Monday, September 27, 2010

“Better Lucky than Smart”: The Urban Legend of Warren Buffett

Asked by an audience member if returns such as those posted by Berkshire Hathaway Inc. Chief Executive Officer Warren Buffett…are the product of luck or talent, Taleb [Nassim Nicholas Taleb, author of “The Black Swan”] said both played a part.
If given a choice between investing with Buffett and billionaire investor George Soros, Taleb also said he would probably pick the latter.
“I am not saying Buffett isn’t as good as Soros,” he said. “I am saying that the probability Soros’s returns come from randomness is much smaller because he did almost everything: he bought currencies, he sold currencies, he did arbitrages. He made a lot more decisions. Buffett followed a strategy to buy companies that had a certain earnings profile, and it worked for him. There is a lot more luck involved in this strategy.”
—Bloomberg Businessweek, September 25, 2010

 Far be it for we here at NotMakingThisUp to take on the author of “The Black Swan,” which is almost certainly the most timely cautionary thesis ever printed, warning as it did of the higher probability of random, dramatic, unforeseen, global cataclysms than most investors believed possible, just a year before the subprime mortgage crisis triggered a systemic risk of near-death proportions.
 But Taleb’s comments, reported this week by the alliterively named “Bloomberg Businessweek,” during a speech in Montreal—comments that echo earlier statements by Taleb that “Soros has 2 million times more statistical evidence that his results are not chance than Buffett does,” whatever that actually means—deserve a quick look, if for no other reason than they are the stuff of urban legend.
 And it is a legend believed by more people than you might think.
 Specifically, the urban legend surrounding Warren Buffett—about whom we took a very clear-eyed look in “
Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett” (eBooks on Investing, 2011), including issues never before examined in the extensive literature on Buffett and his investment style—is that Warren Buffett was more lucky than smart.
  It is a legend that comes up at least once every time we give a speech. Some skeptical guy (it’s always a guy: women love Buffett) who dislikes the personal politics of The Oracle of Omaha and is hoping to find a reason to believe his investment results are a sham, will be sitting there frowning, arms crossed, waiting for a chance to ask a question…and his question will always be along the lines of whether Buffett is really as smart as the masses make him out to be, and isn’t most of Buffett’s success owed to his luck at coming of age as an investor in the right place (America) at the right time (post-Great Depression), and where does Buffett get off going around lobbying for higher taxes anyway?
 Now, Taleb has added a sort of statistical patina to the urban legend of Warren Buffett, by claiming that Buffett’s buy-and-hold investment strategy possesses a “randomness,” and that this randomness makes his returns suspect.
 George Soros, on the other hand, “made a lot more decisions” than Buffett, according to Taleb (trading currencies as well as stocks, and also engaging in arbitrage), which would indicate that Soros’s returns are less random, and therefore more due to brains than luck; Buffett’s more random, and therefore more due to luck than brains.
 The howler here, as anyone who has studied Buffett over the last few decades, is evident immediately, in the line about Buffett making “fewer decisions” in his career—the fallicay being, of course, the notion that buying (or shorting) something is the
only act that involves a decision.
 For if Warren Buffett has demonstrated anything, it is that deciding
not to buy (or short) something is also a decision—and frequently a harder decision to make than writing a trade ticket and going along with the mood of the market.
 Indeed, the reason Buffett left New York City for his native Omaha after working with Ben Graham in the 1950s was precisely the issue that, as he once put it, the closer to Wall Street an investor was situated, the more “stimuli” hit the investor, encouraging all sorts of decisions that were not necessarily productive or likely to be profitable.

 When asked why he moved back to Omaha, Buffett once said, simply, “It’s easier to think here.”
 And that thinking led to extraordinary results—results that everyone accepts but few people actually grasp.

 How good has Buffett been? Well, you can read the graphic facts for yourself in “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett,” but consider that the S&P 500 closed at 89.66 on the day Buffett took control of Berkshire Hathaway (May 10, 1965) and today stands at 1,148—a 13-fold increase excluding dividends
 Meantime, a share of Berkshire Hathaway has risen from $18 that same day to $124,850—a 6,936-fold increase, and purely from price appreciation, since Berkshire doesn’t pay dividends.
 As for Taleb’s charge that Soros is more facile than Buffett for using currencies and arbitrage in his bag of investment tricks (“he did everything”), this actually says more about Taleb’s spotty knowledge of Buffett’s investment history than it does of Soros’ abilities, great though they may be.
 For not only has Buffett bought and sold currencies—his U.S. Dollar short early last decade was a money-maker for Berkshire, as was his long position in the Brazilian Real a few years back—but he has bought and sold commodities such as oil and silver, and frequently engaged in billion-dollar arbitrage deals such as RJR Nabisco.

 Indeed, Buffett once arbitraged a chocolate maker’s stock by selling cocoa beans on the open market, marking his first encounter with the Pritzker family, from whom decades later he purchased, lock-stock-and-barrel, an industrial business—something Soros has never done. So much for Buffett being a mere buy-and-hold equity investor.
 Oh, and as far as shorting stocks goes, well, back in his hedge fund days (yes, Buffett ran a hedge fund before taking control of Berkshire) the Oracle of Omaha once borrowed and shorted the entire stock portfolio in Columbia University’s endowment.

Lucky? Sure. Smart? Surer.

Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Sunday, September 12, 2010

The NotMakingThisUp Book Review: What Ace Said About Jimmy

I hadn’t finished reading the Journal story [describing supposed personal peccadilloes of Jimmy Cayne, the then-beleaguered CEO of Bear Stearns] myself when I knew that this was the end…. Did I discuss it with anybody? No. Did I go running around the firm saying he had to go? No, because I don’t do those things…

But I knew that nobody believed his denials. Did I actually care whether or not he smoked pot? Here’s what I cared about: Bear Stearns, its employees, and its shareholders. I knew that he’d been smoking pot for years. At bridge tournaments I’d seen it myself. Did I ever see him do it in the office? No. Had I heard that he did that? Yes.

—Alan C. (“Ace”) Greenberg, The Rise and Fall of Bear Stearns.

Wall Street guys, especially traders, love nicknames.

Nobody on the trading floor wants to be called “James,” as in James E. Cayne, the former Bear Stearns CEO whose downfall coincided with the firm he helped build.

It’s “Jimmy.”

And it’s not “Jerome” Kohlberg, the LBO pioneer who appears briefly in this book as co-head of Bear Stearns’ corporate finance department: it’s “Jerry.”

Nor did the late “Bernard” Lasker, arbitrage pioneer, mentor to the author of this book, and NYSE chairman during the vicious 1970s bear market, go by “Bernard” any more than Curtis James Jackson III performs as, well, Curtis James Jackson III.

Bernard was “Bunny,” and Curtis James Jackson III is “50 Cent.”

And nobody but nobody calls Alan C. Greenberg, the author of the The Rise and Fall of Bear Stearns and the man most closely associated with that firm in its prime, “Alan.”

It’s “Ace.”

The reason traders on Wall Street go by nicknames, of course, is the same reason Cordozar Calvin Broadus began calling himself Snoop Dogg. It gives them credibility within their profession.

And for Ace Greenberg, that credibility was established early in life, when, like a lot of his peers on Wall Street, he learned the craft of buying and selling not from formal Wall Street training programs: he learned it from his father, who ran clothing stores in Oklahoma.

Indeed, so important was his father’s experience in shaping Ace’s rise to power in the meritocracy of Wall Street that Greenberg lists five of his father’s “truisms” at the end of this book, the very first one being “If you own something you think is bad, sell it today because tomorrow it will be worse”—which applies to stocks and bonds just as well as trousers.

But this book is not merely an instructive look at the humble origins of one of the great individual success stories on Wall Street, nor is it merely an insider’s view of one of the most spectacular corporate failures in American financial history.

It is payback.

Not, however, payback against a harsh and uncaring group of rumor-mongering hedge funds that some believe brought down Bear Stearns (“wolf-packs,” ex-Treasury Secretary Hank Paulson called them.) Indeed, readers will find no mention of the conspiracy theories that swirled in the days and weeks following Bear’s collapse—theories picked up and run with, in the main, by ignorant Senators and Congresspersons during the worst of the financial crisis.

In fact, Greenberg accepts the ending of Bear with an almost eerie equanimity throughout the book. He even calls it “our man-made disaster.”

But this quality becomes not so eerie as the reader comes to realize that Greenberg had wisely pulled millions, and millions, and millions of dollars out of the firm over the years by selling his shares as its stock kept rising. Indeed, Greenberg’s stock selling became a sore point with Jimmy Cayne, who took to ridiculing Greenberg in meetings for “not owning any.”

More fool Jimmy Cayne, of course: when Bear Stearns’ stock plummeted, Jimmy watched billions evaporate thanks to his lack of foresight.

And Ace delights in detailing that lack of foresight to the nearest million:

One shareholder who didn’t wait around for the merger [with JP Morgan] to be consummated was Jimmy, who sold his shares at $10.83, yielding $61.3 million. This outcome entitled him to membership in a rather exclusive club—consisting of individuals who have personally managed to lose more than $1 billion, not on paper but right in the wallet.

Since “Jimmy” was, by then, no longer a Bear Stearns employee, Ace rubs salt in the wound by charging a nickel a share rather than the low flat rate usually offered to insiders:

The trade cost $77,000, rather than the $2,500 maximum commission for employees. As always, I did what I felt was in the best interests of the firm. Nothing personal.

“Nothing personal,” writes Ace, when in fact the book is quite personal.

Indeed, the payback here—and Ace begins to detail his displeasure with Jimmy’s behavior, both personal and professional, starting around page 100, roughly halfway through the book—is the only thing that drags down the otherwise easy flow of Ace’s storytelling.

Invariably, Jimmy ranked very high [in the partnership rankings]. He was a producer, by all means, in a place with a lot of producers….

He could be charming when he wanted to—the technical term would be kissing ass—and he certainly worked hard at cultivating a friendship with me. Not that that ever stopped him when the percentages were announced from complaining that I’d somehow screwed him…

And, there’s the infamous “the elevator thing,” long a sore point with ex-Bear employees:

Why was it that a single elevator in the lobby had to be reserved for one person [Jimmy Cayne] when we had thousands of employees coming and going all day long?

And the cigar thing:

We had a rule that you couldn’t smoke in the building. I used to smoke an after-lunch cigar myself but quit when the city made it illegal. Jimmy kept right at it…

And the golf thing:

The hour of the Hilton financing discussion, it seemed, didn’t work for him. And that was why? Because it conflicted with his golf date.

More serious, of course, was the leverage thing, which Ace attributes to Warren Spector’s mortgage trading business rather than Jimmy himself:

If we were long $60 billion in mortgages and had $40 billion in short positions, I assumed our exposure was $20 billion. But what if we were long apples and short oranges? Then we weren’t necessarily hedged at all, were we? That, alas, to a painful extent proved to be the case.

There are many other such things that set the author’s teeth on edge—he delights in rebutting details from William Cohan’s book House of Cards, a major source for which appears to have been Jimmy himself—but our favorite is the infamous “China deal” that Jimmy trumpeted in the waning days of Bear’s public existence as a sure-fire saving grace for the firm.

The “China deal” was, on the surface, a $1 billion transaction with China CITIC Group, and it was pursued single-mindedly by Jimmy (at least, as Ace tells the story) and announced with much ballyhoo as the answer to the Bear’s shrinking cash reserves, despite much skepticism on Wall Street.

And Ace clearly sides with the skeptics:

China CITIC, according to the deal terms, would make a billion-dollar equity investment in us and…[sic] we would make a billion-dollar convertible-debt investment in China CITIC. If the math on that has you stumped, let me help you out. The net dollars headed our way: zero. For many of us, Jimmy’s characterization of this as “a groundbreaking alliance” had the unmistakable emperor’s-new-clothes ring.

Thus one of Wall Street’s oldest and most accomplished veterans makes it clear that corporate CEOs can be just as promotional and self-serving as any of the “rumor-mongering hedge funds” those same CEOs would rather blame for their crisis.

For that alone—and the stories of Wall Street’s earlier days, as well as the remarkably dispassionate, clear-eyed and un-misty account of the remarkable demise of a Wall Street firm—the book is worth reading.

Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Tuesday, September 07, 2010

Here They Go Again: “The Death of Housing”

The stock market may be dragging, but home prices are soaring, fueling a national obsession with real estate. Your house is now your piggy bank.

—“Home Sweet Home,” Time Magazine, June 2005

Buying a house is supposed to make us better citizens, better investors and better off. But that American Dream may well be a fantasy.

—“The Case Against Homeownership,” Time Magazine, September 2010

Longtime readers of NotMakingThisUp know exactly where we’re going with this—or at least the general direction.

But before we get there, let’s recap the story so far.

All human beings—and especially those creatures residing on Wall Street—operate on the basis of pattern recognition.

Pattern recognition can be employed in the form of using a computer to analyze second-by-second trading patterns in whatever one happens to trade, looking for profitable ways to buy and sell; or it can be just sitting in a meeting listening to a CEO talk, keeping an ear out for things that remind you of similar, past investment ideas that worked or didn’t work.

And one of the things that Wall Street types pay attention to when they look for patterns is something called “Cover Story Syndrome,” which is a shorthand way of saying that when investment themes get so popular they appear on the cover of a major news magazine—a dying breed, but the basic idea is still there—then that investment theme is, by definition, too popular to succeed, and maybe popular enough to start betting against.

It is a pattern that occurs more often than you might think.

The Cover Story of all Cover Stories, as any investor with grey hair will tell you, is the fabled “Death of EquitiesBusinessWeek cover story from August 13, 1979 (“How inflation is destroying the stock market”), which hit newsstands smack-dab at a market bottom—and indeed helped create that bottom by giving readers the intellectual stimulus to finally bail out.

Fast-forward to June 2005, the peak of those balmy home-buying days of Housing Bubble: Time Magazine publishes a front-cover story on the joys—at least, investment-wise—of owning your own home.

Here’s how we began our report on that Cover Story:

I bought Time Magazine today for the first time since…probably since 9/11, when I bought every newspaper and magazine available with a cover story on the World Trade Center attacks.
The relevance of a weekly “news magazine” these days is, after all, right up there with “Book-of-the-Month” clubs and the Sears Catalogue.

Nevertheless, I bought this new issue of Time Magazine because the front cover is titled “Home Sweet Home” (stamped in large letters, the “S” converted into a Dollar sign) with an illustration showing a man covetously hugging a house. The sub-title reads: “Why we’re going gaga over real estate.”

I bought it, quite simply, because this Time Magazine is as good a “cover story” kind of market-mania, surely-we-are-approaching-a-top indicator as I have ever seen.

—“The Last, Best Hope For Prosperity,” JeffMatthewsIsNotMakingThisUp, June 2005.

Well, five years later, they’re at it again: the editors of Time have given us another Cover Story—this one being possibly the gloomiest assessment of the worth of owning a home ever to hit the press:

Rethinking Homeownership: Why owning a home may no longer make economic sense.

Five years ago, Time’s “Home Sweet Home” cover showed a drawing of a man hugging a house; t
his summer’s Time cover shows a gloomy color photo of an empty-looking house in an empty-looking development, baking under a hot summer sun, with not a human being, or a dog, or cat or a tree or a bike or a car or a bird in sight.

Five years ago, Time pushed the benefits of owning a piece of the dream (“Real estate isn’t so much about nesting today as it is about nest feathering”), offered a trivia “test” with questions such as “Which of these entertainers has sold at least seven homes in the past 10 years?” and declared—and we are not making this up—the following:

It’s about the giddy tabulation of how many plasma TVs your house’s appreciation could buy and the embarrassment of feeling too poor for your neighborhood as houses around you are torn down for McMansions…—Time Magazine, 2005

Now, that same magazine—with prices down, oh, 25% at least from those “giddy” years—offers up gloomy anecdotes and a stark litany of the horrors of that very same Bubble it once celebrated:

Yet by idealizing the act of buying a home, we have ignored the downsides. In the bubble years, lending standards slipped…. And we ignored longer-term phenomena too. Homeownership contributed to the hollowing out of cities and kept renters out of the best neighborhoos. It fed America’s overuse of energy and oil. It made it more difficult for those who had lost a job to find another. Perhaps worst of all, it helped us become casually self-deceiving…
—Time Magazine, 2010

Yes, the same editors who five years ago gave us the self-deceiving picture of a no-risk, no-money-down housing bonanza at the absolute peak of the Housing Bubble today lecture about the fallout from those days.

Now, there is one other pattern that tends to shows itself in Cover Story articles of the type Wall Street finds useful in marking peaks and valleys in the landscape of investing, and it is this: the same Cover Story itself invariably contains certain facts that a detached reader would say heralds changes to come.

In the 2005 “Home Sweet Home” article, for example, Time’s editors included a number of happy charts and graphs which were really not so happy, if you looked closely at the data. Here’s how we described some of that data:

However, as in all manias and bubbles, lurking within the happy graphics are some potentially disconcerting statistics, if you really look at the Time Magazine charts.

They show, for example, that the number of second homes purchased in America stayed within a range of 300,000 to 400,000 a year from 1989 to 2002—then suddenly doubled to over 800,000 in 2003 and broke 1 million in 2004. Home equity loans have also spiked, at the same time that rates appear to have bottomed and are moving higher.

And in several non-sexy, non-condo, non-second-home-inflated states, mortgage foreclosure rates have tripled.

But you will not read about all that in the article itself, for Time readers presumably do not want to read about anything except how much fun this house flipping thing is.

—“The Last, Best Hope For Prosperity,” JeffMatthewsIsNotMakingThisUp, June 2005.

And, indeed, in this summer’s cover story, Time’s editors have done it again:

Until February, Star [one Star Korajkic, described as “one of America’s newest homeowners”] lived in a rented apartment in Burlington, Vt., with her husband Danijal and daughter Alina, 6. Now the family lives in a modest Cape Cod, which they own. Danijal works 11-hour shifts as a truck driver, and Star works two jobs in order to make the mortgage, but the sacrifice, she says, is worth it. “It’s amazing. We can do whatever we want… We can live a normal and nice life.”

—Time Magazine, 2010

So it is that, like all really good—and by that we mean really bad—Cover Stories, “Rethinking Homeownership” contains the seeds of a housing recovery in the very same paragraphs it declares the Death of Housing.

Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.