May 2007 Archives

Rupert Murdoch's bid for Dow Jones (parent company of the Wall Street Journal) is a classic for him: Audacious and savvy. The offering price is high enough that the controlling Bancroft family is taking it seriously.

I hope the Bancroft's just say no. The signs are that they will turn Murdoch down. I'd like them to stay independent because the WSJ is the best newspaper in the world. Why mess with a formula that is working so well. The new editorial and management team in place at the Journal should have time to put their own stamp on the paper, online and offline.

However, I don't think a Rupert Murdoch run Dow Jones would be bad--so long as he is in charge. The real question is what happens when he steps down, and that is coming for the 76 year old media baron. Murdoch is News Corp., and he doesn't have an heir apparent that's up to the job of running his empire. Of course, if that's the case, is Murdoch bidding $5 billion to 1) acquire the best newspaper in the world and 2) buy a young Dow Jones management/editorial team that he believes could step in and run News Corp. when it comes time for him to step down?

The implosion in the subprime mortagge market is a tragedy. It's terrible for those people that bought a piece of the American Dream with an opaque, complex, risk-laden, poorly understood mortgage products.

But it's also a tragedy because of a lost opportunity. The subprime mortgage market held out the genuine priomise that the potent combination of financial engineering and the capital markets could lead to greater wealth for deprived, hard-pressed communities. It's a case Michael Milken, the financial innovator behind the junk bond market, has been making for years. The evolution of the subprime market to Wall Street says Milken was on to something.

In his book "Who's Afraid of Adam Smith?" Peter Dougherty drew a bright line between Wall Street and Diamond Street. Wall Street is Manhattan's money bizarre on steriods. Diamond Street is a downtrodden neighborhood in North Philadelphia. Doughterty, a long-time economics editor, muses in his book about how Adam Smith would confront the dismaying contrast between the two places.

The tale of these two streets, one racing with fortune and possibilities, the other rife with desperation, would set Adam Smith's mind astir. In his characteristically philosophical way, he would worry first about Diamond Street. He would think about how to make every North Philadelphian a merchant, for in doing so he would provide the key not only to greater wealth for the unlucky and deprived, but also the basis for community--for enriched social capital and for greater democratic engagement. The key he would identify would be that of new ownership--of homes, of jobs and businesses, of financial assets.... Smith, in his economist's intellectual style, would set himself to figuring out how to harness the financial horsepower of Wall Street in the interest of Diamond. The disparity that seperates these streets, as if on two different plants, has challenged some clever economists to think, in Smithian style, of using the prosperity of Wall Street to power the returns of Diamond Street by turning the undeveloped assets of Diamond into potential profit for Wall.

The growth of the subprime market proves that the fundamental insight is right: The financial might of Wall Street can be harnessed to build assets for the poor. The problem with the subprime mortgage market is that no paid enough attention to the actual contracts being peddled, many of them fraudulent at worst and misleading at best. The neglect is coming home to roost.

I hope that the promise of subprime financial engineering isn't lost during the current backlash against subprime lenders. Where is Milken's successor? To be sure, Milken ended up spending some time for securities law violations. But the junk bond market he helped create has thrived in his absence. Who will be the junk bond king of Diamond Street?

High-cost mutual funds are hazardous to your returns. If everything is equal low-cost funds will outperform high-cost funds simply because of the former's cost advantage. "However, all things aren't equal amd most high-cost funds also have weaker management, higher risk strategies, and fewer resources," writes Russel Kinnel, director of fund research at Morningstar.

Kinnel notes that high-cost funds are far more likely to disappear than their low-cost peers. He examines the survivorship rate of low-cost and high-cost funds, and any gap in survivorship rate should give an investor a good feel for the odds of success when picking a fund.

Kinnel found that you can double or triple the odds of success by being a cheapskate. Take tech funds. All the tech funds that existed in 1998 that were in the cheapest quintile of their category were around 5 years later when the tech market rebounded. In sharp contrast, 47% of the priciest tech funds were liquidated or merged away before the upturn

Let's look at his data on domestic stock funds. The quintile with the lowest expense ratio had an attrition rate of 13% over five year periods, and 25% over 10 year time frames. Yet 29% of the high cost funds had been liquidated or merged over 5 year periods and nearly half over 10 year periods.

How about returns? First, he separates the funds into quintiles based on cost and then sees what percentage within each group beat the category average. Of domestic stock funds, 47% in the cheapest quintile succeeded over a 10 year period in beating the category average. For the next cheapest quintile the comparable figure was 33%, then 30% for the middle group, 27% of the next quintile, and a mere 19% of the most expensive quintile.

Bottom line: Fees matter a lot when evaluating a fund. Don't buy the rhetoric that more expensive means better. It doesn't, at least on Wall Street.

In The Economic Naturalist, a new book by Cornell University economist Robert Frank, he describes the concept of "opportunity cost" as one of the two or three most important ideas in economics. Yet Frank notes that tests and surveys suggest that students don't understand the idea, and that their instructors may not have mastered the concept either. The idea is often taught in a boring manner, too.

Whenever you make a decision to do something, you foreclose other options. "The opportunity cost of engaging in an activity is the value of everything you must give up to pursue it," writes Frank.

Opportunity cost is a measure (albeit a very imprecise one) of what we have given up, and it helps us better understand the return we expect from our choices. The late Robert Eisner, an economist at Northwestern University, somewhat tongue-in-cheek illustrated the notion of opportunity cost this way. The cost of buying and reading his book--The Misunderstood Economy--was not only the dollars spent on it but also the value of time spent reading it and the alternative uses of that time. In other words, his book should only be read if you believe your return, both in enlightenment and enjoyment, exceeds its opportunity cost, that is, money spent on the book and the time required to read it. (By the way, Eisner's book is still worth reading. His chapter on the common belief that there is natural rate of unemployment and whenever it's breached inflation isn't far behind is devastating toward the concept.)

The same opportunity cost dynamic is at work when a student not only pays for four years of college but also doesn't earn a steady income during those years. Again, she must believe the monetary reward and intangible benefits exceed the opportunity cost.

Well, I have a suggestion for teaching students the basic idea. It's Pretty Little Mistakes: One Beginning, 150 Endings: The Choice is Yours by Heather McElhatton, a public radio independent producer. The clever premise is that you've graduated from high school, and now you have some big choices to make. If you decide to go to college, go to page 8; if you decide to drive to California, head to page 9. And so on for 501 pages and 215 chapters. It's a fun read, humorous, raunchy and, at times, touching.

Of course, the short vignettes aren't just about opportunity cost. It's about chance and uncertainty, the odd twists and turns of fate we never anticipate, when making a decision as momentous as marriage or as simple as deciding to smile at a stranger walking by.

Still, who knew that learning about the concept of opportunity cost could be this much fun.

Some good news for homebuyers. The Wall Street Journal (you need to subscribe) has a story about Bank of America cutting fees on mortgage loans.

Under the program, Bank of America won't charge borrowers for loan applications, title insurance, appraisals and flood certifications or require them to get private mortgage insurance. Typically, borrowers who don't put 20% down must get mortgage insurance or take out a "piggyback" loan, which combines a mortgage with a home-equity loan.

The no-fee mortgage program is the latest effort by Bank of America to use what the bank calls "disruptive strategies" to gain market share in businesses where it has been relatively weak.

I expect competitors will match BofA, perhaps even setting of a fee war. Even though they have come down over the years, fees in the mortgage business have been too high for too long.

There was no surprise that the Fed stayed pat on monetary policy at this week's Federal Open Market Committee meeting. Inflation remains the Fed's "predominent policy concern". Perhaps the next move by the Fed is even to hike its benchmark interest rate..

Problem is, what inflation? The core rate of consumer price inflation is trending lower (core means the inflation measure minus volatile food and energy prices). The core personal consumption expenditure price index--a broadbased guage of inflation pressure--is running at a 2.1% rate year over year. That's down from 2.4% pace the previous month. The Fed is tight with the growth in the monetary base close to record lows, according to data from the Federal Reserve Bank of St. Louis. Companies find it tough to hike prices with the international and domestic compeition for markets and profits fierce.

I'd go farther and argue that we really haven't had inflation for some 25 years. All we've had is some hikes in the headline consumer price index and producer price index whenever oil prices spike.

So, why does Bernanke keep worrying about inflation? He's making a "Pascal's wager" with monetary policy. Pasal was a 17th century philosopher and mathematician. He's famous for arguing that after weighing the risks it paid to assume that God exists. Peter Bernstein, the current dean of finance economists, notes that you can't get rid of uncertainty when making decisions. Instead, Pascal's insight was to focus on the how serious the consequences could be if you turn out to be wrong. “Consequences are more important than probabilities,” he told journalist Jason Zweig several years ago.

The probability of inflation taking off is small. But Bernanke knows that if inflation does soar the consequences are dire for the central bank's credibility. Long-term interest rates will rise and the economy tank. The Bernanke Fed is building up its inflation fighting credentials.

Still, my concern is that the Fed will stay too tight for too long. Put it this way: why is the market convinced that a 2.1% inflation rate is ominous but a 1.9% pace is okay? With either number, inflation isn't a concern.

Charlie Munger is Warren Buffet's long-time investment partner at Berkshire Hathway. He's less well-known than Buffet. But he too is a genius at investing.

At the latest Woodstock for Capitalists--the Berkshire Hathaway annual meeting--Munger made some comments captured by an article at Morningstar.

Here's Munger on constant learning:

"The key to success is to continue learning throughout your life with a voracious appetite. Munger later circled back to this topic when he said the best way to gain wisdom was by 'sitting on your [behind] and reading all day.'"

The reporter took notes on some thoughts by Munger on living well:

-- Munger stated that many smart people handicapped themselves with "nuttiness." One example is being an "extreme ideologue," which is the equivalent of "having taken your brain and started pounding it with a hammer."

-- "I'm not going to complain about my age because without it, I'd be dead."

More evidence that inflation isn't a concern, no matter what the Fed says. Today's inflation report has core consumer prices up 2.3% in the 12 months ending in April. (The core consumer price index is the CPI minus volatile food and energy). Higher food and energy prices aren't pushing prices higher in the rest of the economy--and that's been the story for a long time.

In the history of business, B. C. stands for Before Chandler. The Harvard Business School professor transformed the study of Big Business in America. Chandler passed away on May 9th. Here's a link to an appreciation I wrote about Chandler for Business Week online. Professors Tyler Cowen and Alex Tabarrok at Marginal Revolution write about his significance, and offer a number of useful links.

Okay, Warren Buffett doesn't need any financial advice from me. But it's free, so here goes.

The legendary stock-picking head of Bershire Hathaway says he's in the market for a $40 billion to $60 billion deal.

But instead of buying, why not sell off the pieces of the Berkshire Hathaway empire? As Buffett's finance mentor, the great Ben Graham put it, stock price movements offer "an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal."

Mr. Market is saying now is a good time to sell. The stock market is strong, investors are confident and, most importantly, private equity bucaneers are flush with cash. They're buying everything they can get their hands on, and price seems less and less a concern. Deals are going at higher and higher prices. Buffett should take advantage of the private equity bubble.

After all, Buffett (76) and his long time partner Charlie Munger (83) aren't getting any younger. And I doubt that anyone else--even a team of skilled managers--can replace them in running $168 billion holding company with a diverse range of businesses, ranging from insurance to ice cream.

It has been a busy week, so I'm just catching up on some reading I had put aside. The Star Tribune last Sunday had a good story on ethanol: "Will ethanol's flame last?"Researchers at Iowa State University see the ethanol boom going bust with increased supples, falling prices, and a lower return on investment. Kimberly Strassel of the Wall Street Journal editorial staff wrote a piece two days earlier on the growing backlash against ethanol.

Corn ethanol seemed unstoppable, but a remarkable thing happened on the road from Des Moines. Just as the smart people warned, the government's decision to play energy market God and forcibly divert huge amounts of corn stocks into ethanol has played havoc with key sectors of the economy. Corn prices have nearly doubled, which means livestock owners can't afford to feed their animals, and food and drink manufacturers are struggling to buy corn and corn syrup. Environmentalists are sour over new stresses on farmland; international aid groups are moaning that the U.S. is cutting back its charitable food giving, and many of these folks are taking out their anger on Congress.

The prospect of poor financial returns and a political backlash doesn't bode well for ethanol. Instead of subsidies favoring one alternative energy source over another, let's just raise the federal gas tax by a substantial margin.

We warned that this might happen on Marketplace Money, but I am still stunned.

The Texas State legislature has passed a bill exempting Texas from Governmental Accounting Standards Board Rule 45. GASB 45 is a phased in requirement that sets standards for state and local governments to calculate how much they have promised to pay their retirees in health care benefits. It's estimated that state and local governments in Texas are on the hook for $50 billion in future benefits. Nationwide, estimates range from $1 trillion to $2 trillion. That's real money. Don't you think taxpayers should know what politicans have promised public employees over the years?

GASB is a good rule. The move by Texas is bad public policy.

Jeremy Grantham is a legendary value investor. He's also the founder and chairman of GMO, a Boston-based global investment-management firm with $145 billion in assets (including Vice-President Dick Cheney's money).

David Swensen is the chief investment officer for Yale University’s endowment fund. He is hardly a household name, yet when David talks about money and investing it pays to listen. For the past two decades, Swensen has put on a stellar performance at Yale. In the storied rivalry between Harvard and Yale, a competition waged on athletic fields and academic departments, the Bulldog bests the Crimson in the investment sweepstakes over the past two decades-plus.

Thanks to Jim Grant of Grant's Interest Rate Observer, we have some notes from a talk Swensen recently gave to a roomful of active managers. Swensen noted that Grantham lagged behind during the bubble market of 1997, 1998 and 1999. The reason is that he was buying legitimate companies with real earnings. Yet a lot of institutional investors "fired" Grantham for his poor performance. Yet when Swensen looked at the period 1993 to 2003 Grantham did extremely well. "I think it's a stunning indictment of active management by institutions, because even though they are smart enough to find someone who is a winner," said Swensen, "they end up shooting themselves in the foot with their cash flows."

A good commentary on immigration by Michael Mandel at Business Week.

Too much of the commentary about the new proposed immigration bill misses the central point. Here's Mandel:

Immigration reform, in any flavor, has to contend with today's central reality: In a world where goods, capital, ideas, and services are becoming more and more mobile and able to cross national borders, tighter restrictions on the movement of people are increasingly anachronistic.

How can this borderless view of the global economy be reconciled with a bill that actually requires the construction or acquisition of at least 20 new detention facilities capable of holding 20,000 "aliens," as they are called in the bill? The answer is it can't, at least for now. One view of the world tears down the walls that separate countries; the other view builds them up.

The bottom line: Immigration will go up, and the U.S. is the beneficiary.

Not everyone is going to agree with me, but leveraged buyouts (LBOs) in the 1980s were mostly a positive influence on Corporate America. Yes, many people recall the '80s as a time of insatiable avarice and outsized egos, of junk bonds and Ponzi finance, of corporate raiders and merger madness.

But it's worth remembering that U.S. companies stumbled badly in the 1970s. Industrial America lost market share and profits to Japanese, German, and other overseas rivals. Management was risk-averse and isolated from shareholders. The mind-set of the average chief executive officer was economically disastrous. T. Boone Pickens, Michael Milken, Henry Kravis, Carl Icahn, and other financiers shook America's defeatist Establishment out of its gloom. In many ways, the foundation of the high productivity economy of the 1990s was created during the '80s.

My question is, what is the impact of private equity this time around? Like LBOs, private equity takes over companies with a sliver of equity and lots of debt. Problem is, I don't see the benefits this time around, while there are several negatives. First, private equity buccaneers are stripping cash out of the companies they take over through steep management and consulting fees; second, with all the debt payments I doubt management will invest heavily in their business; and third (and most important), it seems that top management is inviting deals so that they cash in with unimaginable riches. Top honchos are more concerned about lining their own pockets by putting their companies up for sale to the private equity bidders than in doing the hard work to manage well.

What am I missing?