WaMu's Collapse: Lessons Learned

From AP News:

The Federal Deposit Insurance Corp. seized WaMu on Thursday, and then sold the thrift's banking assets to JPMorgan Chase & Co. for $1.9 billion.

Seattle-based WaMu, which was founded in 1889, is the largest bank to fail by far in the country's history. Its $307 billion in assets eclipse the $40 billion of Continental Illinois National Bank, which failed in 1984, and the $32 billion of IndyMac, which the government seized in July.

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So, what can we learn from WaMu's ordeal?

• Among WaMu investors are Bill Nygren of Oakmark Funds, David Dreman of Dreman Value Management and Charles Brandes of Brandes Investment Partners. These are respectable, proven value managers with years of experience. So, the most important lesson here is that we have to do our own work. Even professionals can be very wrong.
• WaMu was Bill Nygren’s largest position, accounting over 15% of portfolio. The significant value destruction of WaMu caused Oakmark Select I Fund to drop 14.6% in 2007 and a further 9% drop this year.
• So, don’t make financial company the largest position, unless it has a very strong balance sheet and no liquidity issue with superior management like Berkshire Hathaway.

Happy learning,
David

Buffett's Goldman Steal: Lessons Learned

Warren Buffett has secured another great deal during this great financial turbulence by investing $5 billion in Goldman preferred shares, which has 10% dividend yield. On top of that, Berkshire also will get warrants granting it the right to buy $5 billion of Goldman common stock at $115 a share, which is 8% below the 4 p.m. closing share price Tuesday of $125.05. At Goldman's roughly $50 billion market value, based on that closing price, exercising those warrants would give Berkshire about a 10% stake in Goldman.

So, what are the important lessons that we could learn from Buffett:

1. WSJ summarized Buffett's technique accurately, "Characteristically, Mr. Buffett's investment gives him an attractive income stream, downside protection and the strong chance of big gains."
2. Avoid excessive leverage. If you have significant leverage like Goldman Sachs, Morgan Stanley, Lehman Brothers and other financial institutions, when liquidity disappears either you go bankrupt like Lehman, or you might need to pay extremely high interest on loans to stay in the game.
   

Happy Learning!

A.H. Belo: Sell Out

Dear readers,

On 21st July 2008, I posted my write-up on A.H. Belo, stating why I find A.H. Belo mispriced. The share was trading at $5.83 at that time. Now, two months later, the price has reached $7.07, which is an increase of 21.3%, or an annualized rate of 127.6%.

Although I still believe that A.H. Belo is mispriced and has more upside than downside, I have sold off my stake in A.H. Belo. My primary reason is because A.H. Belo is in a very difficult business and the situation might get worse over time. With current volatility in the market, a lot of significantly better companies with strong cash flow have become very attractively priced. It would be prudent for me to "upgrade" to better quality companies.

To quote Mr. Buffett, "Both our operating and investment experience cause us to conclude that "turnarounds" seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price." [Extracted from Berkshire Annual Report: 1979]

I will stop covering A.H. Belo from now.

Happy investing,
David

Disclosure: No position in A.H. Belo

Constellation Energy: Stars Align for Buffett

Warren Buffett’s ability to act swiftly in buying Constellation Energy Group for $4.7 billion is truly amazing. At the beginning of the year, Constellation traded over $100 and its share has slumped below $25 prior to Buffett’s acquisition announcement. For $26.50 take-over, Buffett is paying about $11.5 billion price tag for Constellation, including net debt and retirement obligation. LTM EBITDA: $1,925 million, which means Buffett paid less than 6 X EBITDA for Constellation. BTW, property, plant and equipment (PPE) are worth $10.4 billion.

The great lessons from Buffett and Munger are:

• Cash is King (in the right hands): In 1987 annual report, Buffett said, “Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun.” Although holding cash isn’t exciting, it is a potent instrument for “offensive” during crisis or panic time.

• Be Prepared: From OID Aug 2008 Edition, Charlie Munger said, “What is interesting is how brief many of these opportunities to take advantage of dislocations are…. The dislocation was very brief, but very extreme. And if you can’t think fast and act resolutely, it does you no good. So you’re like a man standing by a stream trying to spear a fish. And if the fish just comes by once a week or once a month or once every ten years, you’ve got to be there to throw that spear fast before the fish swims on. It’s a pretty demanding activity if done right.”

• Leverage Kills. Even good companies can be killed by excessive leverage. Unlike Lehman, which is loaded with “toxic” investments, Constellation Energy has real, valuable assets. The only reason it is pushed to the brink of desperation is because of the leverage. If it has strong balance sheet at the first place, Buffett would not have the opportunity to get these prized assets.

• Buy from Desperate Sellers: True bargains only come along when there are desperate sellers. Just one week before, Constellation traded above $55 per share and now it is trading at half of that.


Disclosure: LONG BRK.A, BRK.B

Good Deal or Bad Deal? Lloyds TSB to Acquire HBOS

It is fascinating to see HBOS to be acquired by Lloyds, which is only half its size! In my humble opinion, I think the government might have played a key role in this deal to avoid another Northern Rock-like nationalization. However, I'm not sure whether this is a smart move or not.

Lloyds has total assets of £367.8 billion and net tangible equity of £8.54 billion. Leverage of 43 to 1.

HBOS has total assets of £681.4 billion and net tangible equity of £18.32 billion. Leverage of 37 to 1.

These two institutions are as leverage as one can be. How much can a much leveraged, yet smaller bank: Lloyds "rescue" HBOS?

BTW, when Lehman filed for Chapter 11, it has a leverage of 32 to 1. And, Bear Stearns has a leverage of 33 to 1 when bailout by JPMorgan Chase. Even Morgan Stanley with 25 to 1 leverage is potentially merging or selling to Wachovia or other willing buyer.

The Lloyds-HBOS deal doesn't look like a good deal to me. It might solve a temporary liquidity crisis for HBOS, but if residential mortgage defaults start climbing, which I believe it will, then, Mr. Gordon Brown, might need to rethink of bailing out Lloyds-HBOS on a later date....

If HBOS needed a bailout, it would need a larger, better capitalized bank, i.e HSBC. Of course, the government is worried about monopoly, etc, etc. Unless government wants to nationalize HBOS, it really should let bigger bank like HBSC to step in. Bear Stearns is successfully taken over by JPMorgan Chase as JPMorgan is significantly bigger and has a "fortress balance sheet".

Any thought?

Disclosure: No position in any of the above mentioned banks

AIG Bailout; Warren Buffett's, Charlie Munger's and Jeremy Grantham's Advice

It is incredible that AIG is taken over by the U.S. government as credit dries up. I want to share with you what Warren Buffett said at 2008 annual meeting....

Buffett: In fact, that was one of the interesting things that was said in testimony before the Senate finance committee. I think two of the witnesses (Bear Stearns) said: " We understood we couldn't borrow money unsecured if people started looking at us askance. But we never dreamed that we couldn't borrow money secured." Well we found that out at Solomonn 17 years earlier, when we were having trouble borrowing money secured. When the world doesn't want to lend you money, 10 or 20 or 50 basis points - or a bigger haircut on collateral - doesn't do much. They'll only lend you money if they want to lend you money.

And if you're dependent on borrowed money every day, you have to wake up in the morning hoping the world thinks well of you. And there was a period a couple of months ago when almost every investment bank in the United States was plenty worried about whether people were going to think well of them the next morning. [Extracted from OID Aug 31, 2008 edition]

Also, Charlie Munger made excellent point on risk-aversion....

Munger: You can easily see how risk-averse Berkshire is. In the first place, we try and behave in such a way that no rational person is going to worry about our credit. And after we have done that, we also behave in such a way that if the world suddenly didn't like our credit, we wouldn't even notice it for months, because we have so much liquidity. That double layering of protection against risk is as natural as breathing around Berkshire. It's just part of the culture. [Extracted from OID Aug 31, 2008 edition]

Jeremy Grantham wrote this in Jan 2008....

Grantham: About 2 years ago I was introduced to Hyman Minsky's argument on the development of credit bubbles. Remarkably, 'stability is unstable' really captures his point. Investors, when confronted with an apparent reduction in risk, will seek to return to their normal or desired risk by leveraging up. This attitude becomes contagious and reinforcing – risk is ignored and debt levels soar until at the peak capital gains are needed to merely pay the carrying costs. Then something, it doesn't really matter what, goes wrong; the risk in the environment is seen to return to more normal levels. Many players are caught with risk levels far above their desired level and are forced to cut back on leverage and risk in general, which puts pressures on the prices of what they own and so on. It has a simple and powerful logic. Well, the Minsky Meltdown has clearly arrived, and one shoe after another of the market centipede drops onto the floor, and we are waiting for many more. This is the most important U.S. financial crisis since World War II: it is of course far more global than previous crises, with tentacles reaching everywhere, and it coincides with broad overpricing of assets.

So, the take home messages:

* Excessive leverage kills. Just look at Bear Stearns, Freddie Mac, Fannie Mae, Lehman Brothers and now, AIG. Thus, avoid excessive leverage and have plenty of liquidity like Berkshire Hathaway and Fairfax Financial.
* Margin of Safety. Like Munger said, having "double layering protection against risk."
* "Stability is Unstable"!

Best,
David