A Thought Journey

Casual readers of this blog will notice the random themes, introspection, and commentary on events in business and finance. I have decided to channel this, but hopefully in a more meaningful way, into a series of essays. The themes are broad and the ideas random. This fits my personality and allows me to reflect and create. By posting this, I commit myself publicly to this work: a short book of essays.

That said, I will use this site to diffuse any finance-related theme I include in my writings. A note of warning or of jubilee: postings going forward will be more sporadic and less frequent than the past. Below is what I have so far. I'm halfway done with two of the essays. I welcome your comments and ideas.

Education:

i) Why I Write

ii) Types of Books

iii) Education

iv) Cultural Observations

Places:

v) The Real Mexico

vi) The Farm

People:

vii) Mr. Buffett

Misc:

viii) On Investing

ix) My Experience at Goldman Sachs

x) Our Sacred Stuff

xi) Running

xii) Skiing & Golf

xiii) The Buy Recommendation

Fees

Ebay's exit from the Skype debacle is a boon for financial helpers: fees for buying and then fees for divesting. Ain't life grand. It's not that advisers don't always earn their keep. But there are definitely misaligned incentives, when, from their perspective, the payout is: deal closes, big payout; deal fails, little money. Unless of course, you advise on both the acquisition and the divestiture. But I'd hope Ebay would have more sense than using the same helpers twice.

One Question

From its humble beginnings decades ago, Berkshire's annual meeting has morphed into a series of events known as the Woodstock for Capitalists. Rental car prices for that weekend attest to the popularity of the meeting; I can't find a car for less than $50.00 per day.

That said, this year's annual meeting offers a huge improvement over past years: the Q&A format will be half questions pre-screened by three journalists, and half awarded by drawing. Previous years were plagued with disputes about the ethics of hydroelectric dams and the conflict in Darfur (two important issues but not worthy of so much mic time in this type of setting).

And so, I offer my question, which I've emailed to one of the journalists mentioned in the 2008 shareholders' letter.


Messrs. Buffett and Munger:

Berkshire in the past has bought and sold interests in public companies. Could you comment on the orthodoxy of the till-judgment-day-do-us-part philosophy of Berkshire's operating companies?


Disclosure:
None

Credit-Default Swaps

If there's been one benefit of the financial crisis, it's the improvement in financial literacy. People are now paying attention to ratings, interest rates, and Fedspeak. Even credit-default swaps, at whatever level of understanding , are fair game for dinner-time conversation.

The recession has even brought into question the bedrock of finance theory: efficient markets, or the idea that market prices reflect all available information. One professor at the Solvay Brussels School of Economics confesses that the CDS market is "opaque, often illiquid, and prone to manipulation." This leads to share price pressure and a bundle of screwy signals to both rating agencies and short sellers. Alas, the markets are mostly efficient, and certain anomalies are worth exploiting. Just don't try to argue with your business school professor about this.

Oh the joys of TARP

The shotgun marriage between banks and government appears to be having some unintended consequences. While some firms, Goldman in particular, have talked about returning bailout cash, Washington has stalled such attempts saying it's not ready to get its money back. Weird.

Experiences financiers are now seeing today as a great time to jump ship. Punitive tax rates on already-distributed bonuses, further regulatory scrutiny, and a more risk averse balance sheet must have an effect on the most experienced bankers willingness to go to work in the morning.

Goldman offers a great example. Recently, Jon Winkleried, one of the top-3 at GS, decided to retire. Byron Trott, the rare banker (if not the only) to receive praise from Warren Buffett, is leaving to start his own merchant banking firm. And the co-heads of Global Alpha, Goldman's flagship hedge fund, are retiring to pursue other interests.

They'll be glad to be away from TARP.

AmEx: Reasonably Priced Plastic

The below is posted with a one day lag. (it was part of the application process for a freelance/contract writer position).

American Express

To participants of the capitalistic system American Express (“AmEx”) needs little introduction. The firm is a global payments, credit card, and travel company whose products are catered to well-heeled clients. AmEx runs one of the most prominent credit card networks in the world; unlike its largest rivals Visa and Mastercard, however, it profits from the entire economic cycle of issuing the card, swiping the plastic (via the merchant fees), other fees, and the spread on loans it provides. It is an economic powerhouse but is subject to greater volatility because of its risks of operating such a full cycle network.

As a somewhat mature company it “has sought to return at least 65% of the capital it generates to shareholders as a dividend or through the repurchase of common stock,” a goal it has since tempered as a result of the strings attached with money it has taken from Uncle Sam. A more muted target, though impressive nonetheless, of 20% return on equity, is now the company’s goal on account of higher charge-off rates and higher capital requirements.

In 2008 the company grew revenue 3% year-over-year to the impressive sum of $28 billion. This is possible through its boastful network of 92.4 million cards, an industry leading high-FICO-score client base, and ultra-low costs of funds of 3.63% for long-term debt and 2.11% for short-term borrowings.

My unofficial mentor, Warren Buffett—through Berkshire Hathaway—has maintained his position as the largest shareholder. That’s not to say the stock is without risk. A few of AmEx’s risks and uncertainties include: legislation on interest rates would adversely affect the company’s spread (interest charged vs. cost of funds); a really-bad-case-scenario in the macro environment would result in an even bigger spike in the charge-off rate (currently at 8.7%); a longer-than-expected turnaround in the securitization market would force liquidity issues.


Furthermore, at 407 pages, the 2008 10K is long enough to discourage even the most determined annual report aficionados. But the audit report looks clean and the numbers don’t look funny.

Valuation
So what is AmEx worth? Cash flow from operations has historically been 2-3x net income, largely due to the non-cash charge for the provision for losses. I use the more conservative net income as a base. The economy is in “shambles” as Buffett has stated, and a greater portion of the world’s citizens may continue their indifference towards paying their bills. Earnings multiples should be applied with caution since these are truly extraordinary times. Even with a 50% haircut off of last year’s net income, the stock trades at close to 12x earnings, or an 8% adjusted earnings yield (the inverse of P/E ratio)—it currently has a 5.9% dividend yield while paying out only 1/3 of earnings. This is a conservatively adjusted value and reflects the erosion of securitization income ($1bn in 2008) and a marked increase in the charge-off rate.

The Bottom Line
American Express has inched its way up to the 11th spot in CoreBrand’s brand ranking survey of 2008 and is 15th in BusinessWeek’s 2007 ranking. Translation to the card user: If you get charged $1000.00 for a breakfast at a café in Peru, you can trust that AmEx will fight to reverse the charges. It is the antithesis of the IRS. That business moat is hard to replicate. The company is positioned to profit from the long-term demographic trend towards a cashless society. That said, the brand value, and the attractive adjusted earnings multiple, provide an adequate margin of safety. I rate American Express a “buy.”




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P.S. 500 words (about the length of this piece) is a very short space to try to describe and dissect a business.

Disclosure:
The author has an AmEx card but pays off the balance every month. He also owns shares of AXP.

Performance Update

All stock-related sites should report an unbiased scorecard. The Faro portfolio puts itself up against the same test. The fund inception date correlates with the launch of this humble blog--estimates are in that there are 4-5 regular readers. The inception date is Oct 2007. If I had tried to "time" the start of such an auspicious task, well, I'm really bad at timing: stocks have lost half their value since then.

I still believe the case for stock investing stands. The transaction costs are almost nil (tell that to your real estate broker); they allow you to become part owners in pieces of potentially great businesses; owning strong companies over time is a great buffer to the loss of purchasing power (if the business can raise it's prices with inflation, it's returns should rise with general prices); historically, the returns for any one with a long-term horizon better any other asset class.

Since inception, the portfolio is down -17.8% vs. -49.40% for the S&P. It's worse than under you mattress but much better than most mutual funds.


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Full Disclosure: none