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Book summary: Buffett the making of an American capitalist by Roger Lowenstein

Keep things simple. Simple should not be confused with easy.

Business model assessment

  • Easy to understand economics
  • Strong defensible moat
  • Trustworthy management who treat capital of shareholders with ownerlike care
  • Selling at a reasonable price
  • Able to generate high returns without excessive usage of debts

Guiding principles

  • Stick to companies with your circle of competence
  • Ignore macro economics trends and analyst forecast
  • Choosing between growth and value is a misguided one. See the business model holistically.
  • A share in a business is basically a bond whose coupon rate you need to figure in yourself
  • The character flaws of an individual tend to have very serious spill over effects. Always check for serious character flaws of individuals whose company you plan to invest in.

Float

  • Buy cash generating assets to finance purchase of more assets
  • Insurance is a prepaid model
  • Blue Chip is a prepaid stamp sales model

Management of cashflow

  • Give out dividend
  • Share buy back
  • Reinvest or MnA

The last option is almost always value destroying unless the management can generate ROI above it’s current RoA rate. This is predicated upon a strong defensible moat.

Leadership

  • Confidence
  • Perspective
  • Ability to focus
  • Communication
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Federal reserve maintains interest rates 11th Dec 2019

Key indicators

  • Business investments slowed
  • Manufacturing has slowed
  • Exports has slowed
  • Unemployment rate remains at historical low

Employment rate

  • Wage increases of 3.7% observed at non supervisory production sectors.
  • Flexible deployment of jobs to low cost areas remains a strong downwards pressure.
  • Correlation between inflation and unemployment is at 0.1

Repo market concerns

  • Repo markets issue being looked into. Reviewing regulations that are hindering repo market operations by major banks
  • Will meanwhile continue purchase of treasury bills to provide necessary liquidity

Key long term deflationary pressure on the world economy

  • Automation
  • Globalization versus trade inhibiting government policies
  • Aging population
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Book summary: The dollar crisis

Following the  end of world war two, with US being the world’s largest creditor, countries started largely denominating their debts in USD. US in turn pegged USD to a fixed exchange rate with Gold. This agreement was formally known as the Brettonwood Systems.

US experienced difficulty backing this exchange rate during the oil crisis of the 1970s when OPEC started artificially reducing it’s supply of oil thereby driving it’s price in USD. This had a strong downwards pressure on value of the USD which the US propped up through use of their foreign reserves.

Seeing this weakness in US foreign reserve, thereby an discrepancy of the USD against gold, other trading partners started exchanging US dollar for gold. This added further pressure.

To provide relief on their foreign reserves US finally decoupled the fixed exchange rate between USD and gold. This resulted in the collapse of the Brettonwood Systems, leaving USD as the official reserve currency in the world without any underlying backing.

What followed were decades of global growth largely funded by the US government through control of the world’s reserve currency.

Developing countries would sell goods to the US in exchange for USD. Instead of buying US goods in exchange for the USD earned, they would buy US Treasury bills, notes and bonds. This had the effect of maintaining favorable exchange rates for these countries while keeping their products competitive in the US market.

This widespread practice had the long term effect of driving balance of trade deficits in US with it’s trading partners. While negligible in times of strong US domestic GDP growth, this system has of late started exhibiting difficulty sustaining. This is largely due to slow down in US domestic growth and its inability to scale to support trading partners that 4 times times the population size of the US.

It is advised countries which had long relied on this approach to domestic growth transit their economies to become net importers as soon as their economy gains the necessary growth momentum to do so.

Related readings

  • Fault lines, Raghuram Rajan
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Investment Biker, Jim Rogers

Key take aways

  • Central investment thesis:
    • Always bet against the central banks and with the real world
    • truly down trodden people do not rise, but hell hath no fury like suppressed peoples whose expectations have been aroused
    • people don’t change their ways until their are forced to
    • while it is easy to figure out an investment is cheap, the real work is figuring out if a change is about to occur in the near future. It is important to study markets and their history
    • when seeing a big change coming (the opening of the trans Siberian railway), consider the economic, political and social shift
  • modus operandi
    • Why buy a new sofa when it could be put to work in the markets
    • Only invest in what I can sell quickly
    • do nothing until you can see the money to be picked up around the corner
  • key areas of study
    • geography
    • politics
    • economics
    • history
  • Company assessment criteria
    • Price to book value
    • sound balance sheet
    • pay dividend
    • Price to earnings ratios
    • Viable industries
    • start with largest soundest enterprises
      • banks
      • mines
      • news papers
  • On assessing countries
    • Watch out for statism – governments getting in the way of an organic market
      • democracy does not equal prosperity
      • US government piling more and more regulations
      • SnL crisis of the 1980s
      • Artificially suppressed prices
        • 1970s gold in America
        • 2019 prices of pork in China
      • Foreign aids (IMF, UN and Peace Corps) just props up a system that does not work and delays the actual rebuilding process. Have faith in the locals to rebuild themselves in a configuration that works for them as opposed to a system suited to foreigners liking (hubris)
    • On ethnic strife and separatism
      • Some geographical boundaries don’t make sense.
      • no borders remain stable for long
      • economic hardship will bring to surface these fault lines as they get used as a vehicles to get more
      • Wait till wars are fought and border issues sorted out. It might then become a great investment opportunity to enter at the bottom
      • examples
        • Rise of Islam and Christianity in Siberia prior to Soviet collapse
        • Hong Kong riots
        • Barcelona declaration of independence
        • XinJiang, Tibet
    • black markets as signals: difference between black markets rates and official exchange rates provide an indicator of how much the central bank has propped up the exchange rate. Minimal to no differences are signs of a strong economy
    • major red flags:
      • currency controls, import taxes, export restrictions. Makes it hard to pull funds out
      • is country trying to devalue its way out of its internal problems instead of doing a proper fix?
      • frantic purchase of gold in local jewelry store
    • Positive signal:
      • Is the country trying to get foreign hard currency by making things other people want to buy – quality goods
      • Is the country learning to compete and out innovate its competition
      • an educated population
  • On centrally planned economies
    • the market feedback mechanism is missing
    • resources get ruined due to misuse
    • it would have thrive if it was a sound economic theory
  • On China
    • while Russia abused their resources, China having nowhere to go were more deliberate and took better care of their resources
    • success had a lot to do with economic and political organization
    • example
      • took bees to blooming flowers to work them 5-7 times harder than their foreign counterparts
    • Hong Kong, Guangzhou and Shanghai being captured by the capitalist spirit generally ignores capital’s policies
  • Note worthy collations
    • China (labor) / Siberia (natural resources)
    • Australia (natural resources) / Japan (capital)
    • US (capital) / Canada (natural resources) / Mexico (labor)
  • On commodities
    • most local markets will eventually get assimilated into the global market
    • diamonds have artificially propped up prices that will be hard to maintain in the long run. DeBeers will eventually run out of cash buying up supplies from the black market and it will lead to sudden price collapse. Opt for gem and rubies instead
    • when gold gets too cheap companies will figure out ways to use it thereby depleting its supply driving up price. Same could be said of oil
    • underlying structural issues within a country can stay hidden for long during times of a commodity boom
  • The key to success
    • out of every 1000 people who wants to be rich only 6 can master the discipline to do so
    • stay focus on a single goal for five, ten, twenty years

Related readings

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Federal Reserve interest rate cut decision 20191030

Outcome

Core inflation at 1.8% continues to run below target 2%.

Federal reserve decides upon another 0.25% cut in interest rates, targeting range of 1.5% to 1.75%.

Action is taken to provide meaningful support to the economy in response to global economic slowdown and the increasing disinflationary pressure felt from around the world. The special characteristics of this particular slow down is a lack of any large imbalances in the economy.

Dual mandate of the federal reserve

2% symmetrical inflation target

  • Stable prices
  • Low unemployment rates

economic indicators

  • Consumer confidence remains strong
  • Unemployment rate is at historic low
  • Business fixed investments has slowed
  • Global exports has slowed
  • Manufacturing compared to a year ago is down

macro environment risk

  • protracted US/China trade risk is down
  • No deal Brexit risk is down

economic health monitor

  • Leverage in financial system: low
  • Funding risk in banks and non-banks: low
  • Asset prices: no major bubble, high in some
  • Leverage in non-financial sector
    • households:  gone down
    • businesses + corporate debts: historic high

Liquidity concerns

  • Concerns in Overnight Repo markets persist.
  • Banks have liquidity in excess of required reserves level but choose not to participate in the markets.
  • Federal reserve will seek to inject short term liquidity into the system
    • build up short term treasury reserves
    • buying into short term treasury bills thereby boosting treasury reserves
    • opposed to the standard QE mechanism which entails buying up of assets and securities with longer maturity periods

Related readings

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PCG misexecution from blackouts and Kincade fire

Characteristics of mis-execution

Technical aspects

  • GAP down occurred of more than 5%
  • MACD was still negative trending
  • negative trend is yet broken.

Fundamental aspects

  • Failed to account for seasonality:
    • Fire occurrence during summer and autumn is rampant.
    • strong wind
    • global warming
  • Doubled down when negative trend has yet been broken
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Long term reversion to mean patterns

A list of long term reversion to mean patterns observed. General characteristics are:

  • steady negative trend line broken
  • Seeing higher lows
  • MACD signal line turns positive and trends upwards
Zillow does a pivot in both its product and pricing models.
Square sells off its food delivery business unit for USD500 million cash and double down on its consumer and enterprise business
Splunk changes its pricing model from licensing to SaaS base monthly subscriptions
DOMO gets disrupted by entrance established competitors Google (Looker) and Sales Force (Tableau)
Stamps attempts to pivot its product configuration and gets disrupted by USPS

 

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Mother Nature versus City – public utilities

View of wind speeds in the area during the public utilities shutdown
The sizzling power lines
Large dips in PCG attributed to scheduled blackouts and negative ruling by judge.

 

Climate change reduces land mass under occupation.

Overview

Wind speeds across inland California has a negative correlation with public utility company share prices.

Our infrastructure is constructed above ground to avoid disruption from earthquakes when they occur. This makes them susceptible to producing sparks when strong winds blow. Combine that with increasingly dry weather conditions caused by climate change and we have the perfect recipe for power disruptions either by fire hazards or controlled shut downs. 

Utilities are natural monopolies in their region of operations giving them very inelastic demand curves. 

They also happen to be public companies which incentivized them to optimize performance for the short term thereby on a quarterly basis. This thus leaves them disincentivized to invest for the long run (aka infrastructure upgrade) without active government intervention. 

The government does actively intervene when circumstances go awry. They need these companies to continue operating least the whole population plunges back to the Stone Age. The previous instance was when the same utilities went bankrupt during the 2003 oil crisis when prices shot into the stratosphere. They ended up on the receiving end of a government bail out.

In a nutshell, the residents are basically setup to bear the brunt of this shit show. 

The last time I walked under one of those power lines on a windy day, the sound of those sizzling brought a chill down my spine

Proposed models

  • Wildfire (fire)
    • Wind speed
    • Temperature
    • Humidity levels
    • Vegetation density
  • Tornados (air)
  • Earthquakes (earth)
  • Floods (water)
  • Hurricanes (water/air)
  • Tsunami (water/earth)

Related references

 

 

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NYMT rotation from agency RMBS to CMBS

NYMT has been observed to shift much of its portfolio to CMBS from agency RBMS over the year.

This is to guard against the likelihood of prepayment risk and reinvestment risk associated with the lowering interest rate environment we are seeing right now as the US/China trade war forces lower interest rates and a flatter yield curve. The downside to this strategy is that most of the loans will be maturing within 10 years as opposed to 30 years.

Performance across various interest rate environments

In a stable interest rate environment a rotation to RMBS can help guard against reinvestment risk and prepayment risk since loans mature over a period of 30 years and borrowers are unlikely to increase their rates of prepayment.

And since these are agency RMBS, the government become  the ultimate underwriter in the event of defaults.

In an environment where interest rate increase and spread widens, increase in short term interest rates pinches into profit margins thus lowers net interest income for all both types of MBS. Also likelihood of default increases.

Overview of CMBS versus RMBS

CMBS typically matures over a 10 year period. It pays interest during the entire period with a final lump sum principal payment at the end.

Borrowers will usually extend another loan to pay off lump sum as the current loan matures. The new loans is usually at then prevailing interest rates.

CMBS are usually backed by 10 to 300 commercial properties.

RMBS matures over a period of 30 years. It pays both interest and principal steadily over the entire course with increasing amounts of interest paid to the end.

RMBS is usually backed by thousands of homes.

Types of risks:

  • default risk – property does not generate rent to cover interest
  • maturity risk – borrower can not repay final lump sum at maturity
  • prepayment risk – more is paid down rapidly so less overall interest income generated from loan
  • reinvestment risk – associated with prepayment risk. If mortgage is paid down fairly quickly due to low interest rate environments, owner of lender will be forced to lend out loans in prevailing lower interest rate environments
  • extension risk – less principal is paid down by borrower per period because interest rate has increased

Of the above CMBS is usually only subjected to default risk and maturity risk.

Arrangements are within contract to guard against prepayment risk and extension risk in CMBS.

Default risks for CMBS are low unless tenants are no longer able to pay for rental of commercial space. Senior CMBS were not much affected even during 2008 / 2009

Other issues for consideration

Subordination are important points for consideration. Senior loans with 30% subordination means it will only start experiencing default when 30% of tranche beneath it has defaulted.

CMBS annual default rate peaked at 4.07% in 2010 while cumulative default rate peaked at 13.52% in 2013.

Related references

https://www.lordabbett.com/en/perspectives/fixedincomeinsights/investment-brief-commercial-mortgage-backed-securities.html

https://www.sec.gov/ix?doc=/Archives/edgar/data/1273685/000127368519000074/nymt-06302019x10q.htm#s4E8231C084AE58E780F8E58D6BD4C381

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Bloomberg is a laggard for trend reporting

It’s been observed there is an average time lag of around one to three months before obvious trends observed to insider becomes apparent to mainstream media.

Examples

New Blow to Hedge Funds as Software Darlings Start to Crumble
https://www.bloomberg.com/news/articles/2019-10-19/fresh-blow-to-hedge-funds-as-software-darlings-start-to-crumble

 

https://www.bloomberg.com/amp/news/articles/2019-08-07/home-prices-decline-in-some-of-the-costliest-markets-in-the-u-s

 

https://www.bloomberg.com/news/articles/2018-01-24/san-francisco-s-sky-high-office-rents-to-slip-as-building-peaks