Harry Newton's In Search of The Perfect Investment
Technology Investor. Auction Rate Securities. Auction Rate Preferreds.
Auction Rate Preferreds.
8:30 AM EST Monday, April 21, 2008: "Risk
management" stinks. It's one of those polysyllabic words that Wall Street
makes up to regularly to convince you to buy its latest, greatest new product.
The words stick in my brain. Read on. This weekend's Economist talks
the IMF, the Financial Stability Forum, the Basel Committee on Banking Supervision
and other august bodies have drawn attention in the past week to the appalling
risk-management by many banks before the credit crisis.
And then Buffett
talks about reading, reading and more reading, as though it's the universal
investment panacea. And by God, he's right. Reading it yourself removes you
from reliance on the joker (a.k.a. broker) who's trying to push it down your
throat -- the broker selling you the auction rate security, the derivative,
the mortgage in land deals, the sure-fire investment in a new startup.
Reading it ourselves
gives us the strength to say ""NO, I don't want it.." Reading
it gives us the strength to say, "I don't understand it." Here's a
test. Do you know what a credit-default swap is? Me neither. Yet Wall Street
issued $60 trillion of them last year...
Chart from the latest Economist.
Reading it ourselves
finds the risks. We should list them. And then ask ourselves, "Does this
bring the risk of losing all our money?" And if it does -- and remarkably
many things do -- then we need to run 100 miles. Fast.
I'm harping on
this reading thing because too many of us rely on our brokers, our financial
advisers or someone else. If you don't believe me, I'll send you the hundreds
of emails I've received from investors stuck in ARPS. Had we all read the prospectuses
(which most of us never even received), we would be in much better shape today.
Warren thinks... This week's Fortune
has a featured piece with Warren Buffett.
Excerpts (my emphasis)::
Before we start
in on questions, I would like to tell you about one thing going on recently.
It may have some meaning to you if you're still being taught efficient-market
theory, which was standard procedure 25 years ago. But we've had a recent
illustration of why the theory is misguided. In the past seven or eight or
nine weeks, Berkshire has built up a position in auction-rate securities [bonds
whose interest rates are periodically reset at auction of about $4 billion.
And what we have seen there is really quite phenomenal. Every day we get bid
lists. The fascinating thing is that on these bid lists, frequently the same
credit will appear more than once.
Here's one from
yesterday. We bid on this particular issue -- this happens to be Citizens
Insurance, which is a creature of the state of Florida. It was set up to take
care of hurricane insurance, and it's backed by premium taxes, and if they
have a big hurricane and the fund becomes inadequate, they raise the premium
taxes. There's nothing wrong with the credit. So we bid on three different
Citizens securities that day. We got one bid at an 11.33% interest rate. One
that we didn't buy went for 9.87%, and one went for 6.0%. It's the same bond,
the same time, the same dealer. And a big issue. This is not some little anomaly,
as they like to say in academic circles every time they find something that
disagrees with their theory.
So wild things
happen in the markets. And the markets have not gotten more rational
over the years. They've become more followed. But when people panic, when
fear takes over, or when greed takes over, people react just as irrationally
as they have in the past. ...
You don't want
a capital market that functions perfectly if you're in my business. People
continue to do foolish things no matter what the regulation is, and they always
How do you
get your ideas?
I just read.
I read all day. I mean, we put $500 million in PetroChina. All I did was read
the annual report. [Editor's note: Berkshire purchased the shares five years
ago and sold them in 2007 for $4 billion.]
would you give to someone who is not a professional investor? Where should they
put their money?
Well, if they're
not going to be an active investor - and very few should try to do that -
then they should just stay with index funds. Any low-cost index fund. And
they should buy it over time. They're not going to be able to pick the right
price and the right time. What they want to do is avoid the wrong price and
wrong stock. You just make sure you own a piece of American business, and
you don't buy all at one time.
the current turmoil stack up against past crises?
hard to say. Every one has so many variables in it. But there's no question
that this time there's extreme leveraging and in some cases the extreme prices
of residential housing or buyouts. You've got $20 trillion of residential
real estate and you've got $11 trillion of mortgages, and a lot of that does
not have a problem, but a lot of it does. In 2006 you had $330 billion of
cash taken out in mortgage refinancings in the United States. That's a hell
of a lot - I mean, we talk about having $150 billion of stimulus now, but
that was $330 billion of stimulus. And that's just from prime mortgages. That's
not from subprime mortgages. So leveraging up was one hell of a stimulus for
you're describing suggests we're a long way from turning a corner.
I think so.
I mean, it seems everybody says it'll be short and shallow, but it looks
like it's just the opposite. You know, deleveraging by its nature takes
a lot of time, a lot of pain. And the consequences kind of roll through in
different ways. Now, I don't invest a dime based on macro forecasts, so
I don't think people should sell stocks because of that. I also don't
think they should buy stocks because of that.
Do you find
it striking that banks keep looking into their investments and not knowing what
I read a few
prospectuses for residential-mortgage-backed securities - mortgages, thousands
of mortgages backing them, and then those all tranched into maybe 30 slices.
You create a CDO by taking one of the lower tranches of that one and 50 others
like it. Now if you're going to understand that CDO, you've got 50-times 300
pages to read, it's 15,000. If you take one of the lower tranches of the CDO
and take 50 of those and create a CDO squared, you're now up to 750,000 pages
to read, to understand one security.
I mean, it can't be done. When you start buying tranches of other instruments,
nobody knows what the hell they're doing. It's ridiculous. And of course,
you took a lower tranche of a mortgage-backed security and did 100 of those
and thought you were diversifying risk. Hell, they're all subject to the same
thing. I mean, it may be a little different whether they're in California
or Nebraska, but the idea that this is uncorrelated risk and therefore you
can take the CDO and call the top 50% of it super-senior. It isn't super-senior
or anything. It's a bunch of juniors all put together. And the juniors all
If big financial
institutions don't seem to know what's in their portfolios, how will investors
ever know when it's safe?
they can't. They've got to, in effect, try to read the DNA of the people running
the companies. But I say that in any large financial organization, the CEO
has to be the chief risk officer. I'm the chief risk officer at Berkshire.
I think I know my limits in terms of how much I can sort of process. And the
worst thing you can have is models and spreadsheets. I mean, at Salomon, they
had all these models, and you know, they fell apart.
we say to investors now?
The answer is
you don't want investors to think that what they read today is important in
terms of their investment strategy. Their investment strategy should factor
in that (a) if you knew what was going to happen in the economy, you still
wouldn't necessarily know what was going to happen in the stock market. And
(b) they can't pick stocks that are better than average. Stocks are a good
thing to own over time. There's only two things you can do wrong: You can
buy the wrong ones, and you can buy or sell them at the wrong time. And the
truth is you never need to sell them, basically. But they could buy a cross
section of American industry, and if a cross section of American industry
doesn't work, certainly trying to pick the little beauties here and there
isn't going to work either. Then they just have to worry about getting greedy.
You know, I always say you should get greedy when others are fearful and fearful
when others are greedy. But that's too much to expect. Of course, you shouldn't
get greedy when others get greedy and fearful when others get fearful. At
a minimum, try to stay away from that.
rule, now seems like a good time to be greedy. People are pretty fearful.
They are going in that direction. That's why stocks are cheaper. Stocks are
a better buy today than they were a year ago. Or three years ago.
still bullish about the U.S. for the long term?
economy is going to do fine. But it won't do fine every year and every week
and every month. I mean, if you don't believe that, forget about buying stocks
anyway. But it stands to reason. I mean, we get more productive every year,
you know. It's a positive-sum game, long term. And the only way an investor
can get killed is by high fees or by trying to outsmart the market.
continue to love Australian mining stocks. The
two biggest are BHP and Rio Tinto. They have everything going for them including
China. I've banged the table for these two (and other Australian miners) on
many occasions. Check out this piece from this weekend's Economist:
The global reach of China's boom
a taxi or ordering a meal in a restaurant in Perth these days and you may
be in for a long wait. The capital of Western Australia (WA) is suffering
a labour shortage, as young people head north to make real money from a mining
boom. China's insatiable demand for WA's minerals is driving it, and helping
China displace Japan as Australia's biggest trading partner. But Australia
has also to balance its mining windfalls against clashes with China over human
a desert region about 1,300km (800 miles) north of Perth, is the main focus.
BHP Billiton and Rio Tinto, two of the world's biggest resource companies,
roughly share the Pilbara's iron-ore deposits that feed China's flourishing
steel industry. China takes about half their exports. They can barely dig
it out fast enough to meet demand.
Rio Tinto plans
to double its 2007 iron-ore production (160m tonnes) in four years. Last year
iron ore earned the company $8.8 billion, mostly from the Pilbara. The region
is rich in more than minerals. Archaeologists have reportedly found ancient
aboriginal tools at Hope Downs. Rio Tinto jointly controls this iron-ore mine
with Gina Rinehart, daughter of the late Lang Hancock, a pioneer Pilbara tycoon.
The West is
Australia's largest state, with just one-tenth of the country's population.
Thanks to the mining boom, it now underwrites much of the country's economic
growth. Last year the state's economy grew by 6.3%, almost double the national
rate. Eric Ripper, WA's treasurer (finance minister), says his state struggled
to post an A$9m ($8.3m) surplus seven years ago, before China's boom took
off; the surplus last year was A$2 billion.
west, as WA is sometimes known, has seen other booms end in tears. Alan
Birchmore, a veteran of some, and on the board of United Minerals, a company
with a Pilbara iron-ore lease, reckons this one is different: it has depth.
China, he says, is showing that it takes some stopping once
people get a taste for consumption. Some forecasts back him up. In a
report for Rio Tinto and the Australian National University, Ross Garnaut
and Ligang Song, two economists, argue that by 2020 China's demand for metals
may increase by the equivalent of the industrial world's annual total demand
Pilbara's miners are wrangling with their biggest customer. After three years
of successive price rises, BHP Billiton and Rio Tinto are reported to be seeking
a 70% increase in contract prices this year. Chinese buyers are unhappy that
both companies have made a killing selling some iron ore on the spot market;
they are demanding that more be sold under lower-priced, long-term contracts.
The Australian companies believe they have an advantage: their costs of shipping
iron ore to China are about one-third those of Brazil, their main competitor.
jeopardise a huge trading relationship, Australian governments have tended
to tread softly in their dealings with China over human rights. After nearly
five months as Labor prime minister, Kevin Rudd was less constrained in a
speech in Beijing on April 9th, referring to problems in Tibet. And he has
banned Chinese security guards from accompanying the Olympic torch on its
scheduled run through Canberra on April 24th.
need for Australia's resources is likely to override any political offence
it may take from this. The boom's conflicts are closer to home. Mr Ripper
says 500 people are arriving in WA each week to fill jobs for a bonanza whose
scale took everyone by surprise. Rio Tinto's answer is a plan to move ore
from mines to ports on a fleet of driverless trucks and trains, starting in
2010. But jobs will not disappear completely. People in Perth will give the
intelligent vehicles their instructions by remote control.
An old Italian Mafia Don is dying and he calls for his grandson to approach
the bed; 'Lissin a me. I wanna for you to taka my chrome-plated 38-caliber revolver
so you will always remember me.'
The grandson smiles
weakly and replies; 'But grandpa, I really doana lika guns. Howzabout you leava
me your ROLEX watch instead?'
Gasping for air
the old man answers with a snarl in his voice; 'Shuddup an lissin. Somma day
you gonna runna da business. You gonna have a beautifula wife, lotsa money,
a biga home and maybe a couple a bambinos.'
After a slight
pause to catch his breath he continues; 'Somma day you gonna comma home and
maybe find you wife inna bed with another man. Whadda you gonna do then .. pointa
to you watch and say 'Times up'?'
Priest and Rabbi
A priest and a rabbi were sitting next to each other on an airplane.
After a while,
the priest turned to the rabbi and asked, "Is it still a requirement of
your faith that you not eat pork?"
The rabbi responded,
"Yes, that is still one of our laws."
The priest then
asked, "Have you ever eaten pork?"
To which the rabbi
replied, "Yes, on one occasion I did succumb to Temptation and tasted a
The priest nodded
in understanding and went on with his reading.
A while later,
the rabbi spoke up and asked the priest, "Father, is it still a requirement
of your church that you remain celibate?"
The priest replied,
"Yes, that is still very much a part of our faith."
The rabbi then
asked him, "Father, have you ever fallen to the Temptations of the flesh?"
The priest replied,
"Yes, rabbi, on one occasion I was weak and broke with my faith."
The rabbi nodded
understandingly and remained silent, thinking, for about five minutes.
Finally, the rabbi
said, "Sure beats a ham sandwich."
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
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