniscience. One recognizes what the most important issues are for a company and endeavors to have a really clear understanding of them, but also recognizes that there are other issues that might matter but are “somewhat inscrutable”. That is, one has to have a reasonable expectation that with the passage of time, study and observation will clarify the matter. (I will give examples). The art of investing then includes the ability to recognize where “somewhat inscrutable” issues might be significant enough to do damage the value of the enterprise, which means passing on the idea, as well the ability to recognize the difference between “somewhat” and “completely” inscrutable.

Inscrutability does not refer to that which we wish we knew but can be confident of learning more about at some identifiable event in the future, like an earnings release or court ruling. Questions where there will be a pretty definitive answer “we’ll know when we get there” are about something different than scrutability. Strictly speaking, scrutability is more about whether one has the resources to observe, to ask the right questions of the right people and to otherwise “get one’s arms around it”.


SOME EXAMPLES OF WHAT I MEAN
A couple of years ago I decided to buy shares in Pfizer. I was able to get very comfortable with the broad and diverse product lines that were going to deliver sales, earnings and cash flow over the next several years. We knew the company was committed to getting costs out and that redeployment of cash into dividends and repurchase was a high priority. We also nailed down a “what if they lose the patent challenge?” worst case valuation pretty well. There was a lot there, though, that was relatively inscrutable. However many potential new drugs were in the pipeline, no one, not even the company, knew which project would produce what revenues. We discerned an ongoing attack on intellectual property, as manifested in Ranbaxy’s patent challenge, as one of those issues that could get better, get worse or stay the same. All one can do regarding an issue like that is to make sure that a worst case outcome is not a company killer and then pay attention and look for clues. The same goes for that assault on the fruits of innovation that is being undertaken by the Tort industry. With PFE, we enjoyed an above average dividend supported by a very identifiable stream of free cash flow while we waited for the passage of time to give us opportunities to clarify some of the issues that would bear on long term profit growth potential. There were surprises both positive (additional indications for Lyrica, troubles for competitors to Lipitor) and negative (early loss of Norvasc, Exubera, torceptrapib getting pulled from trials). A new CEO came along promising “increased urgency”. Over the course of a year or so, I was able to surmise that while there was no danger of PFE not being able to post moderate earnings growth near term and fund its generous dividend, the risk/reward of “the core of what they do” (developing and marketing new drugs) was at best barely holding its own. Not only does the bar keep going up on new drug approval (i.e., it has to be more efficacious than the drug it will supplant) but the threats that patent challenges and tort might steal away the rewards of innovation were at least holding their own. Coming to this conclusion, which could only happen by patient study and observation of “peripheral” issues over an extended period of time, lead us to exit the stock at an approximately break even price.

Similarly, when we entered into Seagate Technology, we knew we had a technology leader and the low cost producer of an essential item for meeting the rapid growth in demand for data storage. We had a pretty firm basis, which proved out, for industry consolidation leading to improved profitability. We had the core of “how these guys make their money” figured out. However, there were a couple of issues which could only be regarded as “relatively inscrutable”. One was that while STX is far and away the leader among what was then seven (now six) companies that make disk drives (HDD), most of the competitors are subsidiaries of Asian conglomerates, so an understanding of the competitive dynamic would be less than ideal at the outset and slow in coming. Similarly, there was a lot of buzz about flash memory as a potential substitute for HDD. I was able to determine that neither of these issues were likely to matter near term and proceed with the investment. Since then, the beneficial effects of industry consolidation exceeded expectations, even if in the midst of the Hundred Year Financial Flood it is no longer apparent. I have learned only bits and pieces about Asian drive makers, but enough to know that they are at best holding their own. I have learned considerably more about flash memory, including where it is likely to start selling in any kind of quantity, but also that the point when solid state drives start taking enough share to materially slow the growth in HDD keeps slipping out in time.

As I reflect on how varying degrees of inscrutability have affected other recent investments, a couple of general observations come to mind. One is that when the prevailing bias of the Market turns negative as it did a year ago, inscrutability even with regard to secondary (non core) issues can be deadly. Inscrutable problems are the fodder of “short” ideas. Things that are easily ignored when the bias is positive loom large when the aversion to uncertainty intensifies. It also goes without saying that financial leverage magnifies the damage that can be done when inscrutability turns against us. In thinking more specifically about stocks I have owned recently, I find a common source of “inscrutability that hurt” where there are impediments to understanding the competitive dynamic. This occurs when all or most of the competition is privately held, in a non-reporting JV or buried deep in a big company. In the cases of STX and CYMI, the passage of time has rendered the competitive dynamic reasonably scrutable. The same could be said about HTCH, although the question still lingers as to whether TDK will be successful in fixing the Magnecomp assets it acquired and what it might eventually do with them. KEM would be a good example where an inscrutable competitive dynamic has remained obdurately so, as so many capacitor makers are either buried deep in a Japanese conglomerate or are small niche producers. Finally, the worst example of getting bit by an inscrutable matter would be in Handleman, where I failed to recognize that the music industry’s inability to recover its faltering value proposition could be so detrimental to a distributor’s welfare. Surely, “How well is the music industry going to do in competing for discretionary income?” is an inscrutable matter.



PRACTICAL STEPS TO AVOID PAIN OF LOSS

I think every investor needs to develop their own short list of rules of how to manage inscrutability. Mine starts with the recognition that it matters a lot more in Bear markets (or Bull Markets that are “long in the tooth”). It also should include a daily, if not more frequent, reminder, that the ill consequences of inscrutability going against you will be greatly magnified by financial leverage, including the presence of covenants on credit agreements that seem benign until the floodwaters have been rising for a while. The meat of it, though, is to have a list of “Just Don’t Go There” industries, to work up the same facet of intellectual humility that has served the team of Buffett and Munger so well. For me, such a list includes most financial companies. I say “most” to acknowledge the sort of exception I would make for the likes of Wells Fargo. My approval of WFC is not because Buffett owns it but because Buffett had the wisdom and the opportunity for interaction to be able to “sign off” on the executives who set the tone as to how WFC lends and otherwise manages risk. (Banking reminds me of what they used to say about communism: if it wasn’t for human nature, it would be a great system.) I doubt WFC is unique in this respect, but don’t know how I would recognize the exceptional leader. I also screen out defense companies whose sole business is highly classified contracts. (The classified nature of what USEC does has added to the inscrutability of the issues that surround their position as a fuel supplier to the utility industry.). The issues I mentioned in regard to Pfizer are such that I am unlikely to look at another drug company. I find the competitive dynamic of specialty retailing to be unacceptably inscrutable, although a more “diversified” retailer with a solid value proposition might be attractive at the right price. Even in industries as “safe” as electric utilities are thought to be, some work I did on Public Service of New Mexico indicated that a highly politicized utilities commission can be an unacceptably inscrutable problem.

SO WHAT ABOUT GE?

GE is a great example of a company that has defined inscrutability for about as long as any of us can remember. I actually owned it in 1990, but I was much younger then and even then, the finance part of the giving investors pause (at least during the recession). Based on my ad hoc scrutability screen as it has since evolved, I never would own GE. My belief is that no reasonable amount of study and observation could produce an intellectually honest answer to the core “just how do they make their money” question. It is influenced by past exposure to a few of their operations (How they marketed Power By the Hour and their CAT scan systems comes to mind.) All of the leverage only adds to my aversion. We can debate just how leveraged they are, but to paraphrase a colleague who go unnamed, its “whether she is closer to 300 than to 400 pounds is debatable, whether or not she is blimp is not.” In a Bear Market, it just doesn’t matter.

That said, I am not so alarmed as to think that the stock needs to be sold here in what are probably the last days of a Great Bear Market. Buffett’s deal reminds me of when he bought the assets of Fruit of the Loom. It was a low cost, vertically integrated producer of a consumer staple but badly run. He did not buy the company, he bought assets out of bankruptcy and eventually cobbled it together with Russell (which was a stock buy) and who knows what else. It will never be a great business, but the price was right for the okay business that it can be in a somewhat consolidated market. I believe even though Buffett has many more insights into GE (through personal contacts and in the dealings of BH entities) than mere mortals like us will ever have he comes to the same “it’s too tough” conclusion against owning it on the same terms we would. However, based on what he can know, he has obviously determined that whatever GE’s problems are, they are not terminal. It might take them many years to re-tool the management and compensation systems that were very much geared to what some have called “a golden age for financial services” (usually in the context of said age being over), but he will be well paid to wait.

Buffett probably also recognizes that GE is perhaps singularly well situated with respect to all that energy and transportation infrastructure re-tooling that is going to be the big economic driver of the next decade or so. I also believe that he recognized that the reason GE was willing to pay up to his terms was in part because no one at the company has ever been as uncertain about GE’s future as the last few months events have rendered them. It is also likely that he was able to determine that the capital infusion has a reasonably good chance of being enough to allow them to effect an orderly deleveraging as opposed to joining in on the “fire sale”, resulting not only in better realizations but the preservation of at least a semblance of what used be known at “the GE mystique”.

Quite Possibly the Biggest Dump of Your Life

While the first half of this month found us thinking a lot about a particularly dreadful October we endured some 21 years ago and being bombarded with comparisons to the one 79 years ago, the Market was actually a source of encouragement during the week just ended. It was not simply because the indices actually managed a weekly gain for the first time since I can remember. It is because what I think I saw was that vast pile of “assets for sale, name your price, I just want some cash I can hold in my hand” appears to be diminishing down to a size that is manageable relative to piles of buying power that have been waiting nervously on the sidelines. In “technical analysis- speak”, the Market had a great test of a really major low this week.

What I have in mind started on the previous Friday morning, when for what seemed like the umpteenth time trading opened with a wave of “get me out!” sales hitting bids well below the previous day’s close. It was something on the order of a 1000 point gap down opening, the likes of which even multiple decades of being there for the opening does not prepare one for. It closed down for the day and way down for the week, but far less than down 1000 on the day for the Dow. Based on the intraday lows for three indices (DJIA, S&P500 and NDQ) the Market that day traded 46% below its peak of almost exactly a year before. I noticed quite a few stocks indicated higher after the close, in stark contrast to the prior Friday, when a late in the day slump gave off the distinct aroma of no one wanting to be long anything over the weekend.

Monday roared famously and there was some follow through on Tuesday morning, at least for the Dow and S&P. Indeed, from the intraday lows Friday to the Monday close, about 15 trading hours, the indices all shot up better than 19%. Does anyone remember anything catalytic happening over the weekend, like the surprise change in the short selling rules that caused a ripple of excitement a few weeks back? I certainly don’t. No, the selling simply reached an unsustainable emotional climax early Friday and burned itself out. Fifteen trading hours later, the recovery had gotten ahead of itself. This lead to another miserable seeming day on Wednesday, as buyers slinked back to the sidelines and the Liquidation Imperative resumed, no doubt with at least a few of those savvy traders who had bought the opening on Friday joining in.

The rationale for the rally petering out was “recession fears” emanating from earnings releases, as if anyone with access to the internet or a TV in the house might suddenly realize that the global economy might be in danger of slowing down and so he had better sell his stocks. I was particularly struck by how Intel’s release of a record quarter and an outlook that suggests a perhaps unprecedented control of its destiny culminated in a headline about a “murky outlook”. (Is that a “Dog Bites Man” headline or what?) This weakness carried over into Thursday, with the NDQ seemingly leading the way down, setting up what was perhaps a defining moment. Several hours into it, the NDQ got to within 1.2% of the low it made on Friday, 10/10, and then bounced up to close almost 10% above that intraday low. The other two indices got within about 3% of their Friday lows and then made similar moves. This is what the technicians call a successful test of a low. It is an indication that buying interest is no longer being overwhelmed by selling interest. This sharp reversal was followed by a Friday that gapped sharply lower but spent most of the day seesawing with an upward bias, up on the order of 3% at one point before closing down fractionally for the day and up for the week.

What’s going on here is that we are in the late phases of a wholesale liquidation. Call it the Great Asset Dump of 2008. Every day for the past several weeks plan sponsors, committees, spouses, etc. reached a pain threshold and said “Enough!”, and more assets hit the market. It matters, especially in the hedge fund world, that the end of the third quarter was two weeks ago (could they be almost done re the Sept 30 notification deadline?). It wasn’t just stocks and bonds, either. Over the past couple of years, commodities got hoarded, and not just by speculators. All this talk of oil coming down because of weak demand is the same sort of smoke that took it to $147. For instance, uranium has exhibited signs of trade liquidation, dropping a couple of bucks a pound every week over the past month or so. Does anyone think that we are headed into a situation that will involve a reduction in base load electric power generation? I don’t think so. No, what we are going through is simply liquidation. Assets that got squirreled away, some of which (like mortgage backed securities and blue chip stocks) were meant to be held more or less indefinitely, have been hitting a market were even the most seasoned investors have found themselves wondering if maybe this isn’t The Big One and pondering that wisdom about running away so as to live to fight another day.

The Big One, indeed. A recent poll suggests a substantial number of Americans have responded to the barrage of 1930s imagery in the media and have started mouthing the D-word. Other commentators have offered up plenty of comparative statistics that just how far fetched the idea of Depression is at this juncture. Having been a “downsize-ee” at a very inopportune time of life many years ago myself, I can understand depression finding its way into the thinking of many thousands who thought that the fat hog that is the financial services industry would be taking care of all those tuitions, payments on multiple residences and other accoutrements in the great game of keeping up appearances. Cumulative weeks of dealing with people who have had the realizable value of much of their life’s savings being priced by frantic liquidators is depressing, as is not being barely able to look at the prices of stocks you thought you bought so cheaply on a very bad day like March 17. However, we forget that for an awful lot of people, this Market is just a spectator sport, one more place where “other people” do what they do. Last weekend, we took a drive out to a State Park about two hours west of Austin. With all the talk about looming recession, one would have thought that a park several gallons of gasoline away from even outer suburbia would have been close to empty but for a few rangers twiddling their thumbs, but we had to park way off in the overflow parking area instead of in the very large main lot. On the way back, we went through Fredricksburg, a popular destination for shopping and overeating, that one would have also expected to be forsaken by hard pressed householders intent on shepherding their few remaining shekels so as to postpone their inevitable rendezvous with a bread line. There was hardly a parking space to be had along the main street. These little anecdotes suggest that while there are likely many individualized instances of dire financial straits out there, Main Street America, speaking generally, is a long, long ways from depressed.

What matters most in here is that governments are working together to pre-empt those worst case scenarios that prey on our imaginations. The interventions present the potential for all kinds of unpleasant consequences down the road, but they are just that, potential and out there in the future. In the here and now, the specter of the metaphor shifting from meltdown to black hole needs to be put to rest. There are all kinds of bad things that might come out of the government getting more deeply involved in the credit markets, and as time goes by we need to pay attention to how it plays out. There is also potential, although I would not go betting this way anytime soon, that the end games on a lot of these actions can be managed ways that exceed our expectations. For example, the Treasury could earn a nice return for a few years, then sell its shares at a profit five years from now and be out of banking, providing the taxpayers with at least a whiff of relief.

What matters is that the restoration of confidence that things aren’t going to just get worse and worse, which seemed to take root this week, makes those with the urge to liquidate just a little less frantic each week, and those with the deep pockets (like that smart guy from Omaha, who wrote that very encouraging op-ed in the NYT) a little more confident. The Great Asset Dump of 2008 will go on, irrespective of what we read about the economy or earnings, until it becomes apparent that “what’s for sale” has shrunk to a point that it can be easily absorbed by the large piles of buying power that have been sitting nervously on the sidelines. Then there will be more days like Monday and fewer days like all the others that have collectively seared our memories. But for the degree to which most us used up so much of our buying power snapping up bargains before the real ugliness started, these brutal weeks will likely prove to be a blessing. What will likely follow is a multiyear era when all but the most snake-bit equities actually produce double digit returns, a repeat of what many astute value investors reaped during that otherwise dreadful time that was the back half of the Seventies. (You can look it up.) There is something out of kilter about a world where an enterprise like Intel, with its cash hoard overflowing, its innovation engine back in high gear and its competitor in disarray, for less than thirteen times current year earnings and ten times likely year ahead earnings. (I’m thinking something like twenty times earnings a little more than $2 within four or so years.) I’m with Warren, cash is about to become trash.

Don't Blame the Ref!

There are right ways and wrong ways to regulate any activity that generates externalities, and this includes short selling. The latest crackdown, while suboptimal (so what government action is perfect?), was overdue and a step in the right direction.

A few preliminaries are in order. First, speculative activity, including the short selling of securities, is a vital part of well functioning markets. There is nothing in inherently evil about short selling or those who participate in it. It is speculative activity and therefore a part of what is best understood as a game. Games have to have rules, and optimizing the rules optimizes the game. How do we know this? Consider a game like football or hockey, which entail, but are not all about, physical aggression. Would these games be better if we did away with rules that proscribe grabbing face masks, clipping or slashing? Only if one believes that the essence of the game is players inflicting violence on each other. (How about letting the players carry sharp instruments?) Some fans may feel this way, but most fans agree that such games are about much more than seeing people get hurt. Games that get out of hand may be exciting in the moment, but only for a while, and the whole sport suffers when the “reason for being there” heads in such a direction.

Watching the feds act last week reminded me of watching youth hockey years ago. The refs often exercised a certain latitude in enforcing the rules, as calling a game strictly “by the book” tended to inhibit the kids and make for a dull game. However, if there were a few “incidents” and it became apparent that grudges were forming and boiling over into potential brawls, they would get really “literal” about the rules and effectively (most of the time) rein things in. Adroitly enforced rules made for a better game then, and they certainly make for a better game, insofar as the game is about much more than make a few ruthless and well connected rich guys even richer, in securities markets today.

My biggest beef with what has seemed like lackadaisical non-enforcement is that as someone who has shown up every day for decades looking for stocks that have been beaten down, volume is information, so naked shorting is no different than trafficking in false rumors. What I mean by “volume is information” is based on the realization that we can’t kid ourselves about knowing everything there is to know about a company or its stock, so we have to make allowances. One does the best they can to learn as much as they can about a situation, but to presume that one knows all there is, I think that comes under hubris. So one learns to pay attention to how the stock acts. An abnormal amount, or just a lot, of buying or selling might mean that someone knows something important that you don’t. Or maybe not, but seeing a lot of activity contrary to one’s assessment of the situation should give one at least some pause. Most of the time, this means doing some more work, thinking things through again, perhaps making a few phone calls. Sometimes one comes up with “something they missed”, more often, the volume is just noise and one continues to march.

Where this gets problematic is when the mood of the Market is degenerating towards an extreme. This is because in the moment, extreme price action is caused not just by activity on one side, it’s a dearth of willingness to act on the other. I can look at a stock and say, okay, what I care about is where its at three years from now. Based on my research, the company is going to do just fine. I really ought to buy this stock, but I have to take into consideration whether or not other prospective buyers will remain rational and long term oriented, or will they all decide that the rumors are just plausible enough to “wait and see”. Being way too earlier is unpleasant but bearable when doing so with one’s own capital, but when doing so with someone else’s capital, the prospect of having to explain it is likely to be enough to tip the balance to “wait and see”. To the extent that such accountability affects so much of the money in the market, “wait and see” culminates in a dearth of buying interest that gets overwhelmed by whatever is hitting the market that day. And the Bears know it.

“Bear raids” have been a part of the great game of Buy Low and Sell High since it was all happening under the buttonwood tree. When they got out of hand and started doing damage that was felt beyond the confines of the arena, the referees had to step in and make it rational for the marginally informed (i.e., most of us, most of the time) to consider getting involved. That is where we are today. I am sure that with the passage of a few years, enough time for memories of the Panic of 08 to start to fade around the edges, the refs will lighten up a bit. For now, though, the quality of the game has been damaged and it needs to be restored.