Tuesday, August 24, 2010

What Buffett Thinks About Interest Rates

In a news article a couple weeks ago Bloomberg reported that Berkshire Hathaway had been shortening the duration of their bond portfolio. Unlike maturity, duration considers the sensitivity of interest rates and expresses the effective time the bond will be paid back, inclusive of coupon payments .

Bloomberg wrote that the holdings due to mature in less than a year were increased from 16% in 2009 to 21% this past quarter. Though not a significant increase, it was consistent in his Buffett's comments from late last year; "the United States is spewing a potentially damaging substance into our economy - greenback emissions, unchecked greenback emissions will certainly cause the purchasing power of currency to melt.”

Bonds have a precise inverse relationship with interest rates. An increase in interest rates will lead to a decrease in bond prices and vice versa. The logic is simple. If the Treasury was issuing 3% 30 year T-bonds this year and interest rates shoot up to 6% next year, those holding the bonds paying 3% will be stuck with that coupon payment for the next 29 years. The new batch of T-bonds will be offered at the going rate; 6% and demand for 3% bonds will naturally decrease. So in Berkshire reducing the the duration of their bond portfolio, they reduce the risk that interest rates increase and they're left with holding longer dated bonds that would have diminished in value.

Buffett has regularly mentioned the difficulty in predicting where interest rates will go. He mentioned much about this in the early 1980's annual reports. That may explain the relatively minor changes to the bond portfolio. The deflationary threat is more imminent at the moment, but far too often we forget who is manning the Federal Reserve. Ben Bernanke has shown as deep a concern about deflation as any economist. He earned the nickname "helicopter Ben" because of his reasoning (borrowed from Milton Friedman) that deflation could be fought by dropping money from helicopters. Though I wouldn't speculate and short bonds, I think the case for a stagnant Japan-type economy is overdone. In the 1980's the Volcker Fed successfully squashed inflation. If the economy were to dip into a steady deflationary rate, I can't imagine the Bernanke Fed sitting on their hands.

Wednesday, August 18, 2010

Fiserv and Financial Regulation

A new holding that showed up on Berkshire Hathaway's recent stock holdings was Fiserv Financial. Fiserv is a financial services company that specializes in various payments and processing services such as ACH, debit, credit and check images to name a few. The firm serves a broad array of firms in industries like banks, utility companies, healthcare, retailers and municipalities.

The company has had sustained a return on equity of no less than 13% for the past 10 years and as high as 22% in 2008. Fiserv had a times interest earned for the past 10 years in excess of 15 and has also had 10 consecutive years of free cash flows. It trades just under a p/e ratio of 13 for this years earnings. From a financial standpoint it meets many of the qualities Warren Buffett looks for in a stock. Whether it has some kind of moat or is a low-cost producer, I don't know. Being an exceptional business insulated from competition, however, is truly what Buffett looks for. The company does offer a lot technology to banks and thus stands to gain if the condition of banking industry improves. Buffett's steepening position in Wells Fargo and comments about housing may speak to that.

The newspaper American Banker had written an article that gave mention to Fiserv. It spoke about opportunities for firms in wake of the recent financial legislation. In particular they mention the benefit of point of sale machines that can determine the cheapest processing option. One of the features of the bill is the chipping away of the visa-mastercard stronghold of processing payments. The paper writes that a "visa-branded debit card that is currently linked only to Visa's Interlink network for PIN transactions, for example, would have to add another network not owned or operated by Visa to satisfy the requirement." Those other networks would include companies like Discover and Fiserv among others.

The paper also notes that transaction costs for debit cards are expected to be cut significantly further putting a dent in the mastercard-visa moat. The manufacturer Hypercom stands to benefit as newer models of their credit swiping machines with capabilities of finding the cheapest processer should show increased demand.

Monday, August 16, 2010

The Lebron-Buffett Connection

In "Common Stocks and Uncommon Profits" Phillip Fisher delves into a notion known as "scuttlebutt" where the investor engages himself in the business and discerns as much as they can about the firm. This could entail going to the firm directly and trying to glean what nuggets of value that could not be otherwise obtained elsewhere. It could include visiting factories, talking to foremen and getting a feel for the operations and determining if it is a productive operation. Going further you could ask managers how they feel about competition, where they stand in regards to competition and if they could not hold shares in their company then which competitor would they hold shares in. Fisher acknowledges it can be a burdensome task, but it can yield very profitable information.

Warren Buffett credits Fisher for many of his values, though Benjamin Graham did have a much greater influence on him. It would seem to me that Buffett has extended this notion in a unique fashion. Berkshire Hathaway owns about $500 million shares worth of Nike. Nike incidentally has held and recently re-signed a contract with Lebron James in March though the terms were not disclosed. For the past couple years Buffett has been befriending Lebron and even commented something to the extent that "if Lebron was a stock, I'd buy him." Technically Lebron's success is intertwined with his. Lebron's relationship to Nike is no different than a steel factory is to Arcelor-Mittal; Lebron is considered an asset to Nike.

Now it could entirely be a genuine relationship. Buffett who has been a big fan of baseball may just have grown excited about basketball being that Lebron was playing so close to Omaha. Or it could be that he is very interested in the true character of Lebron. As the Tiger Woods and Kobe Bryant scandals have evidenced, shortcomings in character can be quite costly to a company grounded in image. Knowing that Lebron is closer to a John Stockton or Michael Jordan in character rather than a Charles Barkley or Jason Kidd would be valuable information to a shareholder of Nike. Buffett has similarly cultivated relationships with Derek Jeter among other Nike partners.

To put it in figures, the contract Lebon had signed in 2003 was $90 million for 7 years, the more recent one will likely be a much larger sum. Nike made about $1.9 billion this past year and footwear contributed the largest to revenue at 54% followed by apparel at 27%. Sales in both categories would likely see a boost from Lebron, exactly how much is hard to tell.

Now this may all seem like conspiracy theory, but I believe Buffett is all business. Whether the investment was made by him or Lou Simpson who manages the Geico portfolio should make no difference. Being that it is a significant holding of Berkshire should make him very interested in the potential for Nike. Nike is a relatively small investment compared to Coke or Wells Fargo, but it certainly hinges on brand and the quality of the underlying athletes that represent the company. Buffett says of risk, "risk is what you don't know." This effort to get to know Lebron seems very much a move to reduce the risk in Nike.

Sunday, August 15, 2010

The Bottom for Housing Starts?

Warren Buffett commented on CNBC a couple months ago saying we should expect to see an up-tick in house prices in about a year, at least for regions not overproduced. Though it should be read with caution as he acknowledges he didn't appreciate the size of the housing bubble years ago and made some mistimed investments in companies like U.S. Gysum. In any case he's generally more right than wrong and current trends may actually favor his projection.

The price of housing, like all assets are governed by supply and demand so that's a good place to start when examining housing. Below is the annual figure for new housing construction from the U.S. Census

Figures in thousands
1991 1,013.9
1992 1,199.7
1993 1,287.6
1994 1,457.0
1995 1,354.1
1996 1,476.8
1997 1,474.0
1998 1,616.9
1999 1,640.9
2000 1,568.7
2001 1,602.7
2002 1,704.9
2003 1,847.7
2004 1,955.8
2005 2,068.3
2006 1,800.9
2007 1,355.0
2008 905.5
2009 554.0
2010 549.0

The steep drop off is unparalleled in the last 40 years of housing starts, but the boom was equally so. Buffett had noted that in 2005 when housing starts were about 2 million household formations, the demand side, were running about 1.2 million. More houses were being created than people could fill. Fast forward to 2008 and we're left with excess inventory resulting from foreclosures.

There still exists a large inventory of houses and even a "shadow inventory" of delinquent mortgagors that haven't been put into foreclosure by Freddie Mac and Fannie Mae. Inventory levels will need to drop to normal levels before prices can ascend. Both Buffett and Robert Shiller noted that unemployment weighs heavier on house prices than does higher interest rates. Buffett doesn't see a rise in interest rates having a significant negative impact on housing, but unemployment does remain elevated and shows little signs of abating.

So how good does Buffett feel about housing? Good enough to not sell any of his shares in U.S. Gypsum, a maker of sheet-rock. He sold shares in Johnson and Johnson, Ingersoll-Rand, and Proctor and Gamble in the past year. U.S. Gypsum is a unique investment for Buffett because it is quite commoditized and it doesn't appear to have the "moat" like many of his other investments have. The company claims to operate as the low-cost producer and they do hold patents on the name Sheetrock which they are credited with inventing. But many other drywall producers exist, Chinese firms as well.

The company recently unveiled a lightweight version of sheetrock which is about 30% lighter than present models. The company claims heavy sheetrock is the single largest concern of contractors and this new model maintains a pound for pound durability which is stronger than heavier versions. However, the company is seemingly producing more red ink than sheetrock at the moment. It has been operating at a net loss since 2008 and has mothballed facilities until demand picks up. The new lighter model is unlikely to bail them out from current trends, but it should pad earnings in future years.

Case Against Gold

Gold has been slowly gaining the characteristics of assets like the dot-coms in the late 90's and housing in mid 2000's; that being arguments heavy in excitement and light on substantive reasons for it being a good investment. Despite the recent concern towards deflation, interest in gold remains relatively high. Lets start with a cursory examination of gold. Gold is a metal, it yields no rents or earnings, it ostensibly hedges against inflation, but it has tripled in price over the past 10 years (growing over 10% per year) even though inflation has run at around 2%. On that basis alone, gold does not appear to correlate to inflation, yet people concerned about inflation make that a case for gold.

But gold is also a store of value. Unlike the U.S. dollar no government agency can debase the value of gold. The fed can print money to pay ballooning debts, but as long as a sizable gold deposit is not discovered, there should be no concern of a sudden increase in the supply of of gold which would diminish the value of your holding. True enough, but gold is a not a monopoly in store of value. There exist valuable art paintings, silver, platinum and other currencies like the Swiss Franc or even the Chinese yuan which is ostensibly undervalued relative to the U.S. dollar. So why not purchase one of these competing stores of wealth? They may or may not have seen a significant rise in price and perhaps they are run by governments not drowning in debt.

As foolish an argument was for housing a couple years ago, housing can at least be measured against the rents it earns. By that measure it had gotten out of whack in the mid 2000's as the Economist had reported. Gold and other commodities have no such feature. Instead the price of gold can only be determined by speculative activity. Warren Buffett also commented on gold; "it gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head." We must remember that all commodities, except for water, have substitutes in one form or another.

The Economist wrote an exceptional piece on gold: http://www.economist.com/node/16536800
for those interested.

Microsoft Finally a Buy?

Microsoft would appear to be trading at one of its lowest p/e ratios in some time. It traded as high as 40 in 2001 and now it is at around 11.5. Though Microsoft operates in an fast-changing industry I would normally avoid, Microsoft does have some notable competitive advantages in the form of switching costs that many technology companies lack. The most salient feature about this investment is that Microsoft trades at a free cash flow yield (free cash flow per share/price per share) of over 10% at a price of about $24.4

In an article on the Graham and Doddsville newsletter, the investor Glenn Greenberg was quoted as saying "if you could buy a decent - not great, but decent quality business with a 10% free cash flow yield - my experience is that you would rarely lose money." Microsoft is certainly a decent business, maybe not the great business it used to be, but one which you can imagine being around in the next 10 years. Microsoft has been facing steep competition from open software and free operating systems for years, but they've held their ground. Even still, their most recent operating system was well received and even though their game unit only contributes to 1% of earnings, it has been gaining market share on Nintendo and Sony.

Low Cost Producers and a Deflationary Environment

Deflation has been receiving much attention as inflation is running right about at zero, so I was theorizing what kind of of firm would do well in a deflationary environment. On the surface it would seem businesses which produce at the lowest possible cost. Deflation is merely the reduction in the price of goods most often because of diminished demand. Firms like Wal-Mart which prices below competition because of their low costs could surely handle a decrease in prices. Their margins may narrow, but they won't be bleeding red ink like their competition which will not be able to price below their costs.

Warren Buffett has ramped up purchases in Wal-Mart and Wells Fargo, both low cost producers with Wells having a low cost of obtaining credit. Though I don't think Buffett is buying on the premise of deflation, contrarily he has grown exceptionally concerned about inflation. Bloomberg had reported he was reducing the duration of his bonds. The longer the duration of the bond, the more exposed you are to rises in interest rates/inflation as rises in rates leads to a decline in the value of bonds. So his intent to purchase Wal-Mart was more likely because of price. He has held the stock for many years and it is arguably the cheapest its been in the past 10-15 years.

In any case, macroeconomic fundamentals are very difficult to predict. I think Buffett and many other investors would agree, that it is exceptionally difficult to accurately predict macro environments. Case in point would be the mid 2000's. Many were calling (James Grant of Grant's Interest Rate Observer for one) for higher interest rates and a depreciated U.S. dollar. What happened? Post 2008 the dollar appreciates as investors "flee to safety" of the dollar and interest rates plummet to historical levels. Long-term fundamentals probably to favor those projected trends, but predicting short-term values are likely to be exceptionally difficult. So investing should be limited largely to firm and industry specific data. There is plenty to know about any given business, and worrying about the economy just detracts from where your attention should be.