Video: A Conversation with Charlie Munger

DuBridge Distinguished Lecture: A Conversation with Charlie Munger

California Institute of Technology

March 11, 2008

Video length: 106 minutes

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If you would like to download the video, see this post: RealPlayer - A Useful New Addition
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Poor Charlie's Almanack
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Fairholme: Semi-Annual Report

Over the eight and a half years since the Fund’s inception, we have lived by the belief that you should be fearful where others are greedy and to be greedy where others are fearful. We continue to ignore the crowd.

For instance, as energy stocks surged this year, we took profits in Canadian Natural
Resources, reducing our position to about 7% of net assets as of May 31, down from 15% on Nov. 30, 2007. Oil and gas prices have multiplied since our initial purchases and are now high enough to increase supply and slow demand. Alternative sources such as solar and wind are booming while sales of SUVs and other gas hogs have plunged.

We also halved our position in Berkshire Hathaway in the November-May period. While we have the greatest respect for Chairman Warren Buffett, we made this move because we cannot see how the company can replicate its past stellar performance given its current size and the age of its key personnel. Berkshire should still make good money for shareholders, but not enough to justify so large an investment at prices sold.

With the proceeds of sales, new inflows, and cash held for stressful times, we are buying healthcare stocks, ranging from manufacturers of ethical and generic drugs to health maintenance organizations, at what we consider reasonable or even dirtcheap valuations. Many of these stocks’ prices fell off the proverbial cliff prior to our purchases and have declined further since we took our initial positions. On May 31, global pharmaceutical giant Pfizer was about 10% of net assets, making it the Fund’s second largest holding. Also in the top ten is WellPoint, a provider of health maintenance organizations and other forms of medical insurance. These fundamentally sound businesses have become fallen angels, as slowing growth, rising costs, and election-year politics stoke investor fear. Still, these are companies with essential products and services and large free cash flows relative to purchase prices. We expect them to rise again.

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Bill Miller - Legg Mason Value Trust - Q2 Letter

From Bill Miller's Q2 Letter:

A group of us were standing around a few weeks ago when Warren Buffett wandered over. Chris Davis had dubbed us the Value Support Group, as we all adhered to that approach to investing. We were commiserating over how badly we had done in this market, how valuation appeared not to matter and had not for the past couple of years, how it was all about momentum and trend, and how we were all losing clients and assets over and above our losses in the market. It seemed like we needed a 12-step program to cure us of our addiction to buying beaten-up stocks trading at large discounts to our assessment of their intrinsic value. 

Mason Hawkins said, "Warren, I'm an optimist. I think this whole thing can turn quickly, and surprise people. Are you an optimist?" "I'm a realist, Mason," the sage replied. Warren went on to say he was optimistic long term, and backed that up in a talk the next morning on the remarkable history of growth, innovation, and wealth creation the U.S. had produced over the past 200-plus years. He also offered a sober assessment of the current challenges we face, and said it would take some time to work through them. 

He then made the perfectly sensible point that as we are all net savers, we should be happy if stock prices declined a lot more, so we could buy even better bargains. That is a point Charlie Ellis elaborated on in his fine book, Investment Policy, a few years back. As a matter of logic, it is irrefragable. As a matter of psychology, I think most of us value investors think we have plenty enough bargains already, and may not be able to handle that many more. Or more accurately, our clients may not be able to. We are value investors because we are persuaded of the logic of buying shares of businesses when others want to sell them, and we understand that lower prices today mean higher future rates of return, and high prices today mean lower future rates of return.

Oak Value Fund - Q2 Letter

Recent Purchases

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Diageo - Diageo is the world’s leading premium drinks business with an outstanding collection of international brands across the spirits, wine and beer categories. Operating in some 180 countries around the world, the company has become truly global. Well known brands including Ketel One and Smirnoff vodkas, Johnny Walker Scotch Whiskies, Captain Morgan’s rum, Bailey’s Original Irish Cream liqueur, J&B Scotch Whiskey, Tanqueray gin, Crown Royal, Beaulieu Vineyard and Sterling wines, Bushmills Irish Whiskey, and Guinness stout populate the company’s product portfolio. In addition, the company also has the distribution rights for the Jose Cuervo tequila brands in the United States and other countries.

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Diageo is also a prior Fund holding and a company that we consistently monitor for the opportunity to buy its shares at an attractive price/value relationship. The company has been steadily adding brands to its portfolio and continuing to leverage local and regional brands in to create global franchises. On a parallel track, Diageo’s management has been disciplined in its efforts to continually improve its cost structure throughout its brands and business lines.

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Increased investor concern regarding a slowing U.S. consumer has contributed to the weakness of the company’s shares as this geographic region represents about 30 percent of total sales. While we acknowledge Diageo's U.S. market position, it is not the dominance in this market that attracts us. Instead, we are more focused on the global nature of the overall company – the other 70 percent. As we have experienced with other portfolio companies with a similar international mix, we believe the international components will more than offset any further weakness in the U.S. markets. Additionally, we believe the trend seen over the last few years to premium spirits will continue, benefiting Diageo—which holds one of the largest premium portfolios in the global spirits business.

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Put simply, we believe Diageo is a high quality business and that its shares are significantly undervalued. The company management’s focus on improving returns on invested capital has served to only reinforce our attraction to this business.

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Also, Larry Coats (co-manager of the fund) recently made another appearance on BNN and discussed American Express and Tiffany, among other things.

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Upfront and Unscripted with Jeff Bezos (Audio)

I think Jeff Bezos and Chris Anderson are two of the best people from which to learn. I don't know how I missed this podcast the first time, but it is really great (in my opinion). I also think the iPod-like comparison is a valid one for The Kindle. A quote I enjoyed from Bezos: "You have to have a willingness to be misunderstood if you're going to pioneer."

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In this Upfront and Unscripted session, visionaries Jeff Bezos, Founder and CEO of Amazon.com, and Chris Anderson, Executive Editor of Wired and author of The Long Tail, participate in a one-on-one informal but incisive discussion focused on the evolving impact of Amazon’s Kindle on publishing models and reader habits.

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Kindleistas in the digital media continue to fuel the tipping-point chatter while others in the trade point to implications for publishers in a iPod-like digital mono-channel. Meanwhile, newer Kindle models are sure to bring stylistic and user changes that will encourage greater adaptation from consumers farther down the Long Tail. This is a conversation any stakeholder in the book industry should not miss.

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This podcast episode begins with a special announcement from Bezos and Simon and Schuster President and CEO Carolyn Kroll Reidy. Reidy announced that Simon and Schuster will be make 5,000 additional titles available to Kindle users by the end of 2008, more than doubling their current offering.

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The Amazon Kindle

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Previous Bezos posts/links:

Amazon.com's Jeff Bezos - Interviews

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Who's Writing the Book on Web Business? (1996 short interview with Bezos)
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Put Buyers First? What a Concept
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Jeff Bezos D6 Interview - Highlight Reel

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Previous Anderson posts/links:

Free! Why $0.00 Is the Future of Business by Chris Anderson

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Article: "The Long Tail" by Chris Anderson

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The Long Tail: Book and Audio Book

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The Long Tail Web Site

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The Capacity of Self-Control

A quick checklist that might be of use by one under the influence of temptation…...be it the temptation to invest outside of one’s circle of competence, the temptation to break a diet, give in to a bad habit one is trying to get rid of, act over an amorous occurrence (per the example of Epictetus below), or anything else.

1. Remind yourself to take care of your _______.

To illustrate, let’s use the example of one who is either on a diet or just trying (or needs) to eat healthy. When that fresh, 2-slice special of double cheese, pepperoni pizza crosses your path, it may be useful to remind yourself of the importance of taking care of your body/health (to fill in the blank above).

To use another example related to investing, when you see a stock with huge upside but it is either a little outside of your circle of competence or has too much debt, it may be a good idea to remind yourself to take care of your downside first, before thinking about the upside potential.

2. Just because something exists and you are able to do something (i.e. it is physically possible for you to do it, whether you should or not), that doesn’t mean it is an option for you to do (way for you to behave).

Just because the pizza exists (or the orange chicken, fried rice and egg roll combo), that doesn’t mean it is has to be an option for you to pursue if you are trying to eat healthy. Consider only what falls within your parameters.

Likewise, just because a stock looks like it is really undervalued by looking at a few numbers or by looking at who else is buying shares, it doesn’t mean it should actually be an option for you to buy if it is outside of your circle of competence, even if you are physically capable of executing the trade.

3. Ask yourself, what capacity do you have to deal with this situation?

This final determination comes from Epictetus in The Encheiridion (#10 – Nicholas P. White translation):

At each thing that happens to you, remember to turn to yourself and ask what capacity you have for dealing with it. If you see a beautiful boy or woman, you will find the capacity of self-control for that. If hardship comes to you, you will find endurance. If it is abuse [abusive words], you will find patience. And if you become used to this, you will not be carried away by appearances.

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For other translations of The Enchiridion (aka -The Encheiridion or The Handbook), click HERE.

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Mr. Buffett on the Stock Market - 1999 Article from FORTUNE

Let me come back to what I said earlier: that there are three things that might allow investors to realize significant profits in the market going forward. The first was that interest rates might fall, and the second was that corporate profits as a percent of GDP might rise dramatically. I get to the third point now: Perhaps you are an optimist who believes that though investors as a whole may slog along, you yourself will be a winner. That thought might be particularly seductive in these early days of the information revolution (which I wholeheartedly believe in). Just pick the obvious winners, your broker will tell you, and ride the wave.

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Well, I thought it would be instructive to go back and look at a couple of industries that transformed this country much earlier in this century: automobiles and aviation. Take automobiles first: I have here one page, out of 70 in total, of car and truck manufacturers that have operated in this country. At one time, there was a Berkshire car and an Omaha car. Naturally I noticed those. But there was also a telephone book of others.
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All told, there appear to have been at least 2,000 car makes, in an industry that had an incredible impact on people's lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, "Here is the road to riches." So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies--themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America--and also an enormous impact, though not the anticipated one, on investors.
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Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money. But there was one obvious decision you could have made back then--it's better sometimes to turn these things upside down--and that was to short horses. Frankly, I'm disappointed that the Buffett family was not short horses through this entire period. And we really had no excuse: Living in Nebraska, we would have found it super-easy to borrow horses and avoid a "short squeeze."
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U.S. Horse Population 1900: 21 million 1998: 5 million
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The other truly transforming business invention of the first quarter of the century, besides the car, was the airplane--another industry whose plainly brilliant future would have caused investors to salivate. So I went back to check out aircraft manufacturers and found that in the 1919-39 period, there were about 300 companies, only a handful still breathing today. Among the planes made then--we must have been the Silicon Valley of that age--were both the Nebraska and the Omaha, two aircraft that even the most loyal Nebraskan no longer relies upon.
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Move on to failures of airlines. Here's a list of 129 airlines that in the past 20 years filed for bankruptcy. Continental was smart enough to make that list twice. As of 1992, in fact--though the picture would have improved since then--the money that had been made since the dawn of aviation by all of this country's airline companies was zero. Absolutely zero.
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Sizing all this up, I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did.
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I won't dwell on other glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors: the manufacture of radios and televisions, for example. But I will draw a lesson from these businesses: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

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Mandela: His 8 Lessons of Leadership - By Richard Stengel

Nelson Mandela has always felt most at ease around children, and in some ways his greatest deprivation was that he spent 27 years without hearing a baby cry or holding a child's hand. Last month, when I visited Mandela in Johannesburg — a frailer, foggier Mandela than the one I used to know — his first instinct was to spread his arms to my two boys. Within seconds they were hugging the friendly old man who asked them what sports they liked to play and what they'd had for breakfast. While we talked, he held my son Gabriel, whose complicated middle name is Rolihlahla, Nelson Mandela's real first name. He told Gabriel the story of that name, how in Xhosa it translates as "pulling down the branch of a tree" but that its real meaning is "troublemaker."

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As he celebrates his 90th birthday...Nelson Mandela has made enough trouble for several lifetimes. He liberated a country from a system of violent prejudice and helped unite white and black, oppressor and oppressed, in a way that had never been done before. In the 1990s I worked with Mandela for almost two years on his autobiography, Long Walk to Freedom. After all that time spent in his company, I felt a terrible sense of withdrawal when the book was done; it was like the sun going out of one's life. We have seen each other occasionally over the years, but I wanted to make what might be a final visit and have my sons meet him one more time.

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I also wanted to talk to him about leadership. Mandela is the closest thing the world has to a secular saint, but he would be the first to admit that he is something far more pedestrian: a politician. He overthrew apartheid and created a nonracial democratic South Africa by knowing precisely when and how to transition between his roles as warrior, martyr, diplomat and statesman. Uncomfortable with abstract philosophical concepts, he would often say to me that an issue "was not a question of principle; it was a question of tactics." He is a master tactician.

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No. 1

Courage is not the absence of fear — it's inspiring others to move beyond it

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No. 2

Lead from the front — but don't leave your base behind

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No. 3

Lead from the back — and let others believe they are in front

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No. 4

Know your enemy — and learn about his favorite sport

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No. 5

Keep your friends close — and your rivals even closer

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No. 6

Appearances matter — and remember to smile

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No. 7

Nothing is black or white

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No. 8

Quitting is leading too

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Book: Long Walk to Freedom

A Find in Fremont

This is an analysis by my friend and colleague, Matt Miller, on Fremont Michigan Insuracorp (FMMH.OB):
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A Find in Fremont

Fremont Michigan Insuracorp Inc. (FMMH.OB), headquartered in Fremont, MI, the “Baby Food Capital of the World,” underwrites multiple lines of personal and commercial insurance, including homeowners and automobile, exclusively in the state of Michigan. The company dates its founding back to 1876, though it only recently came public via a demutualization in 2004. The company struggled in the early to mid nineties with inadequate rates and was nearly forced out of business by state regulators. Fortunately, Dick Dunning, a former Gerber financial executive came in as CEO and turned the company around.

Discount to Book Value

The company currently trades at a significant discount to stated book value. The reported balance sheet book value per share is $21.64 (adjusted for recent stock dividend, as are all numbers that follow) and the company is currently trading at $18.34 [Note - it is actually at $16.50-$17.00 today, but $18.34 was the price when the numbers were pulled together for the analysis], which means its shares can be purchased for approximately 84.8% of book value.

Hidden Asset

Included in book value per share is the company’s owned headquarters building in the town of Fremont. It is large brick building which provides adequate room for growth, as within the last ten years it housed nearly 100 employees, but now currently hosts approximately 60. According to the company’s statutory financial statements filed with the state of Michigan, the book carrying value at December 31, 2006 was approximately $760,000 while the fair value of the property as appraised in 2005 was approximately $3,400,000. Given that the building has been further depreciated since that time and that there are approximately 1.83 mm shares outstanding, the book value of the company is being understated by at least $1.45 per share. Adjusting book value for this asset leads to an adjusted value of approximately $23.09 per share, which means shares in the company can be purchased in the open market at 79.4% of adjusted book value.

Insurance Operations and Underwriting

The company is a single state indirect writer in Michigan of both personal (70% of DPW) and commercial lines (30% of DPW), including its two largest lines of business, personal auto (33% of DPW) and homeowners (31% of DPW). Its other significant lines of business include business owners, commercial package, workers comp, farm and marine. For the most part, the company writes its business in rural and western Michigan, preferring to stay away from more litigious areas like Detroit. It focuses on insuring good risks, typically with higher insurance credit scores of 700 or higher. The company’s agent base consists of approximately 180 agents in its target markets, a number which has purposefully been trimmed over the last several years from about 220. The company has made a conscious effort to eliminate poor performing agents and create an atmosphere of “franchise-like” territories for its agents.

Despite the current soft market in insurance, the company has been prudently expanding its book of business by growing its auto coverage, a feat made possible by its investments in technology (detailed below). Most of the growth has been achieved by pairing auto policies with its traditionally larger book of homeowners policies. The company would like to be more aggressive with its expansion of its commercial lines, but given the current soft market and the greater price sensitivity in the commercial lines, it has been unwilling to sacrifice the quality of its commercial book for growth in its commercial book.

None of these numbers would mean very much if the company ran a poor insurance operation, but fortunately, the team at FMMH runs a fine book of business. The company’s reserves for claims tend to be conservative, and in fact the company has been redundant in six of the last ten years. Per the company’s most recent 10-k below is the cumulative net of reinsurance redundancies (deficiencies) over the last ten years.

Year..........Net Cumulative Redundancy

........................(Deficiency) (mm)

1997....................682
1998....................866
1999...................-407
2000...................-1,843
2001...................-256
2002...................-477
2003....................2,765
2004....................5,597
2005....................6,584
2006....................4,132

The company’s new CFO, Kevin Kaastra, joined the company in 2003. His stated desire or philosophy when it comes to reserving is to not have to go back to shareholders with deficiencies. There may be some additional upside to the company’s book value given the most recent reserving and this philosophy, but we do not build it into our valuation. At the very least this suggests that the company’s adjusted book value is not overstated because of reserving deficiencies. Stated book value and adjusted book value ought to be fairly representative of the company's true economic position.

Also provided below is a table, from the most recent 10-k of the company’s underwriting results over the last eight years. It highlights two important points. First the significant decline in loss experience, driven partly by the release of reserves and partly by some exceptional underwriting results in 2005 and 2006 (calm weather years). Second, it shows a more recent spike in the expense ratio, something the company is working on improving. All of the company’s investment in technology has taken place in the last three years and those cost of internal technology development are being amortized over three years, which is much shorter than the true useful life of the technology. It is admittedly an area the company needs to improve upon to remain competitive. The company’s target is a 34 expense ratio (as a note its target combined ratio is 94).


.......................................2000.....2001.....2002.....2003.....2004.....2005.....2006.....2007
Net loss and LAE ratio....65.60....86.70....64.80....62.80....62.70....53.40.....44.80.....57.10
Expense ratio....................35.50....33.10....39.40....38.10....35.40....32.30.....34.60.....37.20
GAAP combined ratio....101.10..119.80..104.20..100.90...98.10....85.70.....79.40.....94.30

The company runs a very conservative, perhaps too conservative, reinsurance program. Its maximum exposure on any one risk is $150,000 and on any one catastrophe event is $1,250,000. These low “deductibles” also play a part in the company’s higher expense ratio. As the company is now in a much stronger financial position, it has indicated its willingness to retain some additional risk. While such a decision may add additional risk to the balance sheet and result in a more volatile earnings stream, given the history of the company’s underwriting and the current cost of maintaining its reinsurance coverage, the long-term economics of the business should improve.

Balance Sheet

The company currently runs a conservative investment balance sheet. FMMH has no toxic investments, like those coming to light on a number of other insurers balance sheets. Below is the investment profile of the company’s balance sheet at December 31, 2007. The company’s mortgage-backed securities are all GSE securities.


.........................................................................................2007
...............................................................Fair Value........................Allocation
Fixed maturities:

U.S. Treasury securities and
Obligations of U.S. government
corporations and agencies..................................................3,198,181.............................5.40%
States and political subdivisions..................................... ...25,761,183...........................43.80%
Corporate securities..............................6,833,902...........................11.60%
Mortgage-backed securities..... ........................................14,735,608............................25.10%

Equity Securities:

Common Stocks.....................................8,305,133.............................14.10%
Preferred Stocks...................................................0...............................0.00%

Total investments.............................$ 58,834,007..........................100.00%


Investments in Technology

As the company has strengthened its capital position over the last several years, it has made significant investments in technology. An internally developed system known as Fremont Complete, positions them well in the agency community and for growth in the future. The company has spent approximately $2.5 mm over the last three years developing this automation platform.

Miscellaneous

- the company’s A.M. Best rating was reaffirmed in January of this year at B++ (company is targeting an A- to better position itself in commercial lines of business)
- 13.2% of the company is owned by management, the board and the company’s 401(k)
- the company recently announced a buy-back of 100,000 shares, representing approximately 5.6% of the outstanding shares
- company recently announced a 3% share dividend in conjunction with share repurchase (numbers in this write-up have been adjusted accordingly)
- very little to no institutional holdings

Risks

Local Catastrophes and Weather

The company is a single-state writer of homeowners insurance, which amplifies its risk on localized catastrophes. Though the risk is mitigated somewhat by the nature and frequencies of the risks in Michigan and its current reinsurance policies, expanding to additional states over time would broaden their geographic exposure and provide opportunities for significant growth. The major weather risks faced by the company are the impact of extreme cold weather in the winter (causing fires, frozen pipes, melting water, additional auto accidents, etc.) and thunderstorms in the summer (causing wind, rain damage, etc.). Though there are occasionally tornados in the state, their frequency is far below that of other states in the Midwest. The chart below, generated from NOAA Satellite and Information Services data, puts this storm type in perspective.


.................................................Number of Tornados (1998 through 2007)

State..................................Total Tornados..........F1 or Higher..........F2 or Higer
Michigan...................................178.............................77...........................14
Iowa...........................................643...........................237...........................77
Oklahoma..................................672...........................284...........................93
California...................................102.............................17.............................1
North Carolina..........................326...........................116...........................26

Michigan Economy

Also, as a single state writer in Michigan, the company faces a difficult local economy as industrial jobs have migrated elsewhere. Though something to keep an eye, the company’s focus on western, rural Michigan as opposed to the heavily industrialized areas of the eastern part of the state helps mitigate this risk to some degree.

Michigan Regulation

As a single state writer of insurance, which is heavily regulated by the state, the company will face the threat of adverse regulatory changes in Michigan. Michigan is currently a modified no-fault auto state (suits are permitted only when an injured person suffers death, serious disfigurement or serious impairment of a bodily function) and it requires unlimited medical coverage to auto accident victims. The state run MCCA fund provides mandatory reinsurance for claims over $325k. Currently the state allows the use of credit scoring in insurance underwriting, though this is now being challenged in the state courts. A change in any of these policies or other state regulations could have a significant impact on the company’s operations.

Dependence on Underwriting Results

One of the drawbacks to the current state of the company is the lack of investment leverage (see chart below). The significant growth in equity over the last several years has outpaced the growth in company’s investment portfolio. The result is that future growth in book value is almost completely dependent on sound underwriting results. It certainly necessitates discipline, something we believe the management to have, but it does need to be considered a risk and recognized as a diminishing factor in the company’s valuation profile.


..........................................2002.....2003.....2004.....2005.....2006.....2007
Investment Leverage......3.17.......4.22.......2.66.......2.05.......1.79.......1.60

Valuation

So considering the risks, nature of the business, and economics, what do we think the company is worth? Given the company specific risks, nature of its underwriting and reserving, its prospects for additional market share accumulation in the state of Michigan and possible expansion into other states we believe a multiple to book of 1.3 to 1.4 times is appropriate. The overall price to tangible book value of the property and casualty industry is 1.7 (FMMH book value is all tangible). Allowing for a discount of .4 to .3 times book value due to the single state nature of its business and the fact that it is a micro cap company, we derive a value, per share, of $30.02 to $32.33. That would result in a discount to intrinsic value of between approximately 39.5% and 43.3%, and since we are buying below an understated book value, we see very little downside to a long-term holder at these prices. Believing that the company has the infrastructure and management expertise to grow its intrinsic value in the range of 10-14% per year over the next several years, we find such a discount to be quite attractive. Given these parameters we expect a greater than 20% per year return over the next five years.

Potential Catalysts
- the company was demutualized in 2004 and as part of that process no individual entity could own more than 5% of the company’s outstanding shares for five years; this period ends next fall (there are a couple holders of more than 5% currently which had to go through exhaustive processes with the state of MI after inadvertently going over the 5% limit)
- share buy-back
- further leveraging of expense ratio
- continued growth in BV per share
- change in reinsurance program to add additional risk to balance sheet
- increase investor awareness of a small-cap bulletin board stock

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*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision. We own shares of the company, either directly or indirectly, and we may buy or sell shares at any time without updating this post.

Wesco Financial 1990 Letter

Great find by Dual_Bid on the MSN Berkshire Board.
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Also, if you own the latest edition of Peter Bevelin's Seeking Wisdom: From Darwin to Munger, check out page 268 where he gives Charlie's excerpt as a lesson on why bad lending happens so often. The current financial crisis provides further evidence of this and also shows the wisdom in Mark Twain's quote: "History doesn't repeat itself, but it rhymes." The present situation was very likely avoidable.
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Mr. Munger's insights on the lending business:
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Granting the presence of perverse incentives, what are the operating mechanics that cause widespread bad loans (where the higher interest rates do not adequately cover increased risk of loss) under our present system? After all, the bad lending, while it has a surface plausibility to bankers under cost pressure, is, by definition, not rational, at least for the lending banks and the wider civilization. How then does bad lending occur so often?

It occurs (partly) because there are predictable irrationalities among people as social animals. It is now pretty clear (in experimental social psychology) that people on the horns of a dilemma, which is where our system has placed our bankers, are extra likely to react unwisely to the example of other peoples' conduct, now widely called "social proof". So, once some banker has apparently (but not really) solved his cost-pressure problem by unwise lending, a considerable amount of imitative "crowd folly", relying on the "social proof", is the natural consequence. Additional massive irrational lending is caused by "reinforcement" of foolish behavior, caused by unwise accounting convention in a manner discussed later in this letter. It is hard to be wise when the messages which drive you are wrong messages provided by a mal-designed system.

In chemistry, if you mix items that explode in combination, you always get in trouble until you learn not to allow the mixture. So also, in the American banking system. To us, a lot of foolish, unproductive lending and many bank insolvencies are the natural consequences, given existing American banking culture, of the combination of the following two elements alone:

(1) virtually unlimited deposit insurance; and

(2) uncontrolled interest rates on insured deposits.

These two elements combine to create a Gresham's law effect, in which "bad lending tends to drive out good." Then, if factor (3) below is added to an already unsound combination, we think deposit-insurance troubles are sure to be further expanded -- and not by a small amount:

(3) relatively unregulated, non-insured, low-cost "non-bank" banks.

Moreover, when the government starts suffering big deposit-insurance losses, if it continuously responds (in a natural, unthinking reaction) by raising deposit-insurance prices, we think it creates a "runaway-feedback" mode and makes its problems worse. This happens because the government, by adding even more cost pressure on banks, increases the cause of the troubles it is trying to cure. The price-raising "cure" is the equivalent of trying to extinguish a fire with kerosene.

Many eminent "experts" would not agree with our notions about systemic irresponsibility from combining (1) "free-market" pricing of interest rates with (2) government guarantees of payment. If many eminent "experts" are wrong, how could this happen? Our explanation is that the "experts" are over-charmed with an admirable, powerful, predictive model, coming down from Adam Smith. Those discretionary interest rates on deposits have a "free-market" image, making it easy to conclude, automatically, that the discretionary rates, like other free- market processes, must be good. Indeed, they are appraised as remaining good even when combined with governmental deposit insurance, a radical non-free-market element.

Such illogical thinking, displays the standard folly bedeviling the "expert" role in any soft science: one tends to use only models from one's own segment of a discipline, ignoring or underweighing others. Furthermore, the more powerful and useful is any model, the more error it tends to produce through overconfident misuse.

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This brings to mind Ben Graham's paradoxical observation that good ideas cause more investment mischief than bad ideas. He had it right. It is so easy for us all to push a really good idea to wretched excess, as in the case of the Florida land bubble or the "nifty fifty" corporate stocks. Then mix in a little "social proof" (from other experts), and brains (including ours) often turn to mush. It would be nice if great old models never tricked us, but, alas, "some dreams are not to be." Even Einstein got tricked in his later years.

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COMPLETE 1990 WESCO LETTER

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1997-2007 Wesco Letters

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Berkshire Letters

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Markel Annual Meeting Notes 2008

These are a couple of months old, but with the stock price currently hanging just below $330 per share, I thought one line might be a worthwhile one to review:

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(2) Steve Markel thinks Markel should be valued at 2x Book Value. At the current book value (as of 3/31) of $263 Book value, that puts shares at $526.

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*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

The endowment effect: It’s mine, I tell you

Mankind’s inner chimpanzee refuses to let go. This matters to everything from economics to law

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“I AM the most offensively possessive man on earth. I do something to things. Let me pick up an ashtray from a dime-store counter, pay for it and put it in my pocket—and it becomes a special kind of ashtray, unlike any on earth, because it’s mine.” What was true of Wynand, one of the main characters in Ayn Rand’s novel “The Fountainhead”, may be true of everyone. From basketball tickets to waterfowl-hunting rights to classic albums, once someone owns something, he places a higher value on it than he did when he acquired it—an observation first called “the endowment effect” about 28 years ago by Richard Thaler, who these days works at the University of Chicago.

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The endowment effect was controversial for years. The idea that a squishy, irrational bit of human behaviour could affect the cold, clean and rational world of markets was a challenge to neoclassical economists. Their assumption had always been that individuals act to maximise their welfare (the defining characteristic of economic man, or Homo economicus). The value someone puts on something should not, therefore, depend on whether he actually owns it. But the endowment effect has been seen in hundreds of experiments, the most famous of which found that students were surprisingly reluctant to trade a coffee mug they had been given for a bar of chocolate, even though they did not prefer coffee mugs to chocolate when given a straight choice between the two.

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Moreover, it is now possible to see the effect in the brain. In the June 12th edition of Neurone, Brian Knutson of Stanford University describes a brain-scanning study he carried out recently. The pattern and location of the activity he observed suggests the endowment effect works by enhancing the salience of possible loss. But that still does not explain why this sense of loss should be felt. The question is whether such behaviour is truly irrational, or just “differently” rational. That might be the case if, for instance, it was a hangover from the evolutionary past that worked then, but is no longer appropriate now.

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Mug’s game
The endowment effect has nothing to do with wealth (it is not as if chocolate bars and coffee mugs matter) or transaction costs (in most experiments these are zero). Not even emotional attachment, whatever that means, can really be called in as an explanation, since the effect is both instantaneous and sometimes felt even by those who buy and sell for a living. According to Pete Lunn, an economist at the Economic and Social Research Institute in Dublin, professional market traders are often reluctant to sell investments they already hold, even though they could trade them for assets they would prefer to invest in if starting from scratch.

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Keep on trucking
Because the endowment effect touches on so many areas, Dr Jones thinks it may be helpful for legislators to understand its evolutionary origins. That goods and rights such as pollution permits, radio spectrum and mobile-telephone licences do not inexorably flow towards the most efficient distribution worries the legal scholars charged with designing fair allocations. The effect also complicates the negotiation of contracts, as people demand more to give up standard provisions than they would have been willing to pay had they bargained anew.

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Nor is the endowment effect alone in suggesting that Homo economicus is a rarer species than neoclassical taxonomists would like to believe. Other “irrational” phenomena include confirmation bias (searching for or interpreting information in a way that confirms one’s preconceptions), the bandwagon effect (doing things because others do them) and framing problems (when the conclusion reached depends on the way the data are presented). All in all, the rational conclusion is that humans are irrational animals.

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Related books:
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Nudge: Improving Decisions About Health, Wealth, and Happiness
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Predictably Irrational: The Hidden Forces That Shape Our Decisions (Also available in an AUDIO BOOK)

Tectonic shifts - Apollo Asia Fund: the manager's report for 2Q2008

The greatest economic shock came from inflation. Headline inflation is now running at 9-12% in much of South and Southeast Asia, and 27% in Vietnam. Food and fuel is a large part of expenditure in this part of the world, and increases in the raw commodities have a much greater impact with fewer layers of markup, so there is immediate pressure to increase wages. However, the complacent assumptions of a few months ago on the inflation-hedging merits of property have been shaken even as inflation has accelerated so dramatically: property markets across the region have been softening.

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With consumption in the US and Europe now weakening, due to new caution on the part of both consumers and lenders, Asian exporters will have a tougher time than ever. Many squeezed prices to the bone in recent years and are only now trying to put through price increases: some have pricing power and some do not, but in any case volumes will suffer. And Asia is more, not less, dependent on exports than in past cycles.

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Globally, the initial outcome of the inflation-deflation conundrum is a reversal of the last twenty years: inflation in the price of things we need (food, energy, healthcare...), deflation in the prices of what we own (real estate, many financial assets...). Comprehensive worldviews have never been our strength, and we have a sneaking suspicion that the most visionary are prone to overlook details which reverse the practical implications. It seems easier to think individually about the impact of currently-visible trends on individual companies, and whether the balance of evidence has tipped the risk-reward ratio to the point where action seems appropriate. This is what we do, without necessarily spotting clear trends as a result.

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IFRS, the new accounting standards, make the task of analysing individual companies much harder: for the amateur investor, or for strategists trying to evaluate the whole stock universe, they must be a nightmare. Spreadsheets are necessary to extract long lists of exceptional items from reported profits in order to discern the trends. Headline earnings are so volatile as to be meaningless; book values are now based on shifting sands rather than the rock of objectivity. The job of the institutional CIO is unenviable. A recent FT article revealed that Sir David Tweedie was reacting to abuses he saw in the 1980s: his cure seems likely to result in much greater abuse in the long run, with the immediate drawback of incomprehensibility - which seems especially unfortunate when business conditions are so volatile. The time-honoured Asian practice of keeping three sets of books - one for the bank, one for the taxman, and one for the management - is returning, but now we have one set for the management and another for the public (and doubtless the other sets too). Inefficient markets may favour the stockpicker, but are hardly in the public interest.

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GREENLIGHT CAPITAL RE INVESTOR PRESENTATION

GREENLIGHT CAPITAL RE INVESTOR PRESENTATION

Tuesday, June 3, 2008

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Agenda
John Andre, Group V.P. A.M. Best – Industry Overview and Rating Process
Len Goldberg, CEO – Background and Vision
Bart Hedges, President and CUO – Underwriting Philosophy and Examples
David Einhorn, Chairman – Investment Review/Preview
Tim Courtis, CFO – Capital and Risk Management
Q&A and Reception

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Seth Klarman - 2006 Video

Great find by Dang Le:
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Guest Lecturer Seth Klarman - Psychology of Leadership
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If you would like to download the video, see this post: RealPlayer - A Useful New Addition
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Other Seth Klarman posts/links:
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Seth Klarman Interview
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Seth Klarman - October 2007 Remarks at MIT (pdf)
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The Gospel of Wealth by Andrew Carnegie

Description from Wikipedia:

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"Wealth", or what is more commonly known as "The Gospel of Wealth", is an essay written by Andrew Carnegie in 1889 that described the responsibility of philanthropy by the new upper class of self-made rich. The central thesis of Carnegie's essay was the peril of allowing large sums of money to be passed into the hands of persons or organizations ill-equipped mentally or emotionally to cope with them. As a result, the wealthy entrepreneur must assume the responsibility of distributing his fortune in a way that it will be put to good use, and not wasted on frivolous expenditure. The very existence of poverty in a capitalistic society could be negated by wealthy philanthropic businessmen and women.

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Andrew Carnegie effectively softened some of the harshness of the theory of social Darwinism. He preached that ostentatious living and amassing private treasures were wrong. Carnegie professed the virtues of a laissez-faire system in which the government did not interfere with an individual or organization's right to do as it pleased. His "gospel of wealth" earned much praise, but did not win many converts. Carnegie made it clear that the wealthy were responsible for the recirculation of their money back into society where it could be used to support the greater good. He claimed that, in bettering society and people here on earth, one would be rewarded at the gates of Paradise.

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Carnegie based his philosophy on the observation that the heirs of large fortunes frequently squandered them in riotous living rather than nurturing and growing them. Even bequeathing one's fortune to charity was no guarantee that it would be used wisely, since there was no guarantee that a charitable organization not under one's direction would use the money in accordance with one's wishes. Carnegie disapproved of charitable giving that merely maintained the poor in their impoverished state, and urged a movement toward the creation of a new mode of giving which would create opportunities for the beneficiaries of the gift to better themselves. As a result, the gift would not be merely consumed, but would be productive of even greater wealth throughout the society.
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Carnegie put his philosophy into practice through a program of gifts to endow public libraries in cities and towns throughout the United States, with the idea that he was thus providing people with the tools to better themselves. In order to ensure that his gifts would not be wasted, he stipulated that the municipality must pass an ordinance establishing a tax to support the library's ongoing operating costs after the initial grant provided the costs for building and equipping the library. After several communities squandered their grants on extravagant buildings, Carnegie established a system of architectural guidelines that mandated simplicity and functionality. When it became obvious that Carnegie could not give away his entire fortune within his lifetime, he established the Carnegie Foundation to continue his program of giving.

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Read: THE GOSPEL OF WEALTH

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Related Book: The Autobiography of Andrew Carnegie and The Gospel of Wealth

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Other biographies: Andrew Carnegie By Joseph Frazier Wall; Andrew Carnegie By David Nasaw

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My $650,100 Lunch with Warren Buffett - By Guy Spier

Buffett has always made a point of doing business with integrity — and of working only with people who share his values. As we learned at lunch, he credits his father with teaching him at an early age to rely on his own sense of what's right, rather than look for affirmation from others. "It's very important to live your life by an internal yardstick," he told us, noting that one way to gauge whether or not you do so is to ask the question, Would you rather be considered the best lover in the world and know privately that you're the worst — or would you prefer to know privately that you're the best lover in the world, but be considered the worst?

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