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Posted on 24 Sep 2008 by Forager

Buffett's Goldman deal; when size matters

At every year’s Woodstock for Capitalists – the Berkshire Hathaway annual meeting – Warren Buffett tells the thousands of assembled disciples that its size has become a serious constraint on performance.

‘[O]ur universe has shrunk enormously. And we’ll not do as well in that universe – remotely as  well – as we would if we operated with small sums in a much wider universe and could do all kinds of things … Anyone who expects us to come close to the past should sell Berkshire – because it isn’t going to happen’.

He’s right. But his size and reputation also bring him deals the rest of us could only dream of. Last night’s investment in Goldman Sachs is a case in point. Buffett is buying $5bn of preferred stock paying a dividend of 10% a year. Nothing out of the ordinary in that. But he also gets an option to purchase $5bn worth of ordinary shares at $115 a share – below last night’s closing price of $125.05.

This gives him the best of both worlds. If things go bad, he owns preferred stock which ranks higher than ordinary shares and carries a fixed 10% dividend. But if the stock price recovers from here – the more likely scenario given Buffett is putting his cash on the line – he can simply convert his options into ordinary shares and collect all the upside.

It’s a business he knows well through his involvement with Salomon Brothers in the late eighties and he gets his favourite banker to boot (Goldman’s Byron Trott was described by Buffett as ‘the rare investment banker who puts himself in his client’s shoes’).

All up, a very nice deal. But only available if you have a spare $5bn lying around.

Posted on 15 Sep 2008 by Forager

Wall Street's Mad Monday as Lehman Collapses

“Charlie [Munger] and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”

Warren Buffett’s views on derivatives will be put to the test when Wall Street opens for trading tonight our time.

The US Federal Reserve has finally bitten the bullet and, seemingly, allowed a Wall Street giant to fail. Lehman Brothers Holdings is expected to file for bankruptcy on Monday morning in the US and the liquidation of its $600bn balance sheet will begin in earnest.

That would be a tough ask in itself, but unwinding the trillions of dollars of derivatives that aren’t on the balance sheet runs the risk of financial Armageddon.

And it may not even be this week’s biggest problem. AIG, not that long ago the world’s largest insurer, spent a frantic weekend trying to raise capital. If it fails, its derivatives book will make Lehman seem a drop in the ocean.

Mad Monday and the week that follows are going to be something to remember.

Posted on 10 Sep 2008 by Forager

The Bear is Here to Stay

The Bear is Here to Stay  Resources and banks look set to keep the Australian share market in bear territory Another week, another dead cat bounce. After Monday’s 177-point relief rally, the benchmark All Ordinaries Index fell 84 points yesterday and is well on its way to erasing the remainder of the gain today. The US Government bailout of Fannie Mae and Freddie Mac isn’t going to end the credit crisis. In the words of Michael Lewitt from Hedgemony Capital Management, it might, in fact, be more like the ‘end of the beginning of the end’.





There’s plenty that can go wrong from here. Lewitt anticipates the second phase of the credit cycle being ‘long and protracted’ as sources of new capital dry up. Sovereign wealth funds, scarred by their lost billions from round one, won’t be coming back for round two. As he puts it:

‘In the second phase, which is just beginning, such capital is no longer available due to the realization that the potential losses facing these institutions are much larger than originally envisioned … The second phase of the credit crisis will claim many victims. Some of these unfortunates will not be surprises (ie regional banks that fail); others will be more unexpected (ie one or more large financial institutions).  Certain investment strategies will come under a great deal of pressure, particularly those that have been most highly regarded in recent years – private equity and distressed investing.’

Australia’s banks are not immune. The lending practices of Australia’s banks may have been more restrained than their US and European peers but they’ve hardly been conservative. Margin lending fiascos, a leveraged infrastructure meltdown and the collapse of Centro and ABC Learning Centres represent the beginning of Australia’s own credit crisis. And we may have the unwinding of our own highly regarded investment strategy to contend with. Our big diversified miners are priced for perfection, but while the world may unfold as the bulls expect, that’s only one of a range of possible outcomes – and you’re paying dearly for it. BHP trades on 12 times last year’s record profits and 116 times the 31 cents per share it made in 2003. Believe it or not, China existed in 2003 and its economy had been growing at an average of 10% pa for the previous 25 years. Investing in commodity producers isn’t a risk-free game. At current prices for BHP and Rio, it’s quite the opposite. Predicting markets is futile but, with resources and banks making up such a large portion of the Australian market, there are enough unresolved issues out there to suggest the bear won’t be leaving us just yet.

Posted on 04 Sep 2008 by Forager

The Recession We Have To Have

As a child I always ate my vegetables first and saved the steak for last, bowled first and batted last in backyard cricket and ate all the tiny Easter eggs first. If there’s medicine to be taken, I want it now.

Which is why I’m one of the few investors in Australia supporting the Reserve Bank’s restrictive monetary policy and of the opinion that they should keep the cuts to a minimum. I’m fully aware high interest rates – relative to the past decade at least – are hurting the economy, hurting the stockmarket and hurting my business. But we don’t have an option; it’s either suffer some pain now and correct the imbalances in our economy, or deal with a much bigger problem a few years down the track.

The Recession We Have To Have

For the past decade, the Australian consumer has been on a borrowing binge. The ratio of household debt to disposable income is now 1.6 times – more than double the level of just 10 years ago.

Free-flowing credit has enabled us to take tomorrow’s consumption and have it today. In the quarter to June 2002, for the first time ever, we consumed more than we earned – the savings rate turned negative (in the 1970s it was in excess of 10%). Between then and March 2008, total consumption exceeded total disposable income by $284 billion.

As any Ponzi-scheme operator can tell you, the life cycle of funding a cashflow deficit with more and more debt is limited. Not surprisingly given Australia’s burgeoning debt pile, the percentage of income required to service the interest payments has also blown out. In March 1994 it was 5.5%. In March 2008, 13.9% – the highest level on record.

The Recession We Have To Have

We’re a rich country and can afford to service some debt. But at some point we’re going to have to live within our means. And we need to accept that getting from where we are today to a level of consumption that’s sustainable will most likely cause a recession. A huge cut in rates might delay the pain, but it won’t make it disappear – it’s the recession we have to have.

Posted on 26 Aug 2008 by Forager

Babcock, The Banks and Russian Roulette

Firstly, Babcock isn’t broke yet, despite all the post mortems in the weekend press. The 30 June accounts still showed net assets of $2.6 billion and the locked in management fees on its funds – $138m in the past six months alone – could be the company’s salvation. Considering the current market capitalisation is only $850m, a lot can go wrong before those buying at today’s prices are out of pocket.

Even if they do go down, they can take some comfort in the fact that they won’t go down alone. Babcock’s meteoric rise wouldn’t have been possible without overly accommodating bankers and, if it implodes, the pain will spread far and wide.

Bankers looking no further than their next bonus have been falling over themselves to lend huge sums at ridiculously low margins to the whole infrastructure sector, and Australia’s retail banks have been front and centre.

Yes the assets are safe. Yes the cashflows are predictable. And yes the assets can go bust if you load them up with too much debt.

In fact, due to the limited recourse nature of most of the loans – the lenders have recourse to a specific asset but not the whole Babcock empire – it’s possible the banks lose their shirts while Babcock goes on to prosper. Were Babcock’s power assets in Australia to go belly up (something looking increasingly likely), the equity losses could be offset by profits from the sale of its European wind assets. Investing in small slivers of equity is a high risk high reward game. The banks’ margins – significantly less than one percent at the height of the boom – on the other hand, don’t compensate them for any losses at all.

Babcock has been playing Russian roulette, but much of it has been played with someone else’s money.