Wall Street Journal Recap: April 10-16, 2017

April 19, 2017 / Richard Lewis / Leave a comment

My full notes and analysis on the Wall Street Journal from the past week: April 10-16, 2017 (Week 15). Please Enjoy.

The Wealth Transfer Mechanism

Companies who buy things they do not need, will soon have to sell things that they do. Toshiba is learning this lesson the hard way.

“Toshiba is looking to cash out (its prized computer-chip business) assets to stay alive.” (link)

“Last month, nuclear-reactor maker Westinghouse Electric Co., which is majority-owned by Toshiba, filed for bankruptcy in the U.S., and Toshiba said it expected to book a 1 trillion Yen loss…to account for losses at Westinghouse.”

Investment Lesson:

The stock market works like a wealth transfer mechanism which funnels money from the impatient to the patient.

As a patient investor, Warren Buffett has been on the winning side of this equation for his entire career. He has capitalized on companies selling things they need in order to pay for things they didn’t. An excellent example includes his purchase of a pipeline from Dynergy in 2002.

In November 2001, Dynergy had bought a pipeline from Enron for $1.5 billion. But not too long after, its credit ratings collapsed and it desperately needed to lower its debt levels. So in July 2002, just 8 months later, it sold its pipeline to to Berkshire Hathaway for $928 million. And there you have the wealth transfer mechanism at work. (link)

Gaming Capitalism: How Communists Exploit Free Markets

I don’t think we’ve come to grips with just how easy it is for a communist government to game a capitalist system. Let’s take the following quotes for example:

“A recovery in producer prices in China and a broad rally in commodities have helped stoke Chinese stocks in Hong Kong,” (link)

“The economic data is not bad, and commodity prices have increased compared to last year.”

I tend to view this news with great skepticism. Reason being, there’s just too much incentive for communist governments to manipulate commodity prices through artificial demand. The positive ripple effect of artificial demand through a free-market system is profound. Just a little bit can go a long way as I describe below.

Commodity Prices: Higher prices for steel and other basic commodities create a sense of price stability and fuels investor confidence.
Stock Market: Artificial demand creates artificially high profits. These unsustainable profits are then naively extrapolated and equitized by the stock market, thereby creating a multiplier effect on the value of artificial demand.
- For example: If artificial government demand creates $100 million in profits for Company XYZ, and the market naively extrapolates these profits out indefinitely, a 10% discount rate will create $1 billion in market value. In essence, a communist government can turn the stock market into a printing press. As in this example, 1 unit of artificial profits go in, and 10 units of market value comes out.

Corporate Debt Market: Stable markets and higher profit margins allow companies to borrow and refinance debt at attractive interest rates. This is especially important for highly indebted commodities-based companies. Lower interest rates and fresh capital make companies seem more stable than they are.
Banks : Banks receive three major benefits from artificial demand, as they:
- Remain Solvent: Banks remain solvent as a result of improved financial outlook of debtors.
- Appear to be better capitalized than they really are: Any equity on the banks’ balance sheets that came from a debt to equity swap suddenly looks more valuable, thereby making the banks seem better capitalized than they really are.
- Can make more loans on a larger equity base.

An entire eco-system is then built on top of the foundations of artificial demand. The longer this heavy handed market manipulation persists, the more real investors perceive it to be, and the bigger the bubble becomes.

As Gordon Gekko said, “The illusion has become real, and the more real it becomes, the more desperate they want it.”

Standard Causes of Human Misjudgment

There were many great examples of human misjudgment in last week’s WSJ:

Wells Fargo: (link)

Incentive Caused Bias: “At one point, she is described as being ‘scared to death’ of hurting her unit’s sales figures.”
Over-Influence by Authority: “The report also highlighted how the bank’s push to boost revenue and profit trickled down to thousands of employees who felt pressured to meet unrealistic sales goals. One Wells Fargo branch manager, for example, had a teenage daughter with 24 accounts, and adult daughter with 18, a husband with 21, a brother with 14 and a father with four.”
Liking Bias & Shared Identity: “The board’s effort to understand the scope of the issues were hampered by the ‘insular and defensive’ way in which Ms. Tolstedt ran her division, as well as Mr. Stumpf’s loyalty to her,” Stumpf declined to remove Ms. Tolstedt, calling her, “The best banker in America,”

United Airlines: (link)

Deprival Super-reaction Syndrome: “It is unusual, however, for an airlines to remove passengers who have already boarded the plane.”

Commins & Columbus, Indiana: (link)

Reciprocity: “Amid halting negotiations back in Columbus for the city to land its first Japanese autoparts maker, one of the Japanese executives had an emergency eye problem. So Cummins Inc., the biggest company in town and the key player in its push for internationalization, lent the Japanese executive use of its corporate jet for a trip to the Mayo Clinic. The deal was closed shortly thereafter.”

Lotte: (link)

Disliking Bias & Pavlovian Association: “To top it off, Lotte this year became the target of raucous protests by Chinese nationalists, who uploaded videos of themselves ripping up Lotte products in stores…The Chinese protests,…came after the company made a deal that allows the U.S. military to put a missile-defense battery on a Lotte golf course in southern South Korea.”

“Greater than 0%”

The other week an analyst suggested that Apple could acquire Disney if there’s a cash repatriation holiday. When asked for the probably of such a deal, the analyst responded that it’s “greater than 0%” (link)

“Greater than 0%” means practically nothing. For example, I’d bet there’s a greater than 0% chance that we’re in the Matrix. So the chance that we’re living in a vivid computer simulation and that Apple could acquire Disney both have probabilities greater than 0%…

Causes of Thyroid Cancer

It’s been found that higher rates of Thyroid Cancer are caused by:

Obesity
NOT Smoking Cigarettes
Certain fire-retardant chemicals

Mind-blowing article of the week: 5 Things to Know About Crispr (link)

This is a mind-blowing article about genetic modification. It revolves around Crispr, a bacteria is found in the our immune system’s bacteria and acts like “the Borg” from Star Trek to fend off future diseases. Scientists want to hack Crispr and use it to cure genetic diseases. Ultimately, they could use Crispr to hack egg, sperm or embryos to pass on genetic alterations, thereby permanently altering future generations.

I can just imagine a future where genetic modifications replace vaccinations. It also makes me uncomfortable thinking about the Gattaca-like implications and abuses of such technology.

The Subordinated Investor: Challenges with International Investing

April 18, 2017 / Richard Lewis / 2 Comments

Investing in a foreign country is often akin to investing in non-voting B Shares of common stock or Subordinated Debt. While such investments will allow you to share in a country’s success, it also means that you may share disproportionately in the country’s woes.

Foreign investors are particularly vulnerable to “economic persecution” during periods of political or economic hardship. When a country or political party becomes concerned about self-preservation, foreign investors, who are not part of their “shared identity”, become easy targets for their ire.

The following are three examples where foreign investors were treated as a subordinated class. From them, we can extract some valuable lessons.

Indonesia: Raise taxes on foreign corporations and ultimately force them to sell.

Indonesia has been targeting foreign copper mining corporations with higher taxes and increased pressure to sell their Indonesian assets to domestic investors.

“As part of its push to earn more from the mining sector, Indonesia banned ore exports and placed restrictions on exports of mineral concentrates in 2014 to push companies to invest in domestic smelting.” (link)

“Indonesia has asserted more control over foreign investment with the aim of redistributing economic benefits in a more equitable manner, an effort that began after the fall of dictator Suharto.”

“It said the divestment obligation was meant to “facilitate” mining companies to join with the government and “bring justice” for the people of Indonesia as the “absolute” owners of the country’s resource wealth.”

“Freeport derives roughly one-third of its copper output from Indonesia.”

Reasons for “Economic Persecution”:

Slowing GDP Growth
- “Southeast Asia’s biggest economy has been undershooting the 7 percent growth target set by Widodo when he took office two years ago, mainly due to low commodity prices and weaker global demand.” (link)
Rising Income Inequality
- “Inequality in Indonesia is climbing faster than in most of its East Asian neighbors, raising the concerns of many Indonesians,” (link)
- “The country’s official poverty rate has halved between 1999 and 2012, falling from 24% to 12%. However, the Gini coefficient, a measure of national consumption inequality, has increased from 0.32 in 1999 to 0.41 in 2012[1]. Hence income distribution has become much more unequal.” (link)

Brazil: Sue the heck out of foreign corporations.

Brazilian prosecutors were surprisingly aggressive towards Chevron after an oil spill in 2011. They sought $20 billion in damages and filed criminal charges against the executives. Meanwhile, State owned oil company Petroleo Brasileiro which owned 30% of Chevron’s well, was not sued by the Brazilian government. (link)

“But Brazil remains a politically challenging place to operate, with complex environmental licensing procedures and requirements that a lot of equipment and labor be made and hired locally.”…”Oil companies were rattled in 2011 when a minor oil spill by Chevron prompted Brazilian prosecutors to seek nearly $20 billion in damages and file criminal charges against executives. The charges were ultimately dropped, and Chevron agreed to pay $42 million to settle the suits in 2013.” (link)

Reasons for “Economic Persecution”:

Politically Expedient: A headline catching $20 billion lawsuit will direct the country’s attention and blame towards Chevron, and away from politicians and regulators. Furthermore, it may help advance political careers or party agendas.
Socially Acceptable: A foreign company is an easy and socially acceptable target.

Russia: Force foreign investors to sell.

In 2015, Russia passed a law limiting foreign ownership of Russian media companies to 20%. There was really only one company affected by this law, CTC Media, whose stock price subsequently crashed. Before the announcement, CTCM had attracted many value investors who were enamored with its strong financials and compelling valuation. (link)

What good is it to own a foreign company if you’re forced to “sell low” every time things get bad in that country?

Reasons for “Economic Persecution”:

Political and Economic Tension: 2014 Russian military intervention in Ukraine, subsequent capital flights, and negative GDP growth due to collapsing oil prices. (link)
The Ruling Political party felt threatened: Foreign ownership in Russian media companies could undermine the ruling political party’s agenda and power, especially during an unstable period.

Tombstones

The financial industry uses “tombstones” to announce particular transactions. Perhaps we should use tombstones to announce economic mistreatment of foreign investors. Using the examples above, I imagine they’d look something like this:

Investment Lessons

Be aware that governments can often turn on foreign companies or investors when it suits them. Before investing in a foreign country, ask yourself:

What percentage of this company’s revenue and profits come from this country?
How critical is this company’s relationship with this country?
Does this company, in any way, undermine the agenda or power of the ruling political party?
- Political parties may tolerate minor political subversion when things are stable. But under uncertain political conditions, politicians may act swiftly and harshly against any foreign investors seen as a threat to power.
Is the country’s economy slowing down?
- A country with high growth will have less animosity towards foreign investors than one with slowing growth.
Is Income Inequality becoming an issue?
- Increasing income inequality creates a hostile political environment for foreign investors. They are the easiest and least controversial of targets.
Are there heightened international tensions with this country?
Does this country have a strong history of protecting foreign investors?
- i.e. Does the ruling political party have the autonomy to quickly and effectively subvert the rights of foreign investors?

Russell Westbrook: The Non-Quantifiable Draft Pick

April 17, 2017 / Richard Lewis / Leave a comment

Whether you’re buying a stock or drafting an NBA player, it pays to avoid standard causes of human misjudgment. (link)

In the case of the 2008 NBA draft, most NBA teams committed a huge error of omission when it came to Russell Westbrook. He went overlooked and underappreciated by nearly everyone but the Seattle SuperSonics. There were three key causes of misjudgment associated with this oversight:

An over-reliance on quantifiable data: Most front-offices calculated too much and thought too little. Russell Westbrook was not a very quantifiable player.

“There wasn’t much data to predict his future. Most experts pegged Westbrook as a mid-first round pick.” (link)

“He didn’t start in high school until his junior season and didn’t earn a scholarship to UCLA until after his senior year. He couldn’t dunk until he was 17 and owes his career to a late growth spurt that shot him to 6-foot-3.”

Anchoring & Adjusting: Anchored to their prior assessments, most front-offices weren’t willing to properly update their old assumptions with new information.

“Westbrook’s combine performance, against players who were supposedly better than him, only made the Sonics more curious. ‘He was the best athlete in the gym,’ Weaver said. ‘I was sitting in my seat trying to contain myself.'”

Social Proof: Most professional basketball analysts and front offices did not list Russell Westbrook near the top of their draft lists. Those relying on social proof likely assumed that the crowd’s consensus was rational and accepted it as accurate. Ed Thorp calls this behavior ” the lunacy of lemmings”. (link)

“One day, Weaver went to Presti’s office and declared: ‘I’m looking at everybody, and I don’t understand why this guy is not the best of the group.'”

Investment Lessons:

Standard Causes of Human Misjudgment create great investment opportunities…just so long as you can avoid them yourself and remain objective. In essence, follow the advice from the poem “If” by Rudyard Kipling;

“If you can keep your head when all about you are losing theirs…” (link)

Not everything can be quantified. As Charlie Munger says;

“There’s never going to be a formula that will make you rich just by going through some numerical process. If that were true, every mathematical nerd that gets A’s in algebra would be rich. That’s not the way it works.” (link)

Qualitative Investments can be very lucrative. Warren Buffett’s best investments have been qualitative in nature;

“Interestingly enough, although I consider myself to be primarily in the quantitative school…the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”. This is what causes the cash register to really sing.” (link)

The Seattle SuperSonics relied on qualitative factors such as Russell Westbrook’s character, competitive drive, and shear athleticism, to develop a high-probability insight that paid off in spades. (link)

“That was the day Westbrook sold him. Presti and Weaver looked at his story-overcoming the odds to become an indispensable part of a winning team-and saw his relentless competitive streak. ‘We don’t know how good Russell Westbrook will be,’ Presti said, ‘but the person that Russell Westbrook is will allow him to maximize his potential.'”

Fireside Chat with Charlie Munger: Full Transcript

April 3, 2017 / Richard Lewis / 19 Comments

Following the 2017 Daily Journal meeting, Charlie Munger treated everyone who stayed to an informal fireside chat. For over two hours, he graciously answered any questions. I transcribed this fireside chat verbatim and as accurately as possible.

The Full Transcript is 15,508 words. It was transcribed from this fantastic 1 hour and 48 minute recording of the talk. Below is a sample of this transcript.

For a full copy of the transcript, simply Subscribe via Email to Latticework Investing today. It’s free to subscribe! You should receive the full transcript within 24 hours of signing up.

If you do not receive a copy within 24 hours of subscribing, please email me directly at rlewis(at)latticeworkinvesting.com.

Event Info

Location: 949 E 2nd St, Los Angeles, CA 90012

Event: Informal Fireside Chat following the DJCO Annual Meeting

Date: February 15, 2017

Start of Transcript

(Video 1 of 22 0:27)

Charlie: …Why do you want to strain and (feel like you) have more danger when you’re already filthy rich? As Warren says, ‘What difference does it make to him if he has an extra zero on his tombstone?’.

Question: For return on invested capital, isn’t that already taking into account leverage?

Charlie: Well of course everybody would rather have billions with a high return on capital.

(Video 2 of 22 0:04)

(Video 3 of 22 0:28)

Question: What’s your reading habits every day?

Charlie: I read 3 or 4 newspapers when I get up in the morning, and I always have two or three books that I’m reading. I kind of go back and forth between them. And that’s what I do. That’s what I’ve done all my life.

Question: What are your four newspapers?

Charlie: Wall Street Journal, New York Times, Financial Times, L.A. Times. (Questioner: No Washington Post?) No, no Washington Post.

(Video 4 of 22 1:14)

Question: (Question Regarding deferred gratification)

Charlie: What about medical school, that’s a lot of work. You’re not living very high or this or that. Later you’re a doctor and you have a better life. That’s deferred gratification.

Question: So Charlie, you’re the chairman of the Good Samaritan Hospital, do you have any recommendations or any suggestions about lowering the prices…

Charlie: Well I took that because basically it was basically a losing hand and I play so many winning hands, so I thought, I should force myself to play a losing hand, and I must say it’s been very difficult.

Question: Do you believe in a single-payer health system?

Charlie: I think a single-payer health system would work a lot better, yes. I think it will eventually come. I think the existing system is a ridiculous (inaudible) system. Ridiculous system.

Question: How should we help our children to avoid envy and jealousy.

Charlie: Well you can’t.

(Video 5 of 22 0:41)

Question: What’s your go to (valuation approach)?

Charlie: We don’t have one way of doing it. We have certain things we avoid because we don’t think we have the competency to deal with it. And we have certain things we kind of like because we’re use to them. And so, we don’t have just one set of rules. We don’t have any formulas that are exact or anything like that. And some of the stuff we do, we just know it’s a little better than our alternatives. We’re doing all kinds of stuff now that we would not have done. We would have never bought Apple stock in the old days.

(Video 6 of 22 0:51)

Question: (Regarding Todd Combs. How he got introduced to Charlie and Warren)

Charlie: He seemed like very straight forward. But you see I get a million letters from people who want to come work for Berkshire. Or want to come work…I sometimes get a check from somebody who says, “Here’s $50,000, I’ll pay this to work for you.” I sent the $50,000 back. I will say that it’s kind of a brash thing to do, and I kind of admire it because it was kind of a smart-ass stunt, and I was something of a smart-ass when I was young myself. But I’m not looking for another starting helper or something. I’m playing out the end game. Anybody who’s playing anything else but an endgame when they’re 93 is crazy. It’s an endgame.

(Video 7 of 22 2:35)

Question: So you bet against the jockey, not against the horse necessarily?

Charlie: Well, no…McKinsey. Skilling came out of McKinsey. There are a lot of manipulative types that (inaudible) McKinsey.

Question: So is it simply an observation of the people more so than the quantitative factors? You don’t need to look at the balance sheet when you’re looking at the person.

Charlie: Well I can see the chain-letter aspects of the game. And the huge leverage and the huge…he was just sort of building a chain-letter. It’s intrinsically sort of a dishonorable thing to do. Because the nature of the thing you’re…doing something that you can’t continue on its own motion. You know, making it look like oil. So it’s intrinsically sort of dishonorable. So I don’t like chain-letter operators and I don’t like drunks. I don’t like people who puff and lie and I don’t like people who raise prices on drugs that people have to have by 500% overnight just because it would work. There’s a lot of flags we’re flying.

Question: Charlie, we’ve seen a lot of folks boycotting retailers because they sell Trump brand merchandise and vice-versa because…

Charlie: I don’t like all that. Basically, I’m not in favor of young people agitating them and trying to change the whole world because they think they know so much. I think young people should learn more and shout less. So I’m not sympathetic to anybody…young people are out in the streets agitating and I say, ‘to hell with them’. That’s not my system. I think if you got Hitler or something you can go out and agitate, but short of that, I think the young people ought to learn more and shout less. They ought to act more like Chinese.

Question: Did you personally know Richard Feynman and what do you think of him?

Charlie: Yes. I knew him slightly. Very slightly. Well he was a genius. On the other hand he was a screwball. He absolutely was nuts about screwing around with a lot of different woman, and going after the wives of his own graduate students (I think). That’s disgusting. So he had this blind-spot. Now in physics, in teaching, he was one of the nobelist people we ever had. But in his personal life he was a little nuts.

(Video 8 of 22 2:22)

Question: Charlie, I have a question about real estate. When I look at real estate and stocks, real estate is just easier to evaluate. You know, comps, cash flow, and replacement cost. It just seems like an easier game than the equities market.

Charlie: The trouble with real estate is that everybody else understands it. And the people who you are dealing with and competing with, they’ve specialized in a little twelve blocks or a little industry. They know more about the industry than you do. So you’ve got a lot of bull-shitters and liars and brokers. So it’s not a bit easy. It’s not a bit easy. The trouble with it is, if it’s easy…all these people…a whole bunch of ethnics that love real estate…you know Asians, Hasidic Jews, Indians from India, they all love real estate. They’re smart people. And they know everybody and they know the tricks. You don’t even see the good offerings in real estate. It’s not an easy game to play from a beginner’s point of view. Real estate. Whereas with stocks, you’re equal with everybody. If you’re smart. In real estate, you don’t even see the opportunities when you’re a young person starting out. They go to others. The stock market’s always open. It’s (like) venture capital. Sequoia sees the good stuff. You can open an office, “Joe Schmoe Venture Capitalists: Start-ups come to me!” You’d starve to death. You got to figure out what your competitive position is in what you’re choosing. Real estate has a lot of difficulties.

Those Patels from India that buy all those motels? They know more about motels than you do. They live in the g.d. motel. They pay no income taxes, they don’t pay much in worker’s compensation, and every dime they get, they fix up the thing and buy another motel. You want to compete with the Patels? Not I….Not I.

(Video 9 of 22 1:44)

Question: You and Warren throughout your business history were incredible at judging people. Whether it’s Mrs. B. (Charlie interjects: We were pretty good, yes.) What was it that you and he looked for. And what were mistakes that you made that you learned from along the way in judging who would be good business partners to work with.

Charlie: Well, first there’s some very good people in Warren’s family. One of them I worked under was Fred Buffett. So we had people we knew well that were really noble people. So we had basis to compare people against. And we had basis to compare people in terms of capacity and talent and so forth. So we had a lot of data in our heads that helped us. And I think we had some genetic advantages. Not IQ points, just absolute quirks of nature that made us better.

Question: Like Harry Bottle? Tell me about Harry Bottle and what you saw in him.

Charlie: Well I worked with him in an electronics business that got into terrible difficulties and he’d help us work out of that business trouble by downsizing. He knew how to do it. And Warren had a business that needed downsizing and Warren did not know how to do it. So I put those two together and of course it worked well. (link)

Question: Charlie, could you talk about the episode at Solomon Brothers and what you really learned about people…

(Video 10 of 22 8:14)

Charlie: What I learned is that all that easy money and easy leverage and so forth in investment banking creates a culture that’s full of envy, jealousy, craziness, over-reaching, over-leveraging. It’s a very hard business to manage…investment banking. It was out of control. The envy was…these people went berserk. If one jerk got $4 million some year, the other guy was furious that he only got $3 million. And they just seethed and caused trouble. It was a very difficult business to manage. I think a lot of easy money that comes into finance just ruins practically everybody.

Question: Charlie, anything thoughts on Apple Corporation?

End of Sample Transcript

Subscribe via Email to Latticework Investing today and receive a full copy of the Transcript!