vinod1

Has any one understood the rationale for AIG warrents issues to stock holders? These are issued only to private stockholders (at 0.53 warrents per 1 stock) so the US Govt with 92.5% stake is not getting any warrents. So it effectively means that the ownership of private stockholders is being increased at the expense of US Govt. To me it seems a scenario something like this seems to have happened: The US govt seems to be making quite a bit of money on AIG and much better than say in Freddie/Fannie or on the Banks and this is a backdoor way to reduce some of the US Govt profits and pass on some of the better than expected showing "profits" back to shareholders. I cannot think of any other reason for the issuance of the warrents. Vinod

Isn't this ratio less valid than before since a lot of companies in the S&P500 are heavily active abroad? ex: Caterpillar have plants and operations in emerging countries that if I'm right are not counted in US GDP. That's an excellent point. I wonder how that ratio might be adjusted to account for the proportion of overseas business over time? Dont really know how to adjust for it. This is also closely related to increase in profit margins in US. Most low margin business has been outsourced to developing countries so naturally the profit margins have increased for US companies in aggregate. So this is a big risk for GMO and those of us who tend to take the same attitude that profit margins are going to mean revert - "This time is different". :) Vinod

I think we differ in how inflation should me measured. To me the way BLS measures inflation seems reasonable. We aren't differing in how it's measured. I don't think they should measure it in a different way, because it would be nearly impossible to track in the way that I've describe it. We are differing in how we think of inflation. I think that if I hold cash, for example, it should buy more and more goods every year because of the productivity advances. But it doesn't. It buys less. And we should be able to buy more in a 0% CPI environment (with productivity gains), but we can't due to inflation. Perhaps bad terminology on my part. I do not think I disagree with you. In my own calculations I always factor inflation + increase in living standards (a close proxy to productivity increases) as the minimum growth needed to protect the purchasing power of my assets. Vinod

Taleb seems to me like a man with a hammer syndrome... It has a lot of offer the investor but it is not the basis of an investment strategy. To me the most important points are (1) Ignore standard risk models - anything that uses std dev, beta, etc. (2) Future is unpredictable and mostly develops in random ways, so be prepared to handle black swan type risks. (3) Be particularly skeptical of causality explanations. Vinod

A good article on current market valuations - several methods of valuing the overall market. I pretty must used to do the same calculations, so this guy made my life simple. http://www.valuewalk.com/stock-market-valuations/stock-market-valuation-february-2nd-2011/ Thanks Vinod

S&P mini futures. I have not done it and not sure about the exact mechanics, but that is one way to hedge. Vinod

You are probably correct, I just picked up a random example. Vinod

I think we differ in how inflation should me measured. To me the way BLS measures inflation seems reasonable. You seem to be saying that productivity improvements should be considered - that is the cost to produce a good, must be incorporated into inflation. I do not think that should be the case. Cost savings as a result of productivity improvements gets passed to consumers when the business does not have any competitive advantage. In your road construction scenario, those businesses do not have any competitive advantages and the cost savings are realized by consumers as a result. This issue is separate from how inflation should be measured. Car companies might have a small competitive advantage as result of brand preferences (but not much, although I am not that familiar with these companies), hence they might not have passed on all the cost savings as a result of any productivity improvements they might have made. Vinod

Thanks! Sorry that is the latest that I have. I only update my "inevitables" about once a year when the AR's comes out. Since IV of these companies do not change that much this works out for me. Vinod

I wrote a short article on this for those returning back to India at http://vinodp.com/documents/nri/standard_of_living.html. Imagine that you were living in America in year 1950 and earning as much as the median (50th percentile) American family did in that year. Suppose, in that same year you happen to receive a large inheritance, which your financial advisor then calculates would be enough for you to retire. His calculations shows that you can withdraw the same amount as you are earning now and adjust each year for inflation to maintain your standard of living. You decide to follow his advice and retire. Fast forward to year 2005. You would be surprised to learn that your standard of living is now only marginally higher than that for a family living in poverty (poverty is around the 12th percentile) in America in 2005. By 1994, you would be having a standard of living around 20th percentile - poorer than 80 percent of the population. Most people would not consider this to be “maintaining” their standard of living! Vinod

Say you buy a car in 2000 for $20K without ABS. Now, if you can buy the same make, model car with ABS for $20k. Then you would say there was 0% inflation. But in reality, you had deflation, price did fall, if you had considered the quality improvement. This had been the case in many goods and services. Thus BLS uses hedonic adjustments to account for quality improvements when calculating inflation. When we calculate inflation, we need to take the quality improvements into account. We are increasing our standard of living every year. If you accurately calculate the inflation (without quality improvements) and only increase your expenses by that inflation measure, you would find that you would be falling behind the rest of the country in standard of living. Vinod

Not true at all. Option market makers are quite sophisticated. You can observe "volatility smile" and "volatility skew". Volatility smile means that implied volatility is higher for out of money options than at the money options. And volatility skew means that the implied volatility is higher on one side of the strike price than the other side. This is completely contrary to log normal distribution. You are correct indeed. However, the point I think Taleb makes is that option pricing models as much as they are tweaked (either via a skew or assumptions of higher volatility), do not really price black swan type events. Vinod

They have iShares ETF under their umbrella which has the broad market indices. So they tend to own pretty much every security in the US. Vinod

If I remember correctly he buys way out of the money options. Options are priced with the assumption of something like normal (lognormal) distribution. Thus way out of the money options are underpriced if returns do not follow the neat lognormal distribution i.e. black swan type scenarios tend not to be incorporated into the price. So his strategy losses small amounts of money regularly with the occasional home run. Thanks Vinod

I think he means $1 in current normalized earning power. See his comments below. CONSUELO MACK: And so, when you look at, you know, a Citigroup, for instance. Let’s just take them one at a time. I mean, it’s value now. Do you think that there’s still a lot of value left? BRUCE BERKOWITZ: Yes. Citigroup has the ability to earn a dollar a share, which would put it at $10, let’s just say. And you compare it to where it’s trading today, four. Under four. Vinod

Another alternative is that there are lots of off-balance sheet assets that are not being reflected on the books. I did try to size the off-balance sheet items but not really able to find anything that would be much higher for Citi than BOA. But then I have never been able to get my head completely around the off-balance sheet stuff of the big four banks. Vinod

Here is my notes on Ben Graham's comments on Dividend Policy and how investors should approach dividends. Vinod • The dividend rate is a simple fact and requires no analysis, but its exact significance is exceedingly difficult to appraise. From one point of view the dividend rate is all important, but from another and equally valid standpoint it must be considered an accidental and minor factor. • In the years until 1925, the price paid for a common stock would be determined chiefly by the amount of dividend. A common stock investor sought to place himself as nearly as possible in the position of an investor in a bond or a preferred stock. He aimed primarily at a steady income return, which in general would be both somewhat larger and somewhat less certain than that provided by good senior securities. Even if one company had steady earnings and another company had irregular earnings, this had little impact on the price paid which is dominated by the dividend rate. • Graham questions the established principle of corporate management which subordinates the current dividend to the future welfare of the company and its shareholders. It is considered proper managerial policy to withhold current earnings from stockholders to either strengthen the financial position or to increase productive capacity. The typical shareholder would most certainly prefer to have his dividend today and let tomorrow take care of itself. • Graham questions the assumptions of the dividend policy 1. It is advantageous to the shareholders to leave a substantial part of annual earnings in the business.  If a business pays out only a small part of the earnings in dividends, the value of the stock should increase over a period of years, but it is by no means certain that this increase will compensate the stockholders for the dividends withheld from them, particularly if interest on these amounts is compounded.  An inductive study would undoubtedly show that the earning power of corporations does not in general expand proportionately with increases in accumulated surplus (retained earnings). 2. It is desirable to maintain steady dividend rate in the face of fluctuations in profits.  Stability is usually accomplished by paying out a small part of the average earnings. The question that arises is if the shareholders might not prefer a much larger aggregate dividend, even with some irregularity. The main objection to the above is that stockholders receive both currently and ultimately too low a return in relation to the earnings of their property and that the saving up of profits for a rainy day often fails to safeguard even the moderate dividend rate when the rainy day actually arrives. Gives the example of US Steel that earned a profit of $2.344 billion over the period 1901-1930 and retained $1.25 billon of it. Yet, a small loss over a 1.5 year period in 1931 was sufficient to outweigh the beneficial influence of 30 years of practically continuous reinvestment of profits. Assuming that the reported earnings were actually available for distribution, then stockholders in general would certainly fare better in dollars and cents if they drew out practically all of these earnings in dividends. • Graham questions the accepted notion that the determination of dividend polices is entirely a managerial function, in the same way as the general running of the business. This is because the board of directors consists largely of executive officers and their friends. The officers want to retain as much earnings as possible to simplify their financial problems, expand business for personal aggrandizement to secure higher salaries. • Graham suggests European companies policy of paying out practically all earnings and any capital for expansion purposes be provided by sale of additional stock. • Experience would confirm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus (retained earnings). • Graham suggests that if an investor makes a small concession in dividend yield below the standard, he is entitled to demand a more than corresponding increase in earning power above standard. So if a stock is paying 5% div yield and 7% earnings yield and another company paying 4.4% yield, then the investor should demand an earnings of yield of perhaps 8% to compensate. • The dividend rate is seen to be important apart from earnings, not only because the investor naturally wants cash income from his capital but also because the earnings that are not paid out in dividends have a tendency to lose part of their effective value for the stockholder. • The principle for dividends should be for the management to retain or reinvest earnings only with the specific approval of the stockholders. Such “earnings” as must be retained to protect the company’s position are not true earnings at all. They should not be reported as profits but should be deducted in the income statement as necessary reserves, with an adequate explanation thereof. A compulsory surplus is an imaginary surplus. • Summary  In some cases stockholder derive positive benefits from an ultraconservative dividend policy i.e. through much larger eventual earnings and dividends. In such instances the market’s judgment proves to be wrong in penalizing the shares because of their small dividend.  Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from additions to surplus. This happens because either (a) the reinvested profits fail to add proportionately to the earning power or (b) they are not true profits at all but reserves that had to be retained merely to protect the business. In this majority of the cases the market’s disposition to emphasize the dividend and to ignore the additions to surplus turns out to be sound. A company earning $10 and paying $7 in dividends should increase the value of stock over a period of years. This may be true but at the same time the rate of increase in value may be substantially less than $3 per annum compounded.  The confusion of though arises from the fact that the stockholders votes in accordance with the first premise and invests on the basis of the second.

Good job on Citi! Yes, you do get $1 if you assume a 1.5% ROA on the $1850 billion in current asset base. But, Citi excluding Citi Holdings has only about $1300 billion in assets. The $500 billion odd in assets in Citi holdings I assume are going to be in runoff. So would require more than 2% ROA to generate $1 EPS. To put this in perspective, it require earnings of more than $30 billion a year or 50% more than either WFC or BOA. Also the Book Value has held up because they were able to raise $90 billion in equity sales mostly at greater than book value so BV per share has been helped by this. Also the $300 billion in bad debt that it was able to hand off to Govt has also helped in this regard. Vinod

As much as I try to come up with a "normalized earnings" for citi, I am never able to get much above $0.8 EPS which is based on a very simplistic 1.2% ROA which I think is about average for Citi even after excluding the 2008-2010 period. Given that Citi is shrinking its BS I cannot see how Citi can earn $1 with nearly 30 billion in shares outstanding. Given that it is a near certanity that it would go through a near death experience once again over the next 10 years (having gone through this about once a decade for the last 4 decades and having participated in every significant scandal involving the financial industry of the last 20 years), I am just not able to see the value here. Obviously Bruce is on to something but along with AIG, I have not been able to understand the value he sees in Citi. Vinod

You got great feedback from others. My 2 cents 1. I strongly recommend reading Security Analysis. You would find it astonishingly relevant to the current environment. However, it is not a book that teaches you how to value stocks. The most surprising thing I found after a very detailed study of Security Analysis is that Graham does not think it is necessary to actually value a business. "Instead Graham focused on how to ensure that what you are buying is very cheap, which means you don't know the value is, but you do know that the value is much higher than the price that you are paying. And then you diversify. So, when you follow that approach, for example, you don't have to do management interviews, you don't have to really worry about the industry prospects. Graham said that you don't need to value the business. It's too hard to value a business. Anyway, it is not the job of an investor to value a business, that's the job of a business valuer which is very different from the job of an investor. The job of an investor, he felt, was to make sure that there is a big margin between the value that you are receiving and the price that you are paying." (Quoted from Sanjay Bakshi). If you read this book go with one of the first four editions, the other editions had much less Graham. My notes to the book are at http://vinodp.com/documents/investing/security_analysis_index.html 2. The best practical book on valuation I found is "Value Investing" by Greenwald. This is a definite must read for developing the right method of thinking about valuation. Vinod

Came across a good site for Oil and Gas stocks and thought it might be of interest to those who are following this industry. http://www.mcdep.com/index.htm Think it could be of some use as a screening tool for further analysis of each company. Vinod

A little info you may or may not find useful: I think it might have to do with fund withdrawals for Yacktman. Assets dropped from $1.1 billion to $0.3 billion during 1998-99 period. The withdrawals might be because he loaded up on deep value stocks like Philip Mliorris and also started under performing for whatever reason early in the bubble period than the other value investors. The under performance is concentrated tightly in the three year period between 1997-1999 - a badge of honor. I was told in an online message board discussion from a person who I respect enormously but do not have data that Fairholme has underperformed in its managed accounts in the mid 1990's. Since the fund did not start in this period we do not have public record. Vinod

Good catch. I looked at S&P 500 and Small Cap indices and they are up roughly 29% and 42% over this period. So the 7 year forecast change for these two tally out quite well over this period with the market moves. Quality on the other hand seems to have moved from a 6.1% annual premium over S&P 500 to a 3.5% premium while providing nearly identical returns over this period. Very strange. Vinod

Taking a very quick look it underperformed from its inception till late 1999. Most of the out performance came from 2002-2007 period. Maybe the manager improved his skill. To really assess his performance, reading up his letters to see how he thinks might give you a better indication of his performance. You might find more feedback on the Morningstar board about this fund. Vinod

I am "Inevitables" at 80 cents kind of guy. Vast majority of my portfolio - heck pretty much all - is invested in such businesses. However, I made a first foray into BAC this week. I am afraid that a great calamity is about to fall on US Banking system given my investment :) Vinod