Comments 2008

December 2008

Besides gloomy news appearing abundantly from all sides there are also positive facts. Stocks worldwide have never been as cheap as today for at least 20 years. It is characteristic for stocks to be overvalued in optimistic and rosy times, but also to undershoot fair value in periods, when pessimism and economic problems reign. As an example, the undervaluation of the Standard & Poors 500 index is being estimated at 38%. What does this mean for a despairing investor in the red? Stocks have to go up on average by 60% just to reach normal, average valuation. In addition, stocks have increased in value over the last 137 years in the US in real terms by 6.4% year after year. Therefore, pressure to correct on the upside to revert to the mean is growing. The longer we have to wait, the higher to eventual rise. The outlook may be bleak, but chances for gains are among the best we have ever had. As an example, from 1979 to 1982 the outlook for stocks was dismal and hopeless, undervaluations were equally excessive. In the following 16 years the Dow Jones index went from 1’000 to 12’000. Therefore keep your stocks and add to them.

November 2008

We all have just gone through one of the bloodiest months for investors in history. October has been the worst 30 days for the last 25 years for US and many other stock markets; however, there is some consolation in the fact that, after the unstoppable carnage, the last week has been the best performing for at least the last 25 years. We have had to bear the destruction of valuations at a scale hardly ever seen before and we have witnessed a powerful reaction to outrageous pessimism in the last few days. In October the Russian market has declined by 47%, Japan from an already low base by 20%, the Dow Jones Industrials and the Dax by 14%. For the year most indexes are down 35 to 40%. A global financial crisis which, starting with the collapse of the US real estate bubble leading to an almost total mutual mistrust among banks and financial enterprises and continuously worsening economic news, has resulted in an all crushing and stifling pessimism. Unfortunately we haven’t foreseen or expected anything similar to what has happened to us. We have seen signs of a bubble in US real estate, have known that the US consumer has too much debt, that the banks have had high leverage and that the spreading of complex derivatives could cause problems. What we have underestimated has been that the combination of these problems and the almost incomprehensibly huge scale of the speculation could result in a correction which, like a tempest, could bring down weakened banks and financial institutions. In this disaster luckily Governments and Central Banks, after a slow start, have faced up to the dangers of a collapse. They have saved the financial system by injecting huge amounts of liquidity, by guarantying deposits and loans and by buying up illiquid investments. We think they will prevail and succeed; but it will take some time to deleverage financial institutions and to put them on a sound basis. The first signs of credit markets functioning again are appearing. For us investors it is important not to be swept into selling in moments of freely falling prices and despair. Markets tend to overshoot on the downside in these times. It is important to remember that inevitably there will be a recovery sooner or later. The best advice comes from Warren Buffet in his article: Buy American. I am. He urges us to buy now, despite all the problems plaguing us and gives examples of earlier dire times, which turned out to be judicious for investing; and he advises not to keep cash, which will loose value due to inflation. Global equities are now at their lowest levels in the last 20 years and that supports a cautious optimism, despite a looming recession.

October 2008

September 2008 has been defined by Warren Buffett a "financial Pearl Harbour". In little over two weeks, Lehman Brothers went bankrupt, Bank of America purchased Merrill Lynch, Washington Mutual has been seized by regulators, two legendary investment banks such as Morgan Stanley and Goldman Sachs gave up their investment banking status and joined the ranks of regulated commercial banks. In addition, Buffett injected 5 bn liquidity in Goldman Sachs and Paulson announced a 700 bn package, consisting for the main part in purchases by the US Treasury of troubled assets from banks in order to resell them later on in an orderly fashion. On Monday 29th, Congress rejected the bail out proposal and the US stock market plunged almost 9%. We think these are political tactics and a new plan should be approved in the next few days. The plan of Mr Paulson, while still unclear in its details, seems pivotal to restore order in a chaotic market and is essential to allow banks to de-leverage: the problem does not seem to be any more the overvaluation of these assets, already significantly marked down, but rather the absence of buyers in a market of sellers, and the government intervention would serve the purpose to restore an equilibrium. Despite the current criticism against the plan, we think it is vital and necessary. The taxpayers’ bill may be much smaller than currently speculated as the government will probably buy undervalued assets. While we do not deny the seriousness of the situation and the prospect of a long, slow recovery rather than a quick fix, we also observe that money is being made by investing when blood is in the streets, as Baron Rothschild once said: at the moment, we see panic reaching extremes while the US Treasury actions encourage us to see a light at the end of the tunnel.

September 2008

Many investors ask the question: when will this crisis end? Most agree that it will still drag on for quite a while, but at least it appears that some problem sectors like housing have passed their darkest days and could see stabilization. Investors like Buffett feel that the tough times will not be over soon, but are quite optimistic for the time thereafter. This crisis will leave its marks on professionals involved and on investors, who will have to bear the consequences. There will be changes in regulation, in behaviours, the attitude towards financial leverage and the economy. Many investors have already sold their securities in this area or they are waiting for a recovery to get rid of them once and for all. However, we disagree with this way of thought, with this conclusion. The serious, fairly long lasting crisis with its huge losses for many financial institutions and other owners will have consequences. It will change their thinking and acting and therefore will likely not reappear for many years to come. People will have learned from the past. The shock and nightmare will stay with us for a long time to come. In our opinion financial stocks could be rewarding investments for some time to come. If you disagree, remember inflation and interest rates in the late seventies and early eighties. Inflation and interest rates hovered around 15% in USD in 1983. Everybody wanted to sell his bonds once and for all, if they ever could get a decent price. They were convinced, 15% on long term bonds was insufficient and governments would let inflation reappear. More than 20 years later we still have low yields and relatively low inflation.

September 2008

Many investors ask the question: when will this crisis end? Most agree that it will still drag on for quite a while, but at least it appears that some problem sectors like housing have passed their darkest days and could see stabilization. Investors like Buffett feel that the tough times will not be over soon, but are quite optimistic for the time thereafter. This crisis will leave its marks on professionals involved and on investors, who will have to bear the consequences. There will be changes in regulation, in behaviours, the attitude towards financial leverage and the economy. Many investors have already sold their securities in this area or they are waiting for a recovery to get rid of them once and for all. However, we disagree with this way of thought, with this conclusion. The serious, fairly long lasting crisis with its huge losses for many financial institutions and other owners will have consequences. It will change their thinking and acting and therefore will likely not reappear for many years to come. People will have learned from the past. The shock and nightmare will stay with us for a long time to come. In our opinion financial stocks could be rewarding investments for some time to come. If you disagree, remember inflation and interest rates in the late seventies and early eighties. Inflation and interest rates hovered around 15% in USD in 1983. Everybody wanted to sell his bonds once and for all, if they ever could get a decent price. They were convinced, 15% on long term bonds was insufficient and governments would let inflation reappear. More than 20 years later we still have low yields and relatively low inflation.

August 2008

In these sorry days many investors wonder how it is possible that they own so many lousy stocks, which keep sinking deeper and deeper, and how long it is going to take until all their fortune is lost.In the seventies, stock markets were in a similarly desperate state. My boss at the time approached the problem by separating our universe into two categories: the “wonderful companies” (les belles affaires) and the “lousy companies” (les cochonneries). Purchases were selected from the first list, whereas sales were drawn from the second. That was the solution. The only drawback: we realized, after a few years had passed, that the lousy companies had performed quite well, but not the wonderful enterprises, which were lagging behind.How could this happen? At the point of departure, the selection was clear: good performers with an attractive outlook got on the first list, poor performers with a clouded future on the second. In reality the list proved to be backward looking and more a description of previous developments rather than a predictor of future events. In reality reversion to mean played its role. Favored sectors and companies with fantastic products continued to do well and to enjoy high valuations for a while but soon circumstances changed, their competitive advantages disappeared while other sectors and companies advanced and profited. Our two lists had to be rewritten.Problem sectors and companies, which today face dire prospects, get only minimal valuations in stock markets. Most people avoid them; nobody wants to show them in his portfolio, in particular if holdings have to be published. Clients and superiors will ask a fund manager why he or she is investing in those losers when everybody knows that their outlook is bleak. The easiest path is the one of least resistance, bow to the pressure and fill the portfolio with popular stocks while shunning losers. However, as tables turn, looking ahead past the next few months the sectors and companies with the potential to produce the biggest gains are today’s losers, although this may still be out of sight.Today, energy and raw material stocks look attractive and promising. Sales and profits are reaching new highs, new investments abound and the outlook is rosy. On the other hand, there is only negative news in the press, on the radio and TV concerning financial and to a lesser degree, pharmaceutical companies. Stocks are hammered down without mercy and the outlook is dismal, with further losses almost certain. But within a few years the situation will look quite different. The low prices of today, that cause us so much pain, will appear as a unique chance to get in at a bargain level. Today’s ridiculed buyers may be tomorrow’s smart investors. But it is hard to envision this in the middle of all the gloom and doom. Maybe you ask now: how do you know that valuations in these sectors are really low? You can see it when large parts of a firm or whole companies are being bought and sold. Tesco for example is buying half of TPS (Tesco Personal Finance), which is owned by Royal Bank of Scotland. It pays 13 times the profit of TPS. Royal Bank of Scotland is available at only 4 times. Another example: Zurich Financial Services pays 15 times the profit for a Spanish insurance company, but you can buy its own stock for less than half at 7 times the earnings. It may be that you don’t like the term “within a few years”, but if values double in five years it amounts to a 14.8% annual return; after ten years it is still 7.17%. It pays to be patient and persevering!

July 2008

While most investors are familiar with Warren Buffett's advice to "rejoice when markets decline," many have a hard time putting it into practice. Negative to catastrophic news continues to flow in daily and suppress any positive developments. High energy, raw material and food prices squeeze the average consumer. An endless downside spiral in real estate and financial markets seems to be in process, resulting in staggering losses. It brings to light many questionable, hard to understand practices and behaviours and reinforces the impression that a sick and disintegrating world is on the fringes of an abyss. These are very tough times for the unsuspecting investor. When he talks to friends to find consolation in an unpleasant and worrying situation, they will not fail to mention casually that they sold all their stocks in the autumn of 2007 and are now preserving their savings in cash. They will add that they wouldn’t be able to cope with the steadily shrinking values, which the present bear market would force on them. If the discussion turns to specific companies, their dire situations and how dramatic their fall has been, the acquaintance may add with self-satisfaction that luckily he doesn’t own these stocks, while you take a deep breath and suffer silently. When I look for similar situations in the past, the autumn of 2002 comes to mind. In 2001 Argentina had gone bankrupt. All eyes then turned to Brazil. When elections in 2002 were won by Socialist Lula da Silva, the world expected the country sooner or later to stop paying its debts. Interest rates on Brazilian papers shot up to over 20%, prices plunged and there were practically no takers. We analyzed the situation and decided to sit tight, maybe to add occasionally a few bonds. While placing an order one felt almost obliged to apologize and declare to the counterparty that one was not crazy. Six years later it turns out that these bonds have been a rare chance to earn an exceptional return. In 1997 Asian emerging countries suffered an economic and financial setback that spread also to Russia and South America. Stock and bond prices collapsed and there seemed to be no future and no tomorrow. Many investment funds closed and liquidated after heavy withdrawals, others shrank in size to a fraction of their original size. Disappointment and disillusionment had replaced earlier excessive enthusiasm. Whoever dared to invest during this time of despair had to be very patient, but he has reaped big profits in the following ten years. We could continue this list with earlier downturns and disasters and the upswings that followed them. During a crisis, as prices drop without any end in sight, it is extremely tough to believe that they have to and will stop falling and that the most rewarding purchases will be made during such times. Market sentiment can be very confounding and depressing for investors. In the end worry and panic overwhelm recognition of the fantastic opportunities offered by low valuation, high dividend yields and high earnings power. Anybody who wants to build his wealth has to stay the course in this storm. Lew Sanders of Alliance Bernstein once said, an investor can make a lot of money if he is prepared to live for some time feeling depressed, isolated and afraid, waiting for the market to revert to a normal valuation from a state of high anxiety. This is what is happening to us at the moment. But the reward is higher wealth, comfort and financial safety. It is well worth the temporary inconvenience and hardship.

June 2008

The outlook for the stock markets is not rosy. Inflation in energy and raw materials puts profit margins under pressure. Interest rates are still low, but they could rise in the future. The financial crisis may have passed the point of peak stress, but the extent of the damages to once proud and powerful banks and insurance companies (like UBS, Citigroup, Merrill Lynch and AIG) becomes more apparent from day to day. It will take longer than anticipated to clean up the mess in derivatives and to deleverage the balance sheets. We hope the sad fate of Bear, Stearns, once among the largest investment banks in the US, very successful in trading, then facing bankruptcy within a very short period of time, will serve as a frightening lesson to reckless investment bankers. All these factors weigh heavily on stock prices and dampen enthusiasm. For exactly these reasons they are at attractive levels for long term investors.

May 2008

Since the peak in October 2007 house prices in the USA have declined by 10% on average, the stock market is down 9% (in USD), corporate bond spreads have ballooned, and financial-services companies have lost 25% of their value. But now there are first signs of at least a stop in the fall. The Bank of England has estimated that the markdowns taken so far on derivatives and financial vehicles in the amount of $380 billion may result in much smaller realised losses after the dust has settled. The reason for this difference is the obligation to mark prices to market when nobody is coming forth and making a reasonable bid. Another positive sign is the bid by a group led by J.C. Flowers to buy 24.9% of Hypo Real Estate, a German commercial real estate lender, at a premium of 22% to the market price. It is also remarkable that huge capital increases by numerous banks are being greeted so far with benevolence and have not led to weakness of the stocks. While this is quite encouraging and indicates that the crisis may have reached a floor, it is equally clear that the damages and dislocations have been enormous and will affect the economy for a long time. In other words, any recovery in prices will be slow and interrupted by new corrections. As investors we will focus on undervalued situations with healthy earnings and good dividends. There are also some bonds with high yields which we find quite attractive.

April 2008

Investors around the world anxiously wonder how deep the present crisis will develop. At first it looked like a localised correction in one area of financial markets, i.e. US real estate, which had undergone excessive speculation for some time. But the crisis has grown deeper and deeper in a crescendo of staggering losses, financial failures and bankruptcies, up to the present point where some financial markets no longer function; widespread fear and distrust reign so that the ultimate lenders, the Central Banks, have had to provide liquidity repeatedly to avoid collapses. This is very likely one of the worst crisis since the depression. And we don’t know how much worse it will get or how long it will last. Such circumstances spread scare, fear and panic among investors. Financial markets have crashed, exerting additional pressure and anxiousness on unsettled participants. How does a thoughtful investor react to these changed circumstances; how does he behave in a bear market? The most important rule is: don’t let the market infect you with fear and panic; stand firm against pessimism and don’t succumb to the feeling of doom. We are not leveraged, we don’t have to act since we don’t need the money soon and therefore we should simply disregard ridiculous price swings. Even the best investors like Buffett can’t really predict markets, only boasters can do it. Masters too have bought into weak markets and temporarily suffered big losses. Their strength is that they know when prices are low and they build up positions when everybody else is going into cash to preserve his capital. In addition they are very patient and perseverant. As long as their companies, in which they have invested, do well, they don’t mind living with losses on paper and they don’t waver even under extreme market pressure.

March 2008

Turmoil in financial markets persists. Some of our companies like Allianz, Munich Re, Swiss Re and Royal Bank of Scotland have reported very good results and increased dividends, but the market has not honored it, the mood is too pessimistic. We have the impression that many investors, in particular those who are short term oriented, lack a coherent strategy that enables them to deal emotionally with higher volatility and with mounting quoted losses. Fear overwhelms them; they capitulate and they probably don’t even look at results. The troubles could last for a while. For years risk taking and extreme leveraging have spread in the financial sector, it was the order of the day. New, highly complex products involving securitization of debt have become very popular among investors and very profitable for the originators and traders. Ample availability of funds, low interest rates and a long lasting benign business climate supported these developments and helped to lull investors in a false sense of security. The awakening has for many been harsh and brutal, the amounts lost staggering. We don’t know how long the present crisis will last. We realize that pessimism is pervasive, at least in some sectors of the financial markets. To quote Buffett: “We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.” We will try to seize some of these opportunities and hope that you bear with us until intrinsic values will again be reflected in prices.

February 2008

January 2008 has developed as the mirror image of January 2007. A year ago, all major stock indexes were moving up fueled by a cornucopia of leveraged buyouts, issuance of CDO’s and structured products was reaching new record levels and the most mentioned words in the media were “abundant liquidity”. What a difference a year can make! In these days, buzz words are “recession”, “fear”, “defaults” and “illiquid markets”: Citigroup just announced an 18 billion USD write down and raised more capital, in good company with other banks, while housing data continues to deteriorate and even emerging markets, the darlings of the last few years, have started to correct. Pessimism and uncertainty are very high, and consensus seems to be that things will get a lot worse before they get better. We don’t know to what extent the crisis will deteriorate nor how long it will last: we look at businesses one at the time, we try to assess their intrinsic value based on long term fundamentals and to evaluate their financial strength to bear through the crisis. Buying good businesses when their prices reflect low expectations decreases the risk for the long term investor, so buying stocks in these days at much lower prices is actually less risky than it has been in the last 3 or 4 years. In this land of misery and fear, Warren Buffett is working round the clock, buying entire businesses, fractional ownership interests such as the 3% stake in Swiss Re or even setting up a new bond insurance business. Fear is the friend of the long term value investor.

January 2008

2007 was – after 4 very rewarding years for investors – a sobering disappointment. The optimism at the beginning started to fade in the middle of the year when one financial company after the other began to report losses of increasing magnitude in the US sub prime mortgage market. A recently developed derivative, CDO or Collateralized Debt Obligation, bears the main blame. Luckily we haven’t invested in CDOs, but we own several banks, which have suffered losses in this crisis. The spreading turmoil is also harming companies, which are not directly involved in CDOs. Obtaining any credits has become much more difficult, because a general distrust has replaced the former carelessness. A very restrictive handling of future credits will hurt economic growth and a recession, a time of negative growth in the economy, is now quite possible. This is for the public and most investors a frightening scenario, so that central banks and governments do all in their power to avoid it. We look at it differently, since we are value investors. The best time to purchase extraordinary values cheaply is before or during a recession, when everybody thinks that the downturn will not end soon and stock prices will keep going down. At these points in the cycle the future is admittedly unclear and orientation is difficult. Doubts overwhelm the crowd.