Sunday, April 29, 2018

Cunningham & Cuba, The Warren Buffett Shareholder

I have often marveled at the number of books written about all things Buffett and Berkshire. Reading The Warren Buffett Shareholder: Stories from inside the Berkshire Hathaway Annual Meeting (Harriman House, 2018), I learned one reason for this profusion: they sell. In 2005 The Bookworm, an Omaha bookstore that is the only non-Berkshire affiliated booth at the annual meetings, sold 3,500 copies, or 8.5 tons!, of Poor Charlie’s Almanack. The bookstore at Omaha’s Eppley Airfield, which offers books that Buffett and Munger recommend at each annual meeting, on at least one occasion needed the police to control the crowd. And book signings regularly take place during these meetings in an Omaha Dairy Queen. This is, I guess, what happens when Warren Buffett says, in response to a question about what a young person should do to become a great investor, “Read everything you can.” And when he claims to have read every book in the Omaha Public Library with the word finance in the title by the age of ten, some twice.

The latest addition to the Buffett/Berkshire corpus is a collection of 40 reminiscences about Berkshire annual meetings. One theme running throughout is the people who attend, the relationships that are formed and cemented, the “faith” that is deepened. Yes, attendees hear Warren Buffett and Charlie Munger answer questions, but many of the shareholders are familiar with what they’re likely to say. After all, Berkshire has made only small tweaks to its investing principles over the years. Moreover, they could sit at home and watch streaming video of the meeting. The draw is not so much the words as the ethos and the people. Attendees describe the experience in religious terms as a pilgrimage or a revival meeting, in mundane terms as an oil change (admittedly, for the soul).

Berkshire has a relationship with its shareholders that no other company does. And thus its shareholder meetings are unique. The Warren Buffett Shareholder demonstrates just why that is and why people keep going back, year after year. It’s hard not to feel better having read it.

Wednesday, April 25, 2018

Sachs, Unsafe Thinking

Following the safe path, sticking with the tried-and-true, leads to mediocrity. To thrive, especially in conditions of rapid change, you must be willing to embrace the unconventional. This is the basic thesis of Jonah Sachs’s Unsafe Thinking: How to Be Nimble and Bold When You Need It Most (Da Capo Press/Hachette, 2018).

Sachs talked with more than 100 innovators to learn how they had succeeded in taking bold, intelligent risks. The insights he gained from them, coupled with the findings of academic research, provide the backbone of his book.

The six key components of unsafe thinking (and the six parts of the book) are courage, motivation, learning, flexibility, morality, and leadership. Here I’ll share a couple of the points Sachs makes on learning and flexibility.

Being, and (worse) acting like, an expert can “lead us, unwittingly, down the path to entrenchment. … The endpoint of this path is close-mindedness and over-confidence.” It’s far better to act like an explorer, “to openly ask questions, gain knowledge in new fields, and constantly expand [one’s] expertise.” One should “spend time doing things that make you a beginner again.” Sachs explains that “engaging in just about anything that is both challenging and unfamiliar creates more cognitive flexibility. Being a rank beginner breaks down overactive pattern recognition, giving you a boost of creativity, even when you return to your area of expertise.”

Flexibility is an essential ingredient of unsafe thinking. Sachs suggests that tapping into intuition is a way of becoming flexible. Let’s say a person has a counterintuitive idea. Should he move forward with it? “Because analysis alone can’t prove the unusual idea is right, proceeding demands a heavy dose of intuition.” As Jack Welch said, good decisions come “straight from the gut.”

But intuition can be “fickle and unreliable.” It can be used as “a cover to go into biased thinking.” Intuitions aren’t truths but hypotheses that need to be tested, to be checked with feedback and data.

Unsafe Thinking is an illustrated (with stories) roadmap for navigating those situations, increasingly frequent in our fast-paced world, where more-of-the-same or incremental change just won’t do.

Tuesday, April 24, 2018

Davenport, The Space Barons

I have my feet firmly planted on the earth’s surface, with no desire to travel into space. But that doesn’t undermine the pull of Christian Davenport’s The Space Barons: Elon Musk, Jeff Bezos, and the Quest to Colonize the Cosmos (Public Affairs / Hachette, 2018). It’s a tale of intense competition, dueling styles, and cosmic dreams.

The book focuses on SpaceX and Blue Origin, although it also touches on the endeavors of Richard Branson and Paul Allen and other pioneers whose names are not so well known.

Elon Musk’s SpaceX is normally center stage in any discussion of private, entrepreneurial space exploration. Musk is, as Davenport describes him, “the brash hare” with a knack for grabbing the limelight. (Who else would, in “pure Silicon Valley swagger,” park a shiny, white rocket that stretched seven stories long outside the headquarters of the FAA?) SpaceX’s mantra is “Head down. Plow through the line.” Jeff Bezos, by contrast, has been “the secretive and slow tortoise.” In fact, the turtle is Blue Origin’s mascot, the embodiment of one of Bezos’s favorite Navy SEAL sayings: “Slow is smooth and smooth is fast.” And the company’s only partially turtle-like motto is “Gradatim Ferociter” (step by step, ferociously).

In prose more than worthy of a staff writer at the Washington Post, Davenport glides effortlessly between biographical vignettes, engineering and financial challenges in building spacecraft, government obstacles to private space exploration, project failures and triumphs, and rivalry as “the best rocket fuel.”

Musk and Bezos have different goals, goals that neither of them is likely to see achieved in his lifetime. Musk wants to colonize Mars, a “fixer-upper of a planet.” Mars could be a plan B habitat in case something horrific happens to Earth, such as an asteroid strike that threatens to wipe out humanity. Bezos wants to preserve Earth by zoning it “residential and light industrial” and moving all heavy industry into space. “The thing that’s going to move the needle for humanity the most,” he said, “is mining near-Earth objects and building manufacturing infrastructure in place.” Both goals seem—well—just plain weird. But then so was transforming a tiny online bookstore into a retail juggernaut and cloud computing service company. The sky is no longer the limit.

Sunday, April 22, 2018

Wapner, When the Wolves Bite

The title of Scott Wapner’s book, When the Wolves Bite: Two Billionaires, One Company, and Wall Street’s Most Epic Battle (Public Affairs/Hachette Book Group, 2018), comes from an article in the Yale Law Journal: “Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System.” That’s as academic as the book gets, which is fine, because, even if you know most of the story, it’s still a page-turning account of what became a vituperative personal battle over Herbalife. Is Herbalife in effect a Ponzi scheme that the government should shut down (Bill Ackman’s position) or is it a legitimate company on which investors can make money, especially in the event of a short squeeze (Carl Icahn’s view)?

Scott Wapner was the obvious person to write this book since he hosted “the brawl” between Ackman and Icahn on CNBC’s Halftime Report (January 25, 2013) in which Icahn, despite his Princeton philosophy degree, sounded eerily like his friend Donald Trump, with claims such as “as far as I’m concerned the guy [Ackman] is a major loser.” Unfortunately for Ackman, Icahn would be right in one sense—Ackman would take a major loss on his short Herbalife position and Icahn would profit handsomely from his investment in the company.

Herbalife is a multilevel marketing (MLM) company in which distributors are compensated for what they sell as well as for how many new recruits they bring in. In its swashbuckling early days it often seemed to cross the line of legality, and, even as the shorts and longs battled it out, the FTC fined Herbalife $200 million and put in place regulations to ensure that it had real customers and didn’t misrepresent how much money its distributors could make.

Wapner delves into the early research that eventually prompted Ackman to short the company’s stock and explores the role of activist investors. But at its heart When the Wolves Bite is a tale of outsize egos going to battle using the money of investors in their funds. Ackman came out bloodied, his reputation tarnished (not only by his Herbalife position but also by his forays into Valeant and ADP), and his assets under management now half their 2015 peak. Carl Icahn, in the meantime, stepped down as President Trump’s special adviser on deregulation amid controversy and is smarting from three straight years of either outright losses or massive underperformance in his investment fund.

Is there a moral to the story? I could suggest several, but I’m sure my readers could think of even more. So I’ll leave it to your imagination. In the meantime, if you want an engaging, fast read, When the Wolves Bite may be just the ticket.

Wednesday, April 18, 2018

Schilit, Financial Shenanigans, 4th ed.

It has been 25 years since Howard M. Schilit first published Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports. And it has been eight years since I reviewed the third edition of the book, starting, and hopelessly dating, my post with the words: “with Jeff Skilling (and now Richard Scrushy) back in the news….” It seems like a lifetime ago. But, alas, financial shenanigans never go out of style. And investors must keep an eye out for them.

In this fourth, fully revised and updated edition (McGraw-Hill, 2018), Howard Schilit, with the help of co-authors Jeremy Perler and Yoni Engelhart, delves deep into ways in which companies, even reputable companies, cook their books and corporate management teams fool investors. The book is a must read for every active investor. And, of course, a bonanza for short sellers.

So, what kinds of ruses do companies use? They manipulate earnings, cash flows, and key metrics, and they employ “creative” acquisition accounting. Schilit explains these ploys in easily understandable prose and illustrates them with case studies.

Let’s look at a single case study, new to this edition, and one of my personal favorites: Valeant. In 2007 Valeant hired McKinsey & Company to help jump-start its growth. The team, led by Michael Pearson, “advised a radical strategy—cutting internal R&D and pursuing growth through acquisitions and price increases.” The following year Valeant recruited Pearson to become its CEO, and he set out on an acquisition spree.

In 2010 Valeant and Canadian-based Biovail agreed to merge and, for tax purposes, to locate the headquarters of the combined company in Quebec. Biovail had had a sordid accounting history, but Valeant overlooked such “trivial details.” Two years later Valeant acquired another company with a well-known history of accounting problems, Medicis. In 2013 Valeant paid a steep premium for the financially troubled Bausch & Lomb. Then, in the widely reported and followed “unorthodox” partnership with Bill Ackman, the company set its sights on Allergan but was rebuffed. In 2015 Valeant acquired Salix Pharmaceuticals, another troubled company “just working its way through a major accounting scandal.”

With each acquisition investors cheered and Valeant’s stock price jumped. When Pearson became CEO its stock price was $13.24. Soon after the Salix acquisition it hit its all-time high of $262.52. Expensive acquisitions of tainted or troubled companies caused Valeant’s GAAP-based losses to intensify, “but the profitability metric that management focused on, ‘cash earnings,’ grew and compounded.” This was accounting gimmickry. “Acute investors understood that while it was impossible to know the exact catalyst that would spark the unraveling, they knew the downfall would be inevitable, no matter how big the balloon inflated.”

A Hillary Clinton tweet about price gouging dinged the stock, but it was the expos√© of Valeant’s fraudulent relationship with Philidor Rx, a mail-order pharmacy, that sent its stock into free fall. Pearson was ousted as CEO, the SEC began investing the company for fraud, and all the debt raised to finance acquisitions came back to haunt it. “By April 2017, … Valeant’s share price crash-landed below $9, an incredible decline of 96 percent from its summer 2015 peak.”

Analysis in hindsight, of course, is much easier than analysis in real time, but with the proper tools investors can avoid companies poised to crash and burn—or short them. Financial Shenanigans is a great place to start learning the ropes.

Sunday, April 15, 2018

Brodie and Harnack, The Trust Mandate

The Trust Mandate: The behavioural science behind how asset managers really win and keep clients by Herman Brodie and Klaus Harnack (Harriman House, 2018) is a short book (about 130 pages of text). It starts by looking at some seeming anomalies regarding which managers attract the most asset inflows—notably, not necessarily the best performers. A lot of “soft factors” go into the decision to hire (and fire) an asset manager. People search for “personal character traits to help them make predictions about the manager’s future behaviour or, at least, to reassure them that the positive impressions they have gained elsewhere are justified.” They want an asset manager who is trustworthy, who is both willing and able to act in their interests.

Trust, the authors explain, is “inseparable from risk or vulnerability. There is no need for trust in the absence of risk. … So, in a risk-oriented business, like asset management, trust is a genuine asset—a form of social capital.”

The authors cite a curious finding regarding the relationship between trust and market efficiency. In an efficient market, as we know, prices should respond fully and swiftly to the arrival of firm-specific news. And yet, prior to Sarbanes-Oxley, “this rapid adjustment tended to occur only if the firm was incorporated in a high-trust region. If the firm happened to be based in a lower-trust region, investors were less likely to take the information at face-value. Their hesitation caused the initial stock price reaction to be more sluggish.” Think, for instance, of post-earnings-announcement drift. The region of the U.S. with the highest level of trust was the Northwest; with the lowest, East South Central (Kentucky, Tennessee, Mississippi, Alabama). Following the introduction of the Sarbanes-Oxley Act, “the effect was eliminated. Regulation, it appears, has the possibility to raise the minimum level of trust in all firms—even in a sophisticated and well-developed capital market like in the US.”

How does an asset manager inspire a potential client to trust him? The authors offer a range of suggestions, from the fragrance of hand cleansers in the washrooms of the asset manager’s offices to the trade-off between warmth and competence where “one additional unit of warmth, so to speak, will bring providers closer to a high-trust relationship than one additional unit of competence.”

The authors have struggled mightily to tease out the many strands in a trusting client-manager relationship. Ideally, we want to deal with someone who is, let’s say, talented, diligent, shares our values, and isn’t a jerk. But how do we rate these attributes? Are we willing to hire a less talented investment manager who isn’t a jerk over the jerk who is extremely talented? Probably. I assume that most asset management firms have already figured this out and keep their talented jerks hidden from public view. Or make them CEOs. (And, no, I won’t name names.)

Wednesday, April 11, 2018

Fraser, Class Matters

“Class matters in America precisely because the country has labored so hard to pretend it doesn’t.” This is the defining premise of Steve Fraser’s latest book, Class Matters: The Strange Career of an American Delusion (Yale University Press, 2018).

Fraser chose six icons of American history, none of which at first glance seems to have much to do with class, to frame his narrative: the settlements at Plymouth and Jamestown, the U.S. Constitution, the Statue of Liberty, the cowboy, the “Kitchen Debate” between Richard Nixon and Nikita Khrushchev, and the March on Washington and Martin Luther King’s “I Have a Dream” speech.

Here I’ll look briefly at the utopian view underlying the “Kitchen Debate.” At the American National Exhibition in Moscow in 1959, in the kitchen of a six-room suburban ranch house at the center of the exhibit that, it was claimed, “everyone in the United States could afford,” Vice President Nixon and Soviet Premier Khrushchev argued over “which society was likely to produce the best stoves, washing machines, televisions, electrical appliances, and other consumer delights.” The American Tomorrowland kitchen on display that year “promised to level the playing field between haves and have-nots.”

The notion of leveling was a common cultural theme at the time. One American magazine after the other touted the demise of social and economic classes. House Beautiful, for instance, wrote: “Our houses are all on one level, like our class structure.”

Admittedly, the post-war U.S. economy boomed, as did the country’s standard of living. A dominant view at the time was that “the modern corporation together with the welfare state worked to efface class. … Neither capitalist nor socialist, this new social species fused free-market liberalism with social democracy.”

But, even then, material well-being and social security were not universally available. “[A] whole phalanx of government housing programs, private-sector financing, local zoning protocols, and state and federal tax subsidies and shelters guaranteed that those options were really only practicable for families of more than modest means and of the right complexion. The suburban dream, like the American Dream more generally, turned out to be part real, part hallucination: class (and race) matter, no matter the efforts to make it go away.”

Sunday, April 8, 2018

Yardeni, Predicting the Markets

In one way or another every investor and trader predicts markets, even though some claim they’re not doing it and others decry the very attempt. Warren Buffett, for instance, famously said that “the only value of stock forecasters is to make fortune tellers look good.”

The economist Edward Yardeni, president of Yardeni Research, is a proud, self-described prognosticator. He calls his newly released, 600-page professional autobiography Predicting the Markets.

The book, which spans the author’s 40 years on Wall Street, ranges over geographies, socio-economic and business phenomena (technology and productivity, inflation, business cycles, consumers, demography), and markets (real estate, bonds, commodities, currencies, corporate earnings, valuation, stocks). The book itself contains no charts, a decision I applaud. Instead, the charts, and updated versions of them, are available on a companion website and are downloadable as .pdf files.

Yardeni has always grounded his prognostications in current analysis, which Ben Bernanke described as “getting an accurate assessment of the current economic situation, requiring a deep knowledge of the data mixed with a goodly dose of economic theory and economic judgment.” Throughout the book Yardeni explains the theory and judgment he brought to bear on relevant data to inform his predictions.

Yardeni is an old-school economist who claims never to have run a regression since his graduate school days. As a result, his book, though occasionally dense, is eminently readable by anyone with an interest in the interplay between economics and the financial markets over the years. No math background required.

Although Yardeni’s charts and the book’s final chapter bring his story up to date, one of the greatest contributions of this book is the historical context it provides to those economists and Wall Streeters who haven’t had such lengthy careers as the author. Perhaps even more important is the insight it offers into current analysis and the interplay among economic and market variables. In an obvious case, as Yardeni writes, “Predicting the stock market shouldn’t be all that difficult since only two variables drive it … -- earnings and the valuation of those earnings. But it’s tougher than it sounds, because both of those variables are driven by so many others.” Predicting the Markets connects a lot of dots.

Wednesday, April 4, 2018

Town, Invested

Danielle Town’s “12-month plan to financial freedom,” Invested: How Warren Buffett and Charlie Munger Taught Me to Master My Mind, My Emotions, and My Money (William Morrow, 2018), written with help from her bestselling author father Phil Town, is much better than the search-tag-filled subtitle would lead one to believe.

The setup is this: Danielle Town, a young lawyer, had always tuned out when her father, author of Rule #1 and a motivational speaker, had tried to get her to invest. But she eventually realized that, without investing, she would end up a wage slave for her entire life. And so, she finally decided to become her father’s student—and, having some of the entrepreneurial instincts of her father, to do a podcast of their conversations, and then to write a book based on these podcasts.

Danielle Town had two hurdles to overcome in order to become an active investor. First, she “was never one for numbers.” Second, and more devastating, she was terrified of investing. The first month in her 12-month plan thus dealt with “becoming brave.” Describing her fear, she writes: “I feel like I’m entering a dimly lit parking garage through an enclosed concrete stairwell with heavy doors at both ends, and I didn’t pack my pepper spray because it didn’t fit in my clutch and also I was afraid I would accidentally set it off in the crowded bar, and yes I had a few generously poured aged bourbons and still my radar is going off, saying, ‘Girl, don’t go into that concrete stairwell.’ … There are two types of people in the world—those who look at the Enclosed Concrete Stairwell and think nothing, and those who look at the Enclosed Concrete Stairwell and think, There’s a good possibility that this won’t end well for me. The first type is, more often than not, men; the second type is generally women. … [M]y instinctual reaction to the idea of investing in the stock market was GET THE HELL OUT OF THAT ENCLOSED CONCRETE STAIRWELL AND CALL AN UBER, IT’S WORTH THE SURGE PRICING.”

Even though Warren Buffett would probably have told her to put her money in an index fund, her father wanted her to get returns closer to Buffett’s than to the S&P 500. And she wanted to invest in companies whose mission and values she could support. So, in months two through twelve, she learned about value investing √† la Buffett and Munger, how to compile an antifragile portfolio, when to sell, and living thankfulness.

Invested is an inspirational book for the unwilling investor. Even though many people who read it will get only as far as buying an index mutual fund, it might speak to a new generation of potentially active investors as well. But those who are galvanized to invest on their own should understand that one book doth not a successful investor make. Nor, as Town points out, does one year. “There’s still a lot to practice.” And to learn.