Olympus Kills Japanese Stock Market?

Olympus was down again the limit and I don't think any shares traded, having been offered down the limit all day at 484 yen/share.

Olympus, on it's own is not a big problem.  These things do happen.  The U.S. had it's Enron, Worldcom and others. 

But the problem is that Olympus is an old, stodgy blue-chip company, not some aggressive, MBA-led startup.  If you can't trust Olympus, who can you trust in Japan?  What other companies have similar problems?  If this sort of cover-up is culturally acceptable are any of the income statements and balance sheets in Japan reliable?  Is there something wrong with the auditing system in Japan?  The scary part is not what happened to Olympus itself, but the suspicion that this is not uncommon (as I said, sadly, I was not surprised by what happened).

This is a scary thought for investors.  This is especially true now with sentiment so fragile after the big, global financial blowup.

My fear is that this will turn people off to stocks in Japan for many years.  This is not like the financial crisis in the U.S. where the collapse is easy to understand.  It was a standard bubble and collapse.  People now trust banks quite a bit less and are afraid of leveraged balance sheets and risk-taking financial institutions.  But nobody is worried about Coca-Cola, Starbucks or Google.  Yes, stocks aren't that popular after such a long period of subpar performance. 

But that's different than what is going to happen in Japan going forward post-Olympus.  Olympus was not a subprime lender or bank.  What happened is not industry specific, so people won't just be able to avoid certain risky industries, they will have to avoid Japan overall.

The Japanese handling of the Fukushima crisis also doesn't inspire confidence.  If they can't tell the truth about that, how can we trust the regulators of Japanese corporations?  Would they not also lie and help cover things up for the sake of a bigger, social good?


Back in 2006 there was a Livedoor/Murakami scandal that rocked the Japanese financial markets and that really killed the Japanese OTC market, I think.

You will see that the market peaked in early 2006 just as the Livedoor scandal broke.  This really turned people off to the OTC market (even though Livedoor was Tokyo Stock Exchange listed).  I think it changed the perception of the market as a rigged thing with no chance for outside investors.


Why is this important?  You will say that lower valuations will be good for investors and they can make good returns.  This is true, but in the case of the Japanese OTC market, I think the problem is that with a bad market, low valuations and no liquidity, companies can't raise capital.  If companies can't raise capital at reasonable prices, the market won't develop.  I think the Japanese OTC market is stuck in the vicious cycle and can't get out of it, and it seems to me it is largely due to the Livedoor/ Murakami scandal.  At least it seems like that to me.

You can see that the JASDAQ market did top out earlier than the Nikkei 225 Index.  The Nikkei didn't top out until the financial crisis began to unfold.

The problem here is that any chance of people coming back to stocks in Japan may be set back for years due to this Olympus problem.  Who is next?  As for foreign investors, they will realize that they have no mechanism to resolve these Olympus-type problems as they do in the U.S.  This means that at the margin, foreign investors will be less likely to invest in Japan.

Of course, value investors need not worry about what other people do and whether stocks are popular or not.  But what it does tell you is that Japanese stocks will probably have to get a lot cheaper on a valuation basis before people get interested.

With this lack of transparency, shakey accounting/auditing, no recourse when trouble occurs, rational investors will demand a discount to invest in such a place.

For many years, Japanese stocks traded at a premium to U.S. and other global stocks.  This really made no sense to me as returns on capital, margins and other productivity measures were usually far lower than Western counterparts. 

The premium has disappeared in the past couple of years making people bullish on Japan again, but Olympus, I think, will change that somewhat.  Parity valuation will not be a reason to go to Japan anymore (unless there are other factors that make a specific investment interesting.  All of these things have to be evaluated on a case-by-case basis).

Couple that with the incompetence of the Japanese government in dealing with the economic situation and government finances, this is a recipe for a long, extended bear market far longer than has already occurred.

This is very unfortunate as I have been interested in Japan for many, many years and have been waiting for some sort of bottoming out over there.

It now looks like there won't be a true bottom for a long time.

I will continue to look for interesting situations over there, but things are not looking too good at all.

I do also understand that I may be putting in a low in the Japanese stock market by making such a negative post! 

Possible Downgrade of Nomura's Credit

Moody's announced that they may downgrade the long term credit rating of Nomura Holdings one notch to one notch above junk level.  This really could be lights out for Nomura (as an independent entity, at least).

I don't know if this means Nomura will end up bankrupt, but this is really bad news if the downgrade actually happens (a single downgrade won't bankrupt the company, but the jitteriness of markets will make it difficult).  As I said in my previous post (How Do You Solve a Problem Like Nomura),  one big issue with them is their big move into global markets and my concern was their history of losses and failure in previous attempts at globalization. 

Apparently, Moody's is very worried about this too.  On a balance sheet and capital ratio basis, Nomura seems pretty sturdy, with capital ratios close to 20%.  But I think the constant losses overseas and their big expansion, doubling down (or more) into an area that has been a source of big losses for them over the years is very scary.

Now, this credit downgrade wouldn't matter so much if Nomura was more a domestic business.  Japanese institutions are not so sensitive to the ratings of Moody's or S&P, nor are individual investor clients at their retail branches.

But since they are expanding rapidly globally in the wholesale markets, credit ratings are much, much more critical as clients are sophisticated institutional investors and they do tend to be highly sensitive to credit ratings.  This is even truer today after Lehman, Bear Stearns (and the problems of unwinding trades, getting prime brokerage account assets transferred) and of course the recent MF Global makes things much worse.

Here is a look at the long term credit ratings of the major global investment banks:

                                         Moody's               S&P           Fitch
Deutsche Bank                  Aa3                       A+             AA-
UBS                                  Aa3                       A+             A
Goldman Sachs                 A1                        A               A+
Morgan Stanley                A2                         A               A
J.P. Morgan                      Aa3                       A+             AA-
Merrill Lynch                   Baa1                     A                A+
Nomura                           Baa2                     BBB+

This is obviously problematic for many reasons.  Of course, the first issue is funding cost.  For investment banks, funding is everything.  If you don't have good funding in such a highly competitive, low margin business, you are not going to do too well.

Second of all, for derivatives, repos and other businesses that involve a counterparty, Nomura is not going to be an attractive counterparty.  Counterparties will demand more collateral or less favorable terms. 

Also, even clients that don't get into a counterparty situation with Nomura (such as repos or swaps and other derivatives) may not want to have too much assets in their accounts held there, whether it be in regular accounts, or especially in prime brokerage type accounts. 

This wouldn't have been as much of an issue a few years ago, but especially after the Lehman prime brokerage fiasco and the current MF Global mystery (of missing $600 million in customer funds), I think clients are much more sensitive to these things.


Nomura is going global to compete with the other global investment banks head-on.  But look at the above credit ratings.  Why would someone deal with Nomura when they can get Aa3 counterparties?  What can Nomura offer that the other banks can't that would make it attractive to deal with a lesser credit?  Investment banking is a highly competitive business where only the top players earn profits over time, and I would think this credit rating gap is a huge disadvantage in that situation.



In the end, things may turn out OK, but Nomura sure picked a tough time to go all out expanding globally.  The downgrade may not occur, but even if it doesn't, there doesn't seem to be much margin for error.  Any more surprises to the downside can really be the end of this company.

Having said that, bankruptcy probably won't happen; it will probably be merged with someone given how Japanese regulators have dealt with weak banks over the years. 

As I said in my other post, I really think the best solution is for Nomura to become the Japanese arm of a major global institution.  The domestic operation is a great business that could add a lot of value to a global major.

But of course, that will never happen.

Olympus

What is happening at Olympus is really sad.  The worst part of it is that I'm not even that surprised.  I have been looking to invest in Japan for a long, long time and have only found 'trades' to do there; buying stocks when they are very cheap due to short term worries about this or that.

But I haven't been able to find good, solid blue chips to invest in or interesting vehicles like Berkshire Hathaway, Leucadia or Loews type thing where you don't really care about the industry but trust the capital allocation skills of management.

This really illustrates one of the biggest problems in Japan; lack of transparency, total disregard for shareholders, outright dishonesty at the very top (which is not unusual in the U.S. either) which just seems culturally acceptable over there.  I guess part of it is due to the lack of due legal process.  In the U.S., people lie too, but they get sued or go to jail (OK, OK, I hear the protests about how few bankers have gone to jail...  Yes, yes, Fuld was a liar as were a bunch of others and they remain on the loose.  But still...).  I don't think that happens very often in Japan.

Anyway, let's take a quick look at this thing.  What is shocking to me is that despite the stock price being down 90% from their highs, the stock is not even super cheap.  It's cheap to be sure, but not ridiculously so.   Again, this goes to show how overvalued Japan has been even recently despite a 20 year bear market.

As the chart shows, as recently as 2007, the stock traded at 5,000 yen per share. Peak EPS was 214.44 in the year ended March 2008, which comes to a p/e ratio of 23x.   That might not be ridiculously expensive, but before that going back to 2001, Olympus never earned EPS of over 200 yen/share.

The EPS history goes like this:
year-end
March of:          EPS      
2001                    44.57
2002                    38.87
2003                    91.88
2004                  126.96
2005                   -44.98
2006                  105.99
2007                  176.79
2008                  214.44
2009                 -428.43
2010                  177.22
2011                    27.47

I haven't looked at the reports in 2007, 2008, but these were years at the height of the bubble so these earnings may or may not be repeatable.

Here is a close-up look at Olympus.  The stock crashed over the past few days from over 2,000 yen/share to the current 584 yen per share.

Is that cheap?  Since so many people talk about book value per share with respect to Japanese stocks, let's take a look at that.  According to the quarterly filing (in Japan), Olympus had 151 billion yen in shareholders' equity and 266.9 million shares outstanding (net of treasury stock), so that comes to a book value per share of 565 yen per share.  So even after this stunning drop in stock price, Olympus is now trading at only a slight discount to BPS.

Here are some fundamental figures for Olympus:

If Olympus earned decent returns on equity (ROE) over time, BPS would be a great buy.  But it looks like over time, the ROE of Olympus has been around 5.12%, not so exciting.  This does include the -44.4% loss in 2009, but since that is a real loss from a writedown, I would not exclude that.  The 25.8% ROE in 2010 is mostly due to a gain booked as a result of transferring a business so it's not operational.

Otherwise, Olympus only earned an ROE above 10% in five of the last twelve years.  A decent looking 15-16% ROE was only achieved at the height of the bubble back in 2007 and 2008.

I should point out that much of this book value is goodwill.  Even though there is 151 billion yen in shareholders' equity, there is goodwill of 168 billion yen.  So in the current world where tangible book value is popular, Olympus has a negative tangible book value.

Sales has been declining every year since 2008 and margins haven't been that exciting looking.

It is interesting to note that while Olympus is known for their cameras, the Imaging business accounts for only 15% of sales and hasn't made money recently at all.  The Medical Products business (70% market share of endoscopes etc...) has been the money earner here, accounting for more than 100% of the operating income at Olympus last year.

Since this is the crown jewel of Olympus, let's take a quick look at it:

Sales have been flattish over the past couple of years and operating margins seem to be trending down.    I don't have a lot of understanding of this industry and the outlook for this segment, but it does look like a decent business with decent margins, although it is trending down. 

Growth?  Management says that growth will come from Asia, and that may be so.  Who knows.  Many Japanese companies have been talking about Asia as their engine of growth for many years without too much to show for it so we'll see.

If Olympus does get back to historical earnings that it earned back in 2007, 2008, then Olympus stock is certainly cheap.   Peak EPS was 214 yen and the stock is now trading at 584 yen/share so that's only 2.7x peak earnings.  I am a bit skeptical that earnings can get back up there.

So let's take a look at the balance sheet.   As of the end of June, 2011 there was 151 billion yen in shareholders' equity and 59 billion yen in investment securities, much of it in equities.  Yet another problem with Japanese business is their continuing of cross-holding of stocks.  Twenty years later, a lot of corporate balance sheets are still stuffed with stocks.  This is very annoying, but is another topic altogether.

There is also 267 billion yen in cash and cash equivalents.  So one is tempted to add this up, the 267 billion in cash and 59 billion yen in stock and call that non-operating assets, deduct it from enterprise value and get a cheap valuation on the operating business.

Let's look at it that way, then.  Long term debt as of the end of June, 2011 was 631 billion yen.
With 267 million shares outstanding and a stock price of 584 yen/share, that's a market cap of 156 billion yen, plus 631 billion yen is total capitalization of 787 billion yen.

Deduct cash and cash equivalents from that and you get 520 billion yen enterprise value for Olympus.  If you consider the 59 billion yen as not operating assets and more like cash, then deduct that and you get 461 billion yen in enterprise value.

EBITDA of Olympus in the last three years were 108 billion, 130 billion and 96 billion yen for an average of 111 billion yen or so.

Using the enterprise value with cash and cash equivalents excluded would give a valuation of around 4.7x EV/EBITDA and excluding stockholdings, it would come to 4.2x EV/EBITDA.  Out of conservatism and the reality that these corporations may never sell their crossholdings, it's better to use 4.7x EV/EBITDA.

Is that cheap?

I don't know much about the medical systems business, but here's a quick look at some comparables (which admittedly don't look too comparable, actually).

Just as a quick sanity check, I picked some medical device-like companies:

                                                                           Operating
                                            EV/EBITDA          margin                       ROE
Johnson and Johnson                 8.6x                  25.4%                        18%
Medtronic                                  8.2x                  28.5%                        20%
Covidien                                    8.6x                  21.8%                        19%
Becton Dickinson                      7.5x                  22.5%                        23.6%

All of these are for the last 12 months and are pulled from Yahoo Finance.

Yes, 4.7x EV/EBITDA seems cheap.  But the ROE and operating margins are not even close.  Olympus earns nowhere near 20% ROE or 20% operating margins over time as a whole.

Maybe one should only look at the medical systems segment and see what it is worth since it does earn a 20-23% operating margin.  If that can be valued at 8.0x EV/EBITDA, then maybe we have a good sum-of-the-parts story here (even though betting on a corporate action in Japan is a loser's game; a value realizing transaction will never happen over there!!).

This is a really simplistic sum-of-the-parts, but here goes. 

Let's put a 8.0x EV/EBITDA multiple on the medical systems segment of Olympus, add the cash and stockholdings value, deduct the long term debt for the 'equity' value and divide by the number of shares to see what this thing is worth assuming the rest of the businesses are worth exactly ZERO.

In the year-ended March, 2011, the medical systems segment had the following EBITDA:

Sales:                                       355.5 billion
Operating income:                     69.3 billion
D&A:                                         16.9 billion
Amortization of goodwill:           9.3 billion
Total EBITDA:                          95.5 billion

The operating margin of this segment was a slightly less than 20%, so let's use an EV/EBITDA ratio of 8.0x to value this business and then add the rest of the stuff and deduct the long term debt:

Medical systems segment value:     764 billion  (95.5 billion x 8.0)
Cash and cash equivalents:              267 billion
Investments:                                       59 billion
Total:                                             1,090 billion
  less long term debt:                    -   631 billion
Equity value:                                     459 billion
Number of shares outstanding:          267 million
Equity value per share:                   1,719 per share

With the above assumptions, Olympus shares are worth at least 1,719 yen per share. 
However, this valuation may not necessarily be reached.  My opinion is that if the firm as a whole does not start to earn reasonable operating margins and returns on equity, then this hypothetical valuation may never happen (even though Olympus stock did seem to trade above this level for most of the recent past).

In order for this valuation to be forcibly realized, the medical systems group would have to be sold at this level of 8x EV/EBITDA or something like that, and as I said, in Japan these value realization events rarely happen as many foreign investors in Japan has learned over the past twenty years.

Also, it is not clear what the future of the other segments are.  Japanese companies tend to pump money into even losing segments out of inertia or pride.  This can be a very serious value destroying thing to do.  Japanese companies do  tend to overemphasize market share and sales growth more than return on capital. 

Of course, the biggest problem here is the big question mark of the current scandal.  What actually is going on?  Are the earnings/balance sheet figures even reliable?  What do they mean?  What is the future of Olympus?

These are very hard questions to be sure.

I don't own any Olympus and don't plan on buying any in the near future as I am skeptical that things will be 'righted' soon, but I will keep an eye on it and may post some updates if I see anything interesting.

Having said all that, this is not to say that the stock can't go up.   It is certainly possible that value investors see value here and jump in, pushing the price back up dramatically.    Just because I am not interested doesn't mean it won't go up (in fact, the fact that I'm not interested means it will probably go up).

But although I see some value on a look-through or sum-of-the-parts basis as described above, my experience watching Japanese companies makes me worry that future management will continue to destroy shareholder value, even with a nice, profitable jewel of a business.  I fear that instead of realizing value for shareholders via a spin-off or sale, or by shutting down unprofitable or low profit segments, they will continue to take money from the good business and dump it into the bad to preserve or increase sales, and more importantly, I think, maintain employment.  

Dumping good money into bad businesses seems to be at least partially motivated by Japanese management's aversion to right-sizing/layoffs.  They would rather spend money on a low profit factory to update it with subpar returns on investment rather than close it down and have to lay off workers.

Anyway, I don't know that this is what Olympus has been doing in the past, but their capital management in the past hasn't been very encouraging either way.  Also, even though there seems to be a lot of cash on the balance sheet, this may not go back to shareholders any time soon (it's not net cash anyway).  Just skimming the annual reports going back a few years, they seem to be hell bent on growth.

And one way they want to grow is through acquisitions.  And keep following that thought, Japanese corporations have historically been horrible in acquisitions.  That's partly because of their reputation to pay too high a price (which is no surprise given the history of managements' obsession with sales and disregard of returns on capital), and their reputation for not being able to manage the businesses they buy.

In any case, that's just a quick look at this thing for now.  I will keep thinking about this for a little bit.


 

Eliminate Wall Street Bonuses?

There is some talk that to prevent further financial meltdowns and taxpayer bailouts, we should simply eliminate or ban bonuses at banks.

Whenever someone says "ban" something to solve a problem, warning bells go off in my head.  For example, people say that the Fed is the cause of all financial crises in the past few decades.  So, eliminate the Fed!   Well, OK.  Some argue that the Fed is run by unelected officials and hold more power than elected officials.  But then you have to think, after their competence in running FNM and FRE, do we really want congress to control interest rates and the money supply?

OK, that's another issue.

Ban bonuses at banks?  On the face of it, it sounds reasonable.  Outsized bonus potential incent bankers to take outsized risk that eventually blows up a bank and taxpayers have to come in to bail them out.

This is true to some extent for sure.  But on the other hand, I happen to remember one of the biggest bubbles and blowups in history that a country hasn't recovered from yet:  Japan.  Japan had the biggest bubble of all time up until then; bankers made hugely risky and stupid loans.  Even manufacturers took huge risk in "zaitech" (where they used their own balance sheet to speculate in the financial and real estate markets to boost earnings).

And guess what?  Japan in the 1980s did not have anything close to the outsized bonuses or salaries that Wall Street has had for decades.  Japanese management bonuses were and are tiny.  Traders and other risk-takers at various banks, investment banks and zaitech-ing manufacturers were not paid big bonuses for their profits.  (By the way, this applies to derivatives too.  People are all bent out of shape about derivatives and how that is the cause of all problems in finance.  However, derivatives in my mind played a very small part in this financial blowup.   Japan had very little derivatives during the bubble.  The 1929 crash had very little to do with derivatives.  The tulip bubble had very little to do with derivatives etc...  When the financial crisis came, JPM was the first domino that was supposed to fall because of it's GDP-like notional derivatives exposure.  Nope.  Also, European banks are in big trouble now.  Derivatives?  Nope.  Simple, straight sovereign debt.  Big bonuses caused that problem?  Probably not.)

And yet, the bubble happened.  I also wonder about the 1920s too, in the U.S.  That was quite a bubble.  Was it outsized bonuses then?  I think not.

So what can we do about it? 

Whenever we talk about these things, I am always baffled that nobody talks about the simplest answer.

The answer is quite simply that if the U.S. government (taxpayer) is going to come in to bail out these big financial firms, then we have to get paid for it.

Sure, banks pay FDIC fees and things like that.  If the FDIC loses money on bailouts, it means, quite simply, that the FDIC fees are too low.  (But I think the FDIC has *not* lost money over time, and the TARP money was paid back for most of the large banks.  I think the money lost that people keep talking about include AIG, FNM and FRE which haven't paid back their TARP money).

The problem, as usual, is pricing.  If deposit guarantees are priced correctly, it doesn't matter who does it.  U.S. government?  Fine.  Then let's set a fair price.

Ban proprietary trading?  Don't get me started on that.  Prop trading, in my mind, had nothing to do with the recent financial blowup.  They want to ban prop trading, which include startegies that firms like Och-Ziff does but allow customer facilitation and market-making functions.

Well, if you look at the multi-billion blowups in 2008/2009, I tend to think those losses were not on the proprietary desks, but the customer faciliation/market-making desks.  At Merrill, it was loans warehoused for future sale that did them in.  It was not a proprietary trade, but a huge inventory of loans bought for the purpose of repackaging for future sale.  That's a customer business, not a prop trade.

I think it was probably the same at Bear.  Morgan Stanley too.  I think all of these 'trades' would be allowed under the Volcker rule. 

What can you not do under the Volcker rule?  Stat arb.  Convertible arb.  Index arb. Special situations.  In other words, strategies that had nothing to do with the financial blowup.

Anyway, back to bonuses.

Eliminating bonuses, I think, will do nothing to reduce risk.  We don't know what the unintended consequences are.  When they taxed heavily pay over $1 million to clamp down on excess executive pay back in the 90s, it gave birth to the multi-billion dollar stock option pay outs.  Oops.

So instead of banning this and banning that on a one-shot basis based on one-dimensional thinking, I think it's probably wiser to get to the essence of the problem:  Proper pricing of risk!

Forget bonuses.

Is the bank taking a lot of risk?  Fine.  Then they have to pay more FDIC fees.  It's silly to have a fixed fee regardless of the risk profile of the bank.  If life insurance companies can set the rate depending on whether you smoke cigarettes, go sky-diving every weekend and race formula one cars, then why can't the FDIC set rates according to how risky the bank is?

The fact that they don't even consider that and instead choose blanket bans makes no sense to me. 
(This is another rant, but why can't health insurance companies charge more for people who smoke and don't exercise?  I think the health insurance market can be much cheaper and more efficient if this was allowed.  Because it is not, the rest of us have to pay ridiculous premiums; the unhealthy have no incentive to get healthy)

I'm a free market guy and that's my solution.  Pricing, pricing, pricing.

This solves a lot of other problems too.  Should the federal government guarantee mortgages?  People always seem to argue yes they should or no they shouldn't.  The real question is, yes, why not if it is priced correctly?  If it is priced correctly, then it doesn't matter who does it.  If it is priced incorrectly, then nobody should.

I was always baffled at the fixed nature of mortgage guarantees too.  They charge a fixed rate to guarantee a mortgage seemingly without regard for any risk factors (like price of house compared to affordability).  A mortgage guarantee cost the same whether the house was cheap or very expensive.

Anyway, back to banks and bonuses.  Instead of banning proprietary trading and banning bonuses or doing anything so simplistic and silly, why not just change fees according to risk?  I am a big believer in setting proper incentives, not legislating/banning this and that.

If you make all of your money in proprietary trading and very little on loans (and your balance sheet is allocated accordingly), you pay a very high FDIC fee.  If you make all of your money on loans and do no proprietary trading at all and you have a low levered, conservative balance sheet, then you pay a very low FDIC fee.  Maybe even zero.

So Citibank would pay a much higher FDIC fee than, say, M&T Bank.  Why not?

Investing as a Skill

I am now reading a book by Jerry Yang called "All In".  Jerry Yang is an Hmong immigrant from Laos who came to the U.S. and in a very short period of time won the World Series of Poker in Las Vegas. 

It is a very interesting book for many reasons, one of which is that I have never read a story about the horrors the Hmong went through in their native country.  In the U.S., we pretty much only hear about how bad the Holocaust was.  Yes, the Holocaust was horrible, and it's sheer magnitude is astounding.

But that is not the only horror that occured.  Many have occured more recently, and continues to this day all over the world.

Anyway, that's another topic. 

What struck me about this book is how Yang became a strong poker player and got to the top in Las Vegas. 

He watched a lot of Poker on TV and took notes and studied hard.  He played freqeuntly in local tournaments and meticulously took notes, asked a lot of questions to learn from better players, he analyzed his own playing to see what he could have done better etc...  The sheer effort is very inspiring.

Why does this strike me? 

Because a lot of things, for some reason, are taken for granted and people tend to brush things off with words like "talent".  Oh, he's talented.  Oh, he has a knack for this or that.

But the fact is that behind a lot of success is a lot of hard work.  I know this sounds obvious.  We all understand that.

But somehow, in certain areas of life, people tend to forget that.

And I think this is particularly true in the world of investing.  I have spoken to all kinds of traders and investors, pro and amateur for many years and it's always amazing that a lot of people don't really take investing to be a learnable skill.

Oh, I'm not as smart as Warren Buffett, they'll say, so they'll speculate in penny stocks where people just email me tips.  Oh, I have no luck with stocks so I will speculate on 100-1 leverage in the foreign currency markets (they think they can't be Buffett but they can suddenly become a George Soros).

Even for Warren Buffett, it took a lot of effort to get where he is.  He was not just some smart guy that tended to have knack or special talent to pick stocks.  The guy read all the investment books available at the local library at an early age and spent much of his early career just reading financial reports for many hours every single day (and continues to do this to this day).

Michael Milken (not a hero today, but) used to carry a duffle bag full of financial reports on his long, daily, commutes. He knew more about companies than many other people and that helped him develop his business. 

Speaking of Warren Buffett having read every single investment book at the local library, Bobby Fischer too, did the same thing at an early age.  He went to the Brooklyn Public Library and read every single chess book they had there, and he actually spent time memorizing information in those books he thought would be useful.

Talent? Knack?   Maybe at some level that is required.

But what sets the Buffetts and the Fischers apart from everyone else is the sheer effort they put into trying to get better.  (This is not to say that anyone can be a Buffett or Fischer, of course.  But it's true that anyone can get better with some work).

Let's get back to investing. 

I don't know why, but for a lot of other things, people understand that you have to work at it to get better.  Nobody buys a violin and then surfs the internet and tries to find a website that will promise that they can be virtuoso violinists in five days.   Nobody buys a piano and tries to learn how to play in a week.

Even sports like tennis, nobody expects to be able to learn how to play quickly.  They will commit to weeks and years of lessons to get better, and if they are serious they will enter tournaments (as playing tough competition is a must in improving at anything).

But when it comes to investing, for some reason, many people feel that hard work is not necessary.  If only they can find the right website that will show them how to make money without much effort.  Or the right technical indicator.   Or the right 'system' that promises the an instant fortune with very little money down.

People will buy stocks on a tip, lose money and then condemn Wall Street as a bunch of criminals and swear off stocks.

They will buy internet stocks at the peak of the bubble, lose money and then conclude that stocks are no good.  Or they will assume they have no 'knack' for timing the market.  Or they will blame the immoral banks and conclude that it's impossible to make money in the rigged markets (this is true if you try to play by *their* rules; yes they will take what they can and cut you up so you have nothing left!).

They will buy a bank stock at 0.8x book and it will go bankrupt and conclude, again, that stocks are too risky and no good.

But many people won't take the time to try to understand the process of investing.  It's actually a little mindboggling.  I guess for many people, the stock market is no different than a casino (or at least the slot machine side of the casino); they just make bets and hope for the best.  Whatever happens is good luck or bad luck.

It's OK to not be interested in investing.  For most people, an index fund will do just fine.

As Peter Lynch used to say, he was baffled that people spent more time investigating, analyzing, comparing and studying refridgerators, for example, than when they buy a stock even when the investment in the stock is many multiples higher than the money spent on a refridgerator.

This is so true.  People will comparison shop and be very careful about purchasing a PC, tablet or smartphone, but they will tend to spend tens of thousands of dollars on a stock with very little work or analysis.

Anyway, when I read about guys like Jerry Yang, I realize how similar everything really is.  It is very inspiring to read about people who worked hard at something and got good at it.

By the way, I also read a couple of books about Ichiro and it's the same story.  He spent many, many hours every single day practicing baseball from an early age, and his work regimen continues to this day.  This is how he became a great ball player.  I haven't read a Ted Williams book,  but he was apparently the same.   He was obsessed with improving his hitting.

If one wants to improve as an investor, it will take a lot of work and experience.  Of course, not everyone will want to do it and that's fine.  It's just a little confusing to me when people have a hard time in the stock market and blame all sorts of things and don't really seem to understand that investing is like anything else and will take a lot of work to get better.

Stunningly Bad Analysis

I can't believe how sloppy and bad some of these credit rating agencies are, and it's really obvious how dangerous they are.  We saw how sloppy and bad they were when things melted down in 2008/2009, but this came as a surprise because the perp is Egan-Jones, a small rating agency that wants to compete with the majors, Moody's, S&P and Fitch by being better and more independent (not paid by issuers etc...).

The latest fiasco with Jefferies Group (JEF) is insane.  Egan-Jones downgraded Jefferies after the MF Global bankruptcy because JEF owned $2.6 billion or so of problem sovereign bonds in Europe.  First of all, this seems highly reactionary to me; to downgrade something right after an event like the MF Global bankruptcy.   It's as if they didn't realize that there was a sovereign debt problem in Europe until the MF Global bankruptcy, or didn't notice this $2.6 billion position until then.

And then to only mention a long position in a market-making, hedged book of bonds seems highly ignorant of how investment banks work.  Incredibly sloppy thinking.

Thankfully, JEF responded quickly and clarified their positions.  However, Egan-Jones refused to back down and made a silly statement.

Here's a cut and paste from a Wall Street Journal article:

JEF did clarify that their short positions were in securities and weren't default swaps or other derivatives with credit risk.

This is no different than a long/short inventory position of equity market-makers.  Market-makers have billions in stock inventory but is mostly hedged and this has not been a problem, historically.

JEF responded with a series of releases.  Here's one of them:

The position looks fine.  It's incredible that an analyst would only use a long position to evaluate a balance sheet without looking at what's on the other side of it.

Sure, Morgan Stanley blew $10 billion on poorly hedged mortgages during the crisis (or some such incredibly high number), but they were in fact highly complex products with risk characterstics that are very different than sovereign bonds, no matter the credit rating of the bonds (JEF does in fact specialize in high yield).

JEF also owns $1.68 billion in equity securities (with $1.57 billion in equity short positions) and $4.2 billion in corporate bonds (with $3.6 billion shorts); a large part of the corporate bonds are probably high yield, too. 

Why not mention only the long side of those positions too, which may look even more risky?

Leucadia National (read about here), the largest owner of JEF jumped in and bought 1 million shares for $11.84 and 500,000 shares at $11.35.

It is really scary that this sort of bad analysis can possibly cause a run on a perfectly healthy, fine company (I don't own any JEF, but have positive view about them.  Even the very vocal bank critic Meredith Whitney said JEF is run by a very good, conservative CEO).

Anyway, these are scary times to be sure for everyone.  People are very trigger happy; shoot first and ask questions later.  Or in many cases, just shoot, shoot, shoot and don't think or ask questions!

Market Volatility

The market seems to go up and down these days depending on who said what, or what the latest development in Europe is.  No confidence vote?  Referendum?

It is really silly.  Someone said to me the other day that it must be hard to deal with markets like this.  I said, "What are you talking about?  The market is flat on the year".

These days when the market is up or down 200 or 300 points, I really don't care because I assume someone in Europe will say something tommorow that will reverse it. 

With all this gloom and doom and fear, the market is flat.  Think about that for a moment.  We had a U.S. government debt downgrade that everybody feared.  We had Fukushima, the biggest nuclear disaster since Chernobyl.  We had, or are having a Greece default (or technical non-default).  We have occupiers on Wall Street.

If you told someone at the beginning of the year that these events would happen but the market would be flat by November, no sane person would have agreed with you.

As Seth Klarman (and most other good investors) says, you have to look at what a company may be worth in five years and try to buy it at substantially below that price and not worry about what happens in the near term. 

There was a great Shelby Davis quote that went like this:

"To sail across the ocean, you must balance making progress in fair weather with the ability to withstand the inevitable storms. Those who think only of the storms will never leave the shore. Those who think only of fair weather will never reach the other side."

There was another one that I can't seem to find.  I don't remember where I read it, but it was something to the effect that we must be guided by the light of the lighthouse (or stars) rather than the waves crashing against our boat.   In other words, don't let the short term noise distract you from your medium to longer term goals.

In investing, the light is the intrinsic value of something you own.  If you understand the business and know it can get through some adversity and it is trading at less than instrinsic value at an attractive level, who cares what is going on in Europe?

I know, I know.  Easier said than done.

(Of course, if one thinks that the goings on in Europe is the beginning of the end of capitalism, then they may have other ideas.)