Buffett looks ahead after lousy year.

The much anticipated 2008 year-end Berkshire Hathaway Shareholders’ letter was released today. Buffett’s words are followed both for information on the direction of the conglomerate (highly weighted in insurance and utilities), as well as his thoughts and criticism of both business and politics.

It’s tone, wit, and substance is eaten up by media outlets. Stories are released within two hours after digesting the 20 page later. The headlines, of course, say a lot about how his words are interpreted, what the company’s results mean, and how this bodes for the economy as a whole.

So, I present to you how the most highly-regarded media sources and their spin on what he said. This does not substitute actually reading it, something I would encourage to anyone who either owns stocks or cares about politics or economics.

Here they are:

AP: Berkshire reports a 96 percent drop in 4Q profit

NYT: In Letter, Buffett Is Frank but Optimistic

WSJ: Berkshire Reports Worst Year Ever

Bloomberg 1: Buffett Says U.S. Economy Will Be `Shambles' in 2009, Likely `Well Beyond'

Bloomberg 2: Berkshire Profit Plunges 96% as Buffett Writes Down Derivatives Positions

Reuters: Berkshire net sinks; Buffett says economy in shambles

FT: Buffett’s Berkshire has worst results ever

I would have to cast my vote for the New York Times article, both for the headline and for its content.

As a Buffett devotee, I copied quotes and have lumped them together in this little collage:

“America’s best days lie ahead…economy will

be in shambles throughout 2009 – and, for that matter, probably well beyond…

Home purchases should involve an honest-to-God down payment

of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified... The investment world has gone from underpricing risk to overpricing it…The U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

What does this mean? The last two parts of the quotes are crucial for the individual investor. Buffett is predicting inflation; Bernanke is a scholar of the Great Depression and knows the perils of deflation. Inflation is currently not on the market’s mind, but as money is injected into the system prices and interest rates will rise—a death blow to bonds (prices and interest rates are inversely correlated). But, short-term bonds (little interest rate risk) in high quality corporations will do well—the “overpricing” of risk that he mentions means that some bonds are cheap. That’s why he’s pounced on fixed income in GE, Wrigley, Goldman, Harley Davidson, Tiffany, and others.

We’d be smart to look for similar bargains in high-quality companies’ debt.

JA

What to do with extra cash

The Economist has a great piece on the dilemma of today's prudent savers. It's hard to get excited about 1-2% yields on online savings accounts. And 5-yr treasuries yield only 2%.

There is hope in one end of the capital structure. High-grade corporate bonds that mature in the next 2-4 years offer compelling prospects (longer-term bonds have greater duration and therefore greater interest rate risk--think about possible medium-term inflation as we sell treasuries to Asia.) Spreads now are 400-600+ basis points above treasuries. Now, of course, this reflects perceived and actual risk, but with a little review of the underlying company's balance sheets and off-balance sheet stuff, you'll be rewarded by more than a few pennies.

Here are a few (non-callable bonds) worth considering as an alternative to idle cash:


Company | Rating | Maturity | Price | Coupon | Yield to Maturity | Current Yield

Alcoa BBB Jan/2012 87.88 6% 11.00% 6.83%

Kohls BBB Oct/2011 105.69 7.4% 5.02% 6.98%

Goldman A Feb/2012 99.30 5.3% 5.56% 5.4%

Nordies Reports

Prized by shopaholics and loathed by penny pinching husbands, today after market close, Nordstrom (JWN) reports 4th quarter financial results.

Two days ago, intra-day volume for 10.00 March put options spiked to 1,368 contracts (representing 1.37 million shares, or less than 1% of float); calls of the same strike price only attracted 2 contracts. Betting on short-term momentum has never appealed to my personal investment philosophy. Though JWN’s intrinsic value won’t change much regardless of whether the retailer misses by a penny, traders feel it’s worth betting that the earnings release will disappoint.

Amazingly, during the dotcom bubble, same store sales dropped only 1%. During our current market malaise, however, same store sales have fallen over 12%. There is a price at which I’d love to own such a great brand—the stock is 70% cheaper than the 52-week high. But given the economic headwind, I still wouldn’t now bet on $200.00 jeans.

I’d like to see management cut back on capital expenditures which have eaten into cash flow over the last year. The company should slice its 4.6% dividend yield in half, saving the Seattle-based retailer $70mn per year, which it could use to help trim down the $2.74bn in long-term debt (2x EBITDA).

A note

In a previous post on how the housing bubble grew, I mentioned two potential guilty parties: banks and individuals. I should have added the role of government to the equation. Uncle Sam was complicit through its drastic loosening of the fed funds rate in the post-dotcom bubble. The government, through friends Fannie and Freddie, also encouraged insane lending and scooped up over half the mortgages originated.

This will be written in history as one of the more memorable unintended consequences of government intervention.


Image source: http://www.princeton.edu/~pkrugman/fed-funds-rate.png

Baby Formula and Special Dividends

If you have children you've complained about the cost of baby formula. Today a baby formula maker had an IPO whose success is built on pricey fake mother's milk. Mead Johnson (MJN), leader in the pediatric nutrition market, sold 30M of 200M shares outstanding. Proceeds from the offering, a carve-out from Brisol-Myers Squibb (BMY), valued the company at over $4.8B.

It appears to be reasonably valued. The company is selling for 1.7x revenue, 10x earnings, has grown sales at 5-10% even in challenging economic times, and boasts of a 22% operating margin.

Now to the obligatory "use of proceeds" section. The $600M in net value the company received from the IPO will go to pay an inter-company note. However, $1.4B will still be left in debt since the parent company, surely through the advice of a strategic adviser, decided to "lever" MJN with $2B in debt prior to the carve-out. Not that this isn't manageable given Mead Johnson's level of profitability, but to put the stockholders' equity at a deficit of $800M to line the wallets of Bristol-Myers Squibb is wrong. BMS will use the $2B to pay a special dividend. That ain't so special a way for Mead to start as a public company, even if it can rest on high-priced milk.

On housing, lending, and advice for my grandkids

As all writers of anything finance-related, I feel compelled to comment on housing’s role in our current economic crisis and end with the clichéd "lessons learned" bit.

It’s tempting to say we all foresaw this. There is no doubt that housing was and is a critical part of our deep economic malaise. The seeds were sewn through low interests rates, poor lending practices, and the cultural notion that a house is more than just a roof over one's head. Though it can be more, speculative short-term gains in residential real estate should never drive a rational person’s decisions.

On the housing bubble, there are two predominate ideological camps: 1) it's the banks' fault; 2) it's the home buyers’ fault.

The first group feels the home buyers were unsuspecting victims, preyed upon by Mr. Burns-type lenders: greedy, cold, and with a profit-only code of ethics. (Not all bankers are like this, but it makes for good imagery). These bankers were eager to rush loan approvals to hasten the securitization process whereby ensuring private school tuition, vacations in Bora Bora, and early retirement. Bankers should be punished, regulated, and striped of the compensation that Croesus himself would envy.

Banks are greedy. Their fees are high, and certain aspects of their businesses need to be regulated (OTC options come to mind). But they do, however, provide a valuable service to the economy. Credit drives our economy. Anyone who’s been granted a loan will attest to that.

The other group believes the home buyers themselves are to blame. Stories of credit-less deadbeats buying multiple houses with the idea of flipping and becoming wealthy, draw the ire of penny pinchers. These reckless borrowers collectively failed to notice the bubble-level home price to median income (the PE ratio of homes) ratio. Somewhere down the road, it would have to correct. They deserved their prize; they too were greedy. The modern corporation does not hold a monopoly on unethical behavior. After all, this is capitalism, and individualism rules.

To mend the housing and credit problems there are no easy solutions. I have no idea which items of the current "stimulus bill" will have the greatest multiplier effect. I only hope that government behaves better than in times past.

Understanding this, however, isn’t the real issue from a personal learning point of view. Financial manias and asset bubbles will reappear. They are “Black Swan” events.

The real value in having lived through 2008 (and beyond) is not learning how we can personally predict (and prophetically time) any future crises, but to examine it from the most micro of human levels. What do these events tell me about how I should shape my behavior and views?

At the risk of being too prescriptive, something that I loath about most business books, I offer advice to my children and future grandchildren.

In anything in life, if there are no significant barriers to entry, it's not worth doing. Medicine requires smarts and time. Athletics begs time and talent. Business demands good ideas, execution, and drive. Anyone could set up a mortgage brokerage business and undercut the professional and legitimate players through lackadaisical lending standards. The barrier to doing it right is ethics, work, and patience. Most don’t have all three.

Lastly, (and not that there are only two, but because two are easier to remember) the further you separate the risk taker from the actual risk bearer, the more likely you are to face an unsavory result. A father, through no intermediary, should know and trust his future son-in-law. Bankers should know and trust borrowers.