Inside Wall Street's Black Hole by Michael Lewis

In my opinion, one should just file Black-Scholes in the same category as the Efficient Market Hypothesis/Theory, the Capital Asset Pricing Model (CAPM), Beta, etc. That category, to borrow a term from Charlie Munger, should be labeled TWADDLE. But let's hope 99+% of colleges/universities continue to teach them so that value investors can have some limit to competition.

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For years, investors have relied on a complex formula to manage risk. But what happens if the Black-Scholes model is wrong—and we're in bigger trouble than ever?
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Oddly, this failure of financial theory didn't lead Wall Street to question Black-Scholes in general. "If you try to attack it," says one longtime trader of abstruse financial options, "you're making a case for your own unintelligence." The math was too advanced, the theorists too smart; the debate, for anyone without a degree in mathematics, was bound to end badly. But after the crash of 1987, individual traders at big Wall Street firms who sold financial-disaster insurance must have smelled a rat. Across markets—in stocks, currencies, and bonds—the price of insuring yourself against financial disaster rose. This rise in prices and the break with Black-Scholes reflected two new beliefs: one, that huge price jumps were more probable and likely to be more extreme than the Black-Scholes model assumed; and two, that you can't manufacture an option on the stock market by selling and buying the market itself, because that market will never allow it. When you most need to sell—or to buy—is exactly when everyone else is selling or buying, in effect canceling out any advantage you once might have had.

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"No one believes the original assumptions anymore," says John Seo, who co-manages Fermat Capital, a $2 billion-plus hedge fund that invests in catastrophe bonds—essentially bonds with put options that are triggered by such natural catastrophes as hurricanes and earthquakes. "It's hard to believe that anyone—yes, including me—ever believed it. It's like trying to replicate a fire-insurance policy by dynamically increasing or decreasing your coverage as fire conditions wax and wane. One day, bam, your house is on fire, and you call for more coverage?"

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THE PROBLEM

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 This is interesting: The very theory underlying all insurance against financial panic falls apart in the face of an actual panic. A few smart traders may have abandoned the theory, but the market itself hasn't; in fact, its influence has mushroomed in the most fantastic ways. At the end of 2006, according to the Bank for International Settlements, there were $415 trillion in derivatives—that is, $415 trillion in securities for which there is no completely satisfactory pricing model. Added to this are trillions more in exchange-traded options, employee stock options, mortgage bonds, and God knows what else—most of which, presumably, are still priced using some version of Black-Scholes. Investors need to believe that there's a rational price for what they buy, even if it requires a leap of faith. "The model created markets," Seo says. "Markets follow models. So these markets spring up, and the people in them figure out that, at least for some of it, Black-Scholes doesn't work. For certain kinds of risk—the risk of rare, extreme events—the model is not just wrong. It's very wrong. But the only reason these markets sprang up in the first place was the supposition that Black-Scholes could price these things fairly."

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Black-Scholes didn't work; trillions of dollars' worth of securities may have been priced without regard to the possibility of crashes and panics. But until very recently, no one has bitched and moaned about this problem too loudly. Lay folk might harbor private misgivings about the clergy, but as lay folk, they are reluctant to express them. Now, however, as the subprime market unravels, the beginnings of a revolt against the church seem to be taking shape.

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One of the revolt's leaders is Nassim Nicholas Taleb, the bestselling author of The Black Swan and Fooled by Randomness and a former trader of currency options for a big French bank. Taleb can precisely date the origin of his own personal gripe with Black-Scholes: September 22, 1985. On that day, central bankers from Japan, France, Germany, Britain, and the United States announced their intention to torpedo the U.S. dollar—to reduce its value in relation to the other countries' currencies. Every day, Taleb received a list of his trading positions from his firm and a matrix describing his risks. The matrix told him how much money he stood to make or lose, given various currency fluctuations. That September 22, when the central bankers announced their plan to lower the dollar's value, he made money but didn't know it. "I didn't know what my position was," he says, "because the movement was outside the matrix they'd given me." The French bank's risk-analysis program assumed that a currency crash of this magnitude would occur once in several million years and therefore wasn't worth considering.

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Taleb made a killing that day, but it wasn't thanks to a grand plan and it wasn't happy money. "People in dark suits started coming from Paris," he says. "They said that the only way I could have made that much was to have taken far too much risk." But he hadn't. They had simply failed to account for the true nature of risk in financial markets. "Then I started looking at the history of markets," he says. "And I saw that these sorts of things happened all the time." Taleb became obsessed with the way prices in the options market, based on the famous Black-Scholes model, underestimated the risk of extreme and rare events. He set up his trading to profit from such events by buying up disaster insurance that would, according to Black-Scholes, be considered overpriced. When October 19, 1987, arrived, he was prepared. "Ninety-seven percent of all the returns I ever made as a trader, I made on that day," he says.

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THE SOLUTION

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 In the past two years, Taleb has co-authored a pair of papers that have appeared in the sort of academic journals that originally published the Black-Scholes model. He and his co-author attack the model head-on in its own language (math), and as much as call for a retraction of the Nobel Prize awarded to Myron Scholes and Robert Merton for their work in creating the model. "This is what I'm saying to Merton and Scholes," Taleb says. "You guys are just parasites. You're not bringing anything useful to the market. You are lecturing birds on how to fly. You're watching them fly. And then you're taking credit for it."

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He's saying more than that, actually. He's saying that the academics, in lecturing the birds, have made flying more difficult.

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Books:

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Fooled by Randomness

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The Black Swan

The psychology of the housing mess - By Richard H. Thaler and Cass R. Sunstein

With the housing collapse, human decisions — whether on Wall Street or on Main Street — played a critical role. So it's instructive and, indeed, essential that we understand the human decision-making of today's crisis so that we don't veer down this treacherous road again.
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The first problem is that with respect to borrowing, cultural values have radically changed in the past three decades. For most of the 20th century, most American homeowners had a single-minded goal: Pay off the mortgage. Owning a home outright was every family's dream. If a windfall came their way, people would often use it to pay off that damn mortgage.
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But in the 1990s, this principle dissolved under the pressure of temptation. With house prices rising, families started using home equity loans to finance their spending habits. And as interest rates plummeted, many families refinanced their mortgages to finance more lavish lifestyles. Who could resist the combination of lowering the monthly payment and getting an extra $25,000 to use for a new media room?
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A complicated world
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In normal circumstances, all this borrowing might "merely" have cut into savings rates. That would have been bad enough, because savings has been hovering around zero for the past few years. But when real estate prices began to fall, and variable-rate mortgage payments started to reset, families found themselves in deep trouble.
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Why didn't people foresee the dangers? A key reason is that the choice among mortgage options has become impossibly complicated. With all the bureaucratic mandates, the incomprehensible terms and the fine print, even the most sophisticated borrowers are unable to compare plans.
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Borrowers also fell prey to the pervasive failing known as "extrapolation bias," which is the all-too-human tendency to assume that the current trend will continue forever. Remember when Internet stocks were increasing in value? Many people expected that they could count on continued increases. So what did they do? They put most of their money in technology stocks — and got walloped.
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In real estate, countless Americans caught this fever. Not surprisingly, one of the many markets with the biggest foreclosure problems was Las Vegas, which experienced one of the highest rates of price appreciation in real estate over the past decade.
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The unfortunate group includes homeowners who saddled themselves with mortgages they couldn't pay, and speculators who thought that a good way to get rich was to buy several homes with cheap money.
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The crisis is compounded by what psychologists call "loss aversion." The real estate market is by no means immune to this phenomenon. Numerous studies have shown that humans hate losses much more than they like gains. This means that losing $1,000 hurts you about twice as much as winning $1,000 makes you feel good. In the stock market, investors hold on to losers longer than winners, even though there are tax incentives to do just the opposite.
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How does this play out in the housing market? Reluctant to take less for their houses than their neighbor got just a year ago, sellers tend to keep their houses on the market for far too long. So even as the market began to go south, people foolishly failed to budge.
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For the future, an understanding of these problems offers some important lessons for individuals and government alike. Prudent homeowners should start thinking more like their parents' generation. They should plan to pay off their mortgages by the intended date of retirement; that would be a great start on a retirement savings plan.
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New strategies
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Also, homeowners should beware of extrapolating from current trends. When neighbors start to say prices can only go up because everyone wants to live there, stop listening. A red-hot real estate market tends to usher in what former Fed chairman Alan Greenspan famously called "irrational exuberance."
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People who have a house on the market now would be wise to step back and reassess their strategy. If a house has been languishing for months, it might well be time to accept your fate and lower the asking price. Those who have made bad investments are often tempted to wait until they can recoup their purchase price. That's a mistake.
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For government, the best response is to take immediate steps to ensure that borrowers are able to make sensible comparisons among different plans.
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Mortgage providers today tend to deluge people with fine print and confusing details. Government regulation, which mandates endless pages of complex disclosures, makes the situation even worse. Borrowers feel overwhelmed. They agree, often cluelessly, to the terms placed in front of them.

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Related Book: Nudge: Improving Decisions About Health, Wealth, and Happiness

David Einhorn on WealthTrack

David Einhorn on WealthTrack: Video 4/25/08

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Book: Fooling Some of the People All of the Time: A Long Short Story

Speech: "Private Profits and Socialized Risk"

Major Takeaways from a Visit with Warren Buffett

Some notes from University of Western Ontario students' visit with Mr. Buffett on March 31, 2008. The source and a PDF file of these notes can be found HERE.


Life Learning Lessons

1. Using the concept of buying or shorting 10% of one of your friends to identify the things that make people successful in life. You want to add more of the characteristics that make your friends more valuable and remove those characteristics that are devaluing. It’s never too late to change.

2. Being humble gains respect. Check your ego at the door.

3. Try to live within your means.

4. Be loyal to your friends and expect loyalty in return.

5. Be reasonable with your view towards social responsibility. Berkshire would never buy a tobacco company; however, they will invest in retailers that sell tobacco.

6. Being an inherent optimist is a key trait to success.

7. When I asked how he balanced his passion for investing with his commitments to his wife and family, he said “never have contracts with your family” meaning that no silly rules or formal routines are necessary if true happiness is involved.

8. A good business partnership evolves into something intuitive over time, when it’s based on the proper balance of trust, humour, accuracy, and friendship

9. Formula for happiness: kids that love you, a job you jump out of bed for and working with people you enjoy being around.

10. Most important choice in life is one’s spouse.

11. Do what you’re best at and then give the fruits of your labour to people who are best at humanitarian work. Don’t muddy the waters with inefficient capital or resources.

12. Do what you love, not for the money, do it because it’s in your heart.

Market Specific Recommendations

1. The 19th century belonged to England, the 20th century belonged to the US and the 21st century belongs to China. Invest accordingly.

2. Have a long term view. Short term events are a good source of experience and learning points, but stick with the end goal and don’t be rattled.

3. Use volatility to your advantage.

4. Buy healthcare stocks in a basket to diversify risks since it is very difficult to decipher which company’s pipeline is most optimal.

5. Vices are a good business because they are human nature.

6. Financial institutions should, in general have more regulations.

7. Markets are not efficient.

8. Read as many annual reports as possible per year without knowing the stock price. Try to value the stock independently of knowing its valuation.

9. Buffett reads “Value Line” (http://www.valueline.com/) to source his information on investing.

10. Highly recommends Katherine Graham’s Autobiography

Quotes

1. “Look to be turned on everyday in life. Doing something solely to build your resume is like saving up sex for your old age.”

2. “Happiness is tap dancing to work every day.”

3. "Wealth allows you to be meaner."

4. "It's hard for a man not to be happy when he comes home to happy family and home."

5. "Surround yourself by people who love you and will support you in life. This support system is integral to happiness."

6. "I do what I do because I love to do it, not because I need the money. It's fun and I surround myself with people I enjoy seeing everyday"

7. “Success begets success and it starts from the inside and flow out.”

8. “Brilliance is the ability to simplify a mass amount of information in to a simple yes/no decision.”

9. "There are many very wealthy people (other billionaires) in this world and they are very unhappy. Money does not buy happiness."

10. "If you ever want to find me on line playing bridge, look for TBONE, that's my name."

11. “Success is getting what you want. Happiness is wanting what you get.”

12. “Giving unconditional love is the best thing you can do. When you give it out you get it back 2x, you can’t get rid of it.”

Giverny Capital – 2007 Letter to Partners

It is not easy to have the right temperament toward market quotes. The vast majority of investors perceive the daily market quotes as an ultimate judge of value. At Giverny Capital, we do not evaluate the quality of an investment this way. In our mind, we are owners of the businesses we invest in. Consequently, we study the growth in underlying earnings of our companies and their long-term perspectives. Every year, we submit a table showing the growth of the intrinsic value of our businesses that we measure using the term invented by Warren Buffett: owner’s earnings.

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We therefore come to an estimate of the intrinsic value increase of our portfolio by adding to the growth in owner’s earnings, our average dividend rate (which is around 1% presently).

Looking Up to Warren Buffett

IT OFTEN SEEMS like every hedge-fund manager is reading from the same playbook about how to look, work and behave. Neatly pressed khakis; thumbs glued to a BlackBerry; slick digs in Greenwich or Manhattan staffed by number-crunching research drones. But apparently, Mohnish Pabrai never got his copy. He wears shorts to his Southern California office, keeps e-mail to a minimum and almost never misses his 4 p.m. nap. And forget goosing returns with fancy computer models or using complex derivatives: Pabrai doesn't even sell stocks short.

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About the only thing slick about this 43-year-old investor is his market-trouncing track record — annualized returns of nearly 25% since he set up shop in 1999, enough to earn him a growing cult following. His "secret"? Probably the most documented investment strategy around — a bare-bones, Warren Buffett style of stock picking. While that description may inspire yawns — sometimes it seems like everybody claims to be a Buffett disciple — Pabrai takes it to an extreme. His office houses an impressive Buffett mini-museum: a wall covered with photos and articles he's amassed over the years. He recently dropped a stunning $650,100 at a charity auction for the privilege of just one lunch with the Berkshire Hathaway guru. Even his minimalist approach to e-mail mirrors the Buffett philosophy of avoiding distractions. And his track record is more than Warren-worthy: A $100,000 investment in his flagship Pabrai Investment Fund 2 in June 2001 would have been worth $465,200 at the end of 2007; the same amount invested in the Dow, only $145,500.

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SM: What are some other mistakes investors make?

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MP: Using the market to tell you what a business is worth. If a stock goes from $10 to $3, most people freak out and sell out. You have to have your own internal yardstick. Sell to the market when the price is higher than what you think the business is worth, and buy when the price is lower. Another problem is that our brains are very poorly evolved to deal with the stock market.
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SM: How so?

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MP: Our brains are in sync with the speed at which the market is moving and totally out of sync with the speed at which a business is moving. It seems obvious: The market is repricing a company's stock very quickly. I can process very quickly; therefore, I make decisions based on that. You have to learn to dramatically slow your brain, which is very hard for most people. The reality is that you should make decisions based on how that business is changing, and that's a very slow process.

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SM: What stocks do you like now?
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MP: Pinnacle Airlines. Depending on how things work out, it's anywhere from a double to five or six times return in the next two or three years.
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SM: An airline?
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MP: It's a regional jet company. The large airlines, like Northwest and Delta, outsource the small planes to Pinnacle. Many of the reasons why airlines are so terrible — load factors, price wars — don't matter. The revenue is the same whether there is one passenger or the plane is full and whether Northwest charges $200 or $2,000 round-trip. The contracts are long-term, usually 10 years, and will hold up in the event of a merger. So you can estimate what their cash flows will be many years into the future.
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SM: What's the investment case?
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MP: Pinnacle has more than $10 a share in cash on the balance sheet. In the next few years, free cash flow will be $3 to $6 a share, depending on how much more business they get. With a simple 10 or 15 multiple on those numbers, you end up with $30.
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SM: Why are the shares so cheap?
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MP: One overhang is that they have a past-due contract with pilots. But not a lot of Wall Street analysts follow Pinnacle, and the business itself is changing. The evolution away from hub-and-spoke and toward more nonstop flights is driving demand for their services. When you connect one small city to another directly, you aren't going to run a jumbo or a 737.

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Book: The Dhandho Investor: The Low - Risk Value Method to High Returns by Mohnish Pabrai

Amazon.com's 2007 Letter to Shareholders - Jeff Bezos

We humans co-evolve with our tools. We change our tools, and then our tools change us. Writing, invented thousands of years ago, is a grand whopper of a tool, and I have no doubt that it changed us dramatically. Five hundred years ago, Gutenberg’s invention led to a significant step-change in the cost of books. Physical books ushered in a new way of collaborating and learning. Lately, networked tools such as desktop computers, laptops, cell phones and PDAs have changed us too. They’ve shifted us more toward information snacking, and I would argue toward shorter attention spans. I value my BlackBerry—I’m convinced it makes me more productive—but I don’t want to read a three-hundred-page document on it. Nor do I want to read something hundreds of pages long on my desktop computer or my laptop. As I’ve already mentioned in this letter, people do more of what’s convenient and friction-free. If our tools make information snacking easier, we’ll shift more toward information snacking and away from long-form reading. Kindle is purpose-built for long-form reading. We hope Kindle and its successors may gradually and incrementally move us over years into a world with longer spans of attention, providing a counterbalance to the recent proliferation of info-snacking tools. I realize my tone here tends toward the missionary, and I can assure you it’s heartfelt. It’s also not unique to me but is shared by a large group of folks here. I’m glad about that because missionaries build better products. I’ll also point out that, while I’m convinced books are on the verge of being improved upon, Amazon has no sinecure as that agent. It will happen, but if we don’t execute well, it will be done by others.

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Your team of missionaries here is fervent about driving free cash flow per share and returns on capital. We know we can do that by putting customers first. I guarantee you there is more innovation ahead of us than behind us, and we do not expect the road to be an easy one. We’re hopeful, and I’d even say optimistic, that Kindle, true to its name, will “start a fire” and improve the world of reading.

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Related previous post: Put Buyers First? What a Concept

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The Amazon Kindle - $399.00

Leucadia 2007 Letter to Shareholders

In 2007, Leucadia reported $484.3 million in after tax income ($2.10 per share, fully diluted). We lost $88.3 million from continuing operations pre-tax and had non-cash income of $542.7 million by bringing into income part of our deferred tax asset. In the confusing world of GAAP, in a year where we lost money, did not harvest any major gains and all of our reported income came from tax savings on income we have yet to earn, net worth went up 43%, principally from marking to market our investment in one security.

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To sum up as we see it: 2007 was a mediocre year in which (a) the combination of operating company earnings, corporate overhead and security gains were negative and (b) interest on our cash hoard was less than the interest due on our corporate debt. We also had mark to market losses in several limited partnership investments. Time will tell whether they recover. Fortunately our investments in our two mining ventures described below are progressing very well and we have potential profits in both, only some of which has already been recognized in shareholders’ equity.

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Run Spot Run
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What follows is our oversimplified version of what has happened to the world over the last 30 years.
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In 1988, one of us, with children, took a trip up the Amazon River on a flat bottom boat. After a week of travel, as the river grew shallower and narrower, we rounded a bend. There ahead, someone had cleared an open space where a small village resided. We disembarked to investigate.

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Off in the distance a familiar sound could be heard. With the village children in tow we followed a path into the jungle. There was a small Sony generator, a TV and a moveable satellite dish that a scientific team left behind years before. Using this equipment, the inhabitants of the village were watching CNN.

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Even people living in the jungle eking out a subsistence living were watching television and vicariously experiencing the abundance of the Northern Hemisphere. Governments in every part of the world have responded to the rising expectations of their populations. China, despite being a dictatorship, has devised ways for its population to raise its standard of living by becoming the low cost manufacturing center of the world. India has followed a slightly different path, but there too living standards are rising at a dramatic rate. These two countries alone account for one-third of the earth’s population and adding in the rest of Asia over half. The demand generated by the growth of Asia accounts for the dramatic increase in commodity prices that we are all experiencing and reading about in the newspapers.

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This prologue explains why we have ended up doing well with our investments in two mining companies. A great deal of steel and copper is required to supply and build the infrastructure for 3.7 billion people. The growth story in Asia is continuing and in the future we may be looking for more opportunities to participate, whether inside or outside the U.S.

Whitney Tilson: Let the herd stampede first before making your move

Without doubt, timely and democratic access to financial and market information contributes to smoothly functioning financial markets. But it’s worth asking whether the ubiquity of such information today is a friend or foe of sound investment decision-making. For all but the most active professional traders, the answer is often “no”.

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The biggest problem, as studies have shown, is that investors tend to over-react to news, so its 24/7 availability harms their long-term success.

Take financial talking-heads with a grain of salt - By Mark Sellers

Everyone acts in his or her self-interest. This is a key facet of humanity, and keeps our society moving forward.

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Think about that the next time you make an investment decision. As an investor, it is in your interest for your portfolio to do as well as possible with the least risk possible. Unfortunately, this is not the goal of most of the people you may rely on for news and advice. There are conflicting incentives everywhere in the world of finance.

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This is something to keep in mind when you read the newspaper, watch CNBC, or manage your personal finances. Various stock market players have different incentives, none of which is necessarily in your best interest:

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And a note to Mark Sellers, since the above links to the last article he'll be writing for the Financial Times, thank you for your rational thoughts and all the best!

What Warren thinks...

In early April the megabillionaire hosted 150 students from the University of Pennsylvania's Wharton School (which Buffett attended) and offered Fortune the rare opportunity to sit in as he expounded on everything from the Bear Stearns bailout to the prognosis for the economy to whether he'd rather be CEO of GE - or a paperboy. What follows are edited excerpts from his question-and-answer session with the students, his lunchtime chat with the Whartonites over chicken parmigiana at Piccolo Pete's, and an interview with Fortune in his office.

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I know you had a paper route. Was that your first job?

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Well, I worked for my grandfather, which was really tough, in the [family] grocery store. But if you gave me the choice of being CEO of General Electric or IBM or General Motors, you name it, or delivering papers, I would deliver papers. I would. I enjoyed doing that. I can think about what I want to think. I don't have to do anything I don't want to do. It might be wonderful to be head of GE, and Jeff Immelt is a friend of mine. And he's a great guy. But think of all the things he has to do whether he wants to do them or not.

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How do you get your ideas?

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I just read. I read all day. I mean, we put $500 million in PetroChina. All I did was read the annual report. [Editor's note: Berkshire purchased the shares five years ago and sold them in 2007 for $4 billion.]

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What advice would you give to someone who is not a professional investor? Where should they put their money?

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Well, if they're not going to be an active investor - and very few should try to do that - then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They're not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don't buy all at one time

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How does the current turmoil stack up against past crises?

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Well, that's hard to say. Every one has so many variables in it. But there's no question that this time there's extreme leveraging and in some cases the extreme prices of residential housing or buyouts. You've got $20 trillion of residential real estate and you've got $11 trillion of mortgages, and a lot of that does not have a problem, but a lot of it does. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. That's a hell of a lot - I mean, we talk about having $150 billion of stimulus now, but that was $330 billion of stimulus. And that's just from prime mortgages. That's not from subprime mortgages. So leveraging up was one hell of a stimulus for the economy.

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If that was one hell of a stimulus, do you think the $150 billion government stimulus plan will make an impact?

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Well, it's $150 billion more than we'd have otherwise. But it's not like we haven't had stimulus. And then the simultaneous, more or less, LBO boom, which was called private equity this time. The abuses keep coming back - and the terms got terrible and all that. You've got a banking system that's hung up with lots of that. You've got a mortgage industry that's deleveraging, and it's going to be painful.

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The scenario you're describing suggests we're a long way from turning a corner.

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I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.

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Your OFHEO example implies you're not too optimistic about regulation.

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Finance has gotten so complex, with so much interdependency. I argued with Alan Greenspan some about this at [Washington Post chairman] Don Graham's dinner. He would say that you've spread risk throughout the world by all these instruments, and now you didn't have it all concentrated in your banks. But what you've done is you've interconnected the solvency of institutions to a degree that probably nobody anticipated. And it's very hard to evaluate. If Bear Stearns had not had a derivatives book, my guess is the Fed wouldn't have had to do what it did.

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In the above article, it mentions that Mr. Buffett told students, in response to the question on how he gets his ideas, "I just read. I read all day." Along similar lines, take note of the quote from Charlie Munger:

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"In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time -- none, zero... You'd be amazed at how much Warren reads -- at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out."

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And the Mark Twain quote:

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“The man who doesn’t read good books has no advantage over the man who can’t read them.”

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So, if you're looking for something good to read, START HERE.

CEO Interview: Costco's James Sinegal

IN HIS WARMLY lit open-air office, James Sinegal pulls up the back of his shirt collar to reveal Costco's in-house brand. The shirt is a noticeably fine, tightly woven sky-blue cotton, and the obvious point from the chief executive wearing it is that it's a bargain, at $14.99. "This would sell for $50 to $70 in a department store," he says.

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One of the best bargains Costco offers is the CEO himself. Though the stock is up 15% in the past year, his salary has remained at $350,000 with a maximum $200,000 bonus, putting him near the bottom of most corporate-salary surveys. At a time when investment-bank CEOs are resigning with huge payouts, this sort of frugality is refreshing. But instead of finding the charm in a thrifty CEO who's content to shove six Formica tables together in the conference room, many analysts have pleaded with him to cut costs elsewhere. Take salaries: Costco's average hourly pay, $18.15, is 68% more than the average pay at Wal-Mart. What's more, "he could raise prices a negligible amount and the stock would go through the roof," says Deutsche Bank analyst William Dreher. That advice falls on deaf ears. "That's where it starts, and before you know it, you've got Sears," whose decades-long decline is an American tragedy, in Sinegal's view.

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These days Sinegal is gearing up for another potential tragedy: the American consumer. With unemployment up and home prices down, consumers are getting squeezed. The store that Sinegal cofounded in 1983 caters to the cost-conscious, whose ranks will certainly be growing in the coming year. Costco's goods are priced no more than 15% above cost, which explains why store sales amount to less than 1% of profits.

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Costco's 2.7% profit margins don't indicate much progress toward your 2003-stated goal of 4%. Apparently, this is a thorn in your side. Want to take it back?

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I will not take it back. Shareholders have a right to earn more. But when there is difficult competition, we have to respond.

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You could raise the price of, say, a bottle of ketchup to $1.03 instead of $1, and no one would know. Raising prices just 3% per product would add 50% to your pretax income. Why not do it?

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It's like heroin: You do a little and you want a little bit more. Raising prices is the easy way.
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So how will you improve margins?

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We will sell more of our private label — up to 25% of sales, instead of the 15% we sell now. But I don't want to confuse people. We realize people come for our Sony TV sets and Michelin tires, and we won't disappoint them. We are opening 35 new stores a year — any more would be tough on our management team. We'll buy smarter.
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You're Costco — how much smarter can you possibly buy?

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That's why it's called work. There are ways to cut expenses.

Basic Structure of Investment Process and Valuation by Bruce Greenwald

Prof. Bruce Greenwald's presentation in India, courtesy of Prof. Sanjay Bakshi:

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Basic Structure of Investment Process and Valuation

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Books:

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Value Investing: From Graham to Buffett and Beyond

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Competition Demystified : A Radically Simplified Approach to Business Strategy (In my opinion, it is hard to find a better value than this for $5.49)

Buffett tips off MU crowd

During a videoconference yesterday, University of Missouri business students had the chance to pick the brain of the billionaire investor and CEO of Berkshire Hathaway Inc. as a part of a daylong educational forum hosted by MU’s Trulaske College of Business.

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"Develop your own talents," Buffett said via satellite from a television station in his hometown of Omaha, Neb. He added that oral and written communication skills are the most important tools a person can have coming out of college.
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"If you have those abilities when you’re young, you jump out," the 77-year-old business giant said.

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Related previous posts on the importance of writing well:

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Greg Mankiw - How to Write Well

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So You Want To Be The Next Warren Buffett? How's Your Writing?

Crossing the Rubicon - Bob Rodriguez, FPA

These past two weeks have been extraordinary in that the Federal Reserve has had to take actions that have not been used since the Great Depression and a few that heretofore have never been used. There have been several crises in the capital markets that lead us to comment on what they appear to mean. During the last year, we have conveyed a growing concern, through several prior commentaries, as to the dangers and implications of an absence of fear toward various types of increasing risks in our financial system. We believe the culmination of these risks forced the Federal Reserve to take the recent extraordinary actions of creating two new lending facilities for primary dealers and facilitating a merger of Bear Stearns with JPMorganChase to prevent a liquidity and solvency crisis from potentially toppling the U.S. capital markets. The partners of First Pacific Advisors, LLC (FPA) discussed these events on March 21 and came to several conclusions about what the long-term implications of these actions might be and we will share them with you in this commentary. Fortunately, over the last two years, our preparations for potential financial market disruptions have meant that FPA and most of our product areas have essentially avoided the calamitous effects of this credit crisis.

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The Federal Reserve did not regulate broker/dealers since this was the responsibility of the SEC. Now it appears the Fed has become the lender of last resort to a borrower that had not been regulated or subject to review by the Fed. In essence, the balance sheet of the Fed, and potentially U.S. taxpayers, is being placed at risk for institutions that increased their balance sheet leverage and risk, during good times, so as to enhance their firm’s profitability but now, during a time of difficulty, they are looking to the Fed to be the savior, despite their previous business mismanagement practices. In our opinion, this is a strategy of heads they win, tails the U.S. taxpayer loses.

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In an earlier era, Bear Stearns would have been left to fail. This is not the case today since there was apparently a deep fear on the part of the Fed that a failure of Bear Stearns could create a domino-like crisis infecting a wide array of financial institutions, thereby accelerating and deepening the current credit contagion. As Steven Romick said in our FPA partner meeting on March 21, “I’m more concerned about what I don’t see. Why is it that we are not being told about or seeing another bidder for Bear Stearns other than JPMorganChase? Might JPMorganChase be playing defense so as to protect its $91.7 trillion dollar derivative exposure (according to September 2007 Office of the Comptroller of the Currency data) that is supported by just $123 billion of equity? How much counter party exposure did JPMorganChase have to Bear Stearns?” In our opinion, the Bear Stearns transaction looks very suspicious. If the situation were so precarious, why shouldn’t shareholder ownership have been entirely wiped out because of the excesses and mismanagement by their firm? Why should the Fed’s balance sheet be placed at risk while shareholders are receiving some type of compensation? A week later, the bid was raised from $2 to $10 per share, increasing the value conveyed by approximately $1 billion. Again, why should there be any compensation to shareholders? This compensation is being conveyed to owners of a firm that had derivative positions, with notional amounts as of November 30, 2007, totaling $13.4 trillion. Warren Buffett has, on several occasions, described derivatives as potential “weapons of mass destruction.” Apparently, the collapse of Bear Stearns might have triggered a financial market nuclear meltdown and this potential outcome forced the Fed to intervene.

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Apparently, the risk of a CDS contagion helped to force the Fed’s hand to create a bailout of Bear Stearns. The lack of supervision and control by the SEC that allowed this expansion in risk to develop, and the Fed’s bailout of Bear Stearns, are highly disturbing to all of the partners at FPA.

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In light of the above comments, the partners of FPA came to a unanimous conclusion that the recent Federal Reserve actions and the potential new Congressional policies under consideration are likely to lead to a significantly higher level of long-term inflation in the U.S. We are more than disappointed in the substandard decision making that has taken place within the Federal Reserve and other governmental entities these last several years. The misguided monetary policies of the former Chairman of the Federal Reserve, Alan Greenspan, created an era of “too big to fail” that has led to two major asset bubbles. With each successive bubble, the policy actions available to the Federal Reserve to reduce financial system risk have been systematically reduced. The extraordinary actions taken by the Bernanke Federal Reserve reflect acts of desperation rather than long-term policy solutions. The rapidly changing events within the capital markets are forcing the Fed to adopt policies that have the potential of long-term negative consequences. These recent events, and their fundamental changes to the U.S. financial system, are forcing the leaders of FPA’s product areas to reassess their present portfolio allocations. In essence, we believe we have “Crossed the Rubicon” into a new financial era.

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Related Article: How Fund Manager Didn't Lose a Bundle

Amazon Launches Text-Message Shopping

Amazon.com Inc.'s brick-and-mortar competitors have yet another reason to fear the Web: a new service that lets shoppers compare prices and buy things with a few quick taps on their cell phones.

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Amazon TextBuyIt, which launched late Tuesday, lets people text the name of a product, its description or its UPC or ISBN to 262966 (that's "Amazon" on the keypad) from anywhere their cell phones work - including from inside physical stores.

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If Amazon stocks matching items, the service returns two results at a time. Shoppers can immediately buy one of the first two the selections by texting back the number "1" or "2," or they can ask for more by texting the letter "M."

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New TextBuyIt customers will be prompted to enter the e-mail address associated with their existing Amazon account plus a shipping zip code. The service then calls them and walks through the checkout process using an automated voice system. Shoppers get confirmation by text message and e-mail.

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From there, the customers can check on order status on Amazon's Web site.

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Related previous posts: Put Buyers First? What a Concept, Newsweek: The Future of Reading

Fooled by a Percentage Into Catching Falling Knife! - by Sanjay Bakshi

One of my favorite experiments in class involves asking my students the following question:

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“Suppose that you visit a furniture store in a mall to buy a lamp for your bedroom. You find a lamp you like and it has a list price of Rs. 5,000. Happy with this deal, when you approach the sales representative ready to buy the lamp you picked, she informs you that one of their stores which is just a ten-minute walk from there is closing down and you can buy the same lamp over there for Rs 1,000 less. Please raise your hand if the 20% discount is sufficient incentive for you to walk ten minutes to the other store to buy your lamp.”

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About 70% of the students raise their hands.

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My next question is then addressed to only those who raised their hands. I ask them:

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“Suppose that you visit a car showroom to buy a car and after checking out many models, you find one you like. It costs Rs. 500,000, you are told by the sales representative. However, she also informs you that one of their showrooms which was just a ten-minute walk from there is closing down and you can buy the same car over there for Rs. 499,000 or Rs. 1,000 less. How many of you would like to walk ten minutes to go over to the other showroom to save Rs. 1,000?”

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I hardly see a hand raised.

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Somehow, students who were happy to walk ten minutes to save Rs 1,000 on a lamp are reluctant to walk ten minutes to save Rs. 1,000 on a car!

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What is going on here?

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Indeed, when I reframe both questions again, in a different form, students appeared puzzled:

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“Would you walk ten minutes to increase your net worth by Rs. 1,000?”

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In the lamp vs. car experiment, students who chose to walk ten minutes to save Rs 1,000 while buying a lamp but who refused to walk ten minutes to save the same amount of money while buying a car, were suffering from “anchoring bias”. Their minds were latching on to the wrong anchor of a large percentage savings on a list price, instead of latching on to the right anchor of their personal net worth.

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Related link: Presentation by Whitney Tilson - How to Avoid - and Profit From - Manias, Bubbles and Investor Irrationality

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Books:

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Poor Charlie's Almanack

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Seeking Wisdom

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Influence: The Psychology of Persuasion

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Why Smart People Make Big Money Mistakes

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The Winner's Curse

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Nudge

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Irrational Exuberance

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Against the Gods: The Remarkable Story of Risk

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Behavioural Investing

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How We Know What Isn't So

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Filters against Folly

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Everyday Irrationality