Death Grip of A Falling Knife

Mortgage in Latin translates to "Death Grip" and it just happens to be a festival of falling knives nowadays. Your truly, whom by the way, bought puts on the financial index less then six months ago, found a way to participate in the "death grip" festivity during the past two months.

Thankfully, the Christmas Spirit found a way to resurrect the evaporation of gains this past Friday. The question now is, why would an aspiring value investor devote a whole post on a loss at such a young age? The answer, it's never too late to take a bite of the humble pie. The reason, put short, I maintain a strong bias in believing the business franchise and industry fundamentals.

"and so it goes", like the beginning of every change of heart in "Slaughterhouse Five" by Kurt Vonnegut. Fittingly, we learn from out mistake and swear to never make the same mistake again. The business I speak of is The First Marblehead Corporation (FMD). Up until this past Friday, I was down a little over 50%, that is until Goldman Sachs made a decision to infuse capital. The dividend was eliminated and an increase in dilution. My average purchase price of this business was around 20 and change, and I sold what the market was offering at one time on Friday around 18.11.

As I mentioned earlier, I still believe that the private student lending business represents some opportunities for growth for the foreseeable future. However at the time of sell I felt that First Marblehead, after the Goldman Sachs deal had become a 80-85 cent dollar. After I made the sell, I added to a position that I believe is being offered to the marketplace at 60-65 cents on the dollar. I will not disclose the business in question until next week for the annual 2007 annual business of the year, "Make it Rain."

Because I still believe in the fundamentals of the student loan industry, more so the private. I have started to navigate an alternative to FMD that I will expand on in a future post because I have not yet examined all aspects of the company. I did find it Ironic that GS made this purchase on a) options expirations day, b) after 14 straight down days for FMD, and c) year-end meet the number's game.

Moreover, I also sold half of my puts on the Financials at a 435% gain in 5 months because I wanted to add to the same position that I placed the FMD proceeds in. Thus far, the position in question represents a little over 8% of my portfolio of businesses and I hope to increase to 15-20%. It is an insurance company, run by superb management, trading at book value, and offered at a 4% premium to the average price the company has been buying back shares over the past nine months. Management, has been aggressive with their buyback and I will say no more. Well...until next week!

And so it goes...

It has been an eventful past four months, starting my underwriting career has allowed me to pursue other learning curves that I find most intriguing. I sincerely apologize for being unable to write more often and have placed the task at the top of my 2008 new year's resolution.

The insurance industry is interesting and I challenge any avid Sir Buffett enthusiast to look past the numbers that any insurance company reports and for a change try to read a Commercial General Liability ("CGL") guideline for a change. Or any other guideline for that matter.

I also had the opportunity to have "brown bag" lunches with the executives of a top 5 P & C company, and I will write about that in a future post.

And so it goes...

I want to wish Merry Christmas to everyone other there who aren't already depressed about the title of this post and be careful not to catch a falling knife. Next week I will attempt to strike in one of the better cells.

Take care,

S. K.

Lessons From Ted Williams

"Don't swing that often. And don't swing at bad pitches"

-Warren Buffett

Personally, I don't like baseball at all, I think it is boring. However, this doesn't take away from the fact that baseball has some of the greatest analogies out of all sports. I was reading Malcolm Gladwell's book Blink and I ran into Ted Williams again. The first occurrence was the 2001 Berkshire Annual when Sir Buffett stated:

"[At times when prices are high for both business and stocks], we try to exert a Ted Williams kind of discipling. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his 'best' cell, he knew, would allow him to bat .400; reaching for balls in his worst' spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; singing indiscriminately would mean a ticket to the minors."

Now, I think the main point is pretty obvious, but there are always players that know where the best zones to hit are, yet always reach to swing outside the zone. That is true with every aspect of life. There will always be this minority (majority in Wall Street) who always go for the reach only to be disappointed over and over again. Swinging in the "best" cell is value investing, and swinging in the "worst" cell is every other type of investing. Now I would presume there are very few "best" cells and many "worst" cells, but that's just the result of probability.

In Blink, a book filled with numerous studies to prove that your first glance is sometimes the most powerful and important piece of information. The paragraph mentioning Ted Williams states:

"Williams was perhaps the greatest hitter of all time, a man revered for his knowledge and insight into the art of hitting. One thing he always said was that he could look the ball onto the bat, that he could track it right to the point where he made contact. But Braden (world's top tennis coach) knew from his work in tennis that that is impossible. In the final five feet of a tennis ball's flight toward a player, the ball is far too close and moving much too fast to be seen. The player, at that moment, is effectively blind. The same is true with baseball. No one can look a ball onto the bat. 'I met with Ted Williams once,' Braden says. 'We both worked for Sears and were both appearing at the same even. I said. 'Gee, Ted. We just did a study that showed that human beings can't track the ball onto the bat. It's a three-millisecond event.' Ad he was honest. HE said, 'Well, I guess it just seemed like I could do that."

And that makes perfect sense, some people have the talent to do anything so swiftly and effortless that the explanation pales in comparison to the event. Ted Williams had the talent, Warren Buffett has it. And if you read Sir Buffett's explanation of a buy or sell, it seems too natural. For example, screaming buys would be considered a once in a 10 year even, in my opinion. That doesn't mean there aren't 10 year intervals between specific opportunities, Japan is a good example of that. While the U.S stock market went higher for the better part of the 90's, Jappan's market went lower and lower, or what a head of a securities desk would call: "Inversely Correlated."

When, Sir Buffett makes a purchase such as Posco, Tesco, or Petro China in times when he can't find anything attractive in the U.S., the explanation is useless. The process is Sir Buffett swinging at Fat Pitches, scanning the universe of opportunities and looking for screaming buys. That is why, Malcolm Gladwell goes on to say in the paragraph after Ted Williams:

"We have, as human beings, a storytelling problem. We're a bit too quick to come up with explanations for things we don't really have an explanation for. "

That is why sometimes, when a purchase is made, the explanations of a decisions is worthless. The person making the decision is almost programmed to hit in the "best" cells or swing at the "fat pitch" and we find the explanation to be entertaining because we can't fathom being so disciplined to not swing in the "worst" cells or to invest in something outside of our circle of competence.

Consequently, mistakes are made outside the strike zone, Sir Buffett goes on to say:

"If they are in the strike zone at all, the business 'pitches' we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive pries of the past were the aberrations, not the full pries of today. Unlike, Ted, we can't be called out if resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."

The beauty of it all is I think the last sentence is his idea of fun. You could almost picture the now 77 year old (happy birthday!) standing near the batters box waiting for a watermelon-like pitch to hit out of the ball park. He doesn't swing even if they are in the strike zone, to take the 77 cells image a little further, lets examine it with a little design that I made:
Red: 32 (41.6%) Worst Cells
Orange: 24 ( 31.2%) Bad Cells
Yellow: 12 ( 15.5%) Decent Cells
Light Green: 8 ( 10.4%) Good Cells
Green: 1 ( 1.3%) Best Cell(s)

Now, these 77 cells are really open to interpretation and for others there may be more "Green" cells, but it really doesn't make a difference. The point is don't swing in the worst cells or the bad cells, the decent cells will give you 'decent" returns and the good and best cells will give you "good" and some of the "best" returns. Very simple in theory, very tough to implement! Personally, I think that Sir Buffett only swings in the Green, rarely in the light green, and more rarely in the yellow. I would place the Mid American utility purchase in the yellow, even he stated that returns will be decent.

In the future, I will reference this image often to point out whether I swing or not.

Moving on...

I wanted to also focus on what makes the price of businesses in the marketplace go upward because I believe the consensus is misinformed. Earnings do play an important role, but the most important is risk premiums. In fact, earnings and the stock market have very little to do with each other, they are more of a coincidence then a source of useful information to make a decision on. I would say much of the blabber of how earnings are rising so the stock market is cheap or vice versa is part of the "human being story telling problem." When the market falls and the earnings are high, the consensus doesn't have an explanation.

The explanation has more to do with risk premiums than earnings. Low and expanding risk premiums cause damage to the markets, because when the consensus has a high risk appetite, they will buy anything earnings or not. This is more psychological and is less quantifiable, but more sensible. The talk now that there is a repricing of risk is true because the consensus is changing from a period of high risk appetite to low risk appetite. Obviously this is a top-down view, but it is essential to understand why some businesses are selling at a lower price. Moreover, this repricing takes time!

That's it for today, tomorrow is a holiday and hopefully after packing up for my trip I can put together another post. On Tuesday I live to Hartford for three weeks, based on the little amount of free time, I can't guarantee a post, but I will try my hardest. Now that we have an idea of a strike zone with a visual, it makes sense to look at it more in depth in the future. To make the process look intellectually challenging, we will call it "Cell Theory"; who said investing isn't fun?

Until next time,

S.K.

Bull Markets and Bear Markets, Uranium Part Two

"Bull markets are income statement driven, while bear markets are balance sheet driven"

-Don Coxe

After a one week hiatus, I want to refocus our attention to the previous post in relation to uranium and the outstanding opportunity. But for now, I want to direct your attention to the quote above because I believe it screams simplicity. Over the past month and half, the market place has asked the question of survival. In fact, by checking the archives, the very first post, titled "Cancer and Random Gleanings" highlighted the possibility of liquidity problems. Now, the question is who will survive?

Banks, Mortgage lenders, and anyone that has anything to do with real estate, financing, equity, etc. have been beaten up. Is this the start of a bear market? That is not a question I like to answer and I really don't care where the market goes. As a value investor, a 50 cent dollar is a 50 cent dollar, the search for an undervalued business does not care where the market is going, given time the intrinsic value of a business will/should meet the price quoted in the market. Sometimes it takes a long time and other times it's shorter, not having patience is a problem. In fact, most value investors are in the business of time arbitrage. The average holding period of a business today is around 11 months, a little under a full year business cycle. So a value investor places a value on a business that is bought and sold on a daily basis in Wall Street fashion, if there is a high margin of safety with a high risk to reward ratio, a purchase is made.

If not, you wait! Often times it takes a long time for a business to meet a criteria for purchase. In that first post I stated: "Personally, I want to see some volatility because I am itching to buy at discount levels not seen today." And that's the cost of being in business; you wait for the fat pitch. Now the question everyone asks is which of the financial stocks will kaput? The way to gain a better perspective is to understand the balance sheet, because the income statement doesn't matter if you are burning cash and are over leveraged. That is why the quote at the top makes so much sense, if you are looking to buy a business involved in finance, real estate, mortgage, don't salivate over the P/E ratio, it is meaningless, worry about the balance sheet. Don't look at the yield and nod to yourself thinking you have found a fat pitch, that was before, some of these businesses will slash dividend for the sake of liquidity.

The above paragraph might sound facetious, but take it at face value. Look at the balance sheet! For me the decision is easy, finance was my major and although I have studied these businesses, they are not yet in my circle of competence. If I don't understand it, I don't buy it. Doesn't mean that someone who buys it will face losses, it just means that it is not my cup of tea. Furthermore, they are still too popular, now I understand Sir Buffett made some purchases, but he made the acquisitions when there was extreme pessimism short-term. He simply sits on his 45 plus billion war chest and has ample purchasing power. As soon as he made the purchase, suddenly everyone thought, "Well if he is buying, they must be undervalued." Again, I don't agree or disagree, but the logic of the lemmings is fallacious and based on the confirmation bias.

moving on...

From Balance Sheets to Income Statement

Tangible assets and intangible assets have an obvious difference, one you can touch and the other you can't. Intangible assets can be created out of thin air and if you are in the wind power business it is good. Tangible assets can't! A tangible asset that creates or allows for the creation of an intangible asset is smart. Take for example a bank, they take deposits ("tangible") and make loans ("intangible") to buy a house ("tangible"), it's a circular cycle, once you purchase the house ("tangible") you can use it's equity ("intangible") to make another ("tangible") purchase. You get the idea.

Uranium is tangible, used in a nuclear reactor, it provides an energy source such as electricity (intangible) that you could use to operate machines (tangible). The market has undeservedly punished the mining businesses. Now there is a distinction, there are producers and hopeful producers, and the hurdles are very high for the hopefuls. It takes a number of years to approve a location, then you need to get the authority to mine (very tough!), then you have to get the working capital to work on the mine (even tougher!), finally you run a bunch of tests. To run those tests, you need equipment, and if you are in a business that has been through one of the worst 25 year periods, there are not a lot of companies that are interested in providing you business. Even worse, the location, in real estate (commercial or residential) the three things you look for are location, location, and location. In mining it is similar, but each of the three locations are different and rightfully so, they include:
1) Location- what kind of country are we mining in?
-What are their property rights?
-Tax system? Royalties?
-Politics? Honest? Corrupt?
-Working Conditions?
2) Location- How is the weather like?
-How many months out of the year can you mine?
-Flooding?
3) Location- Transportation
-Highway system?
-Easy to move equipment?

I'm pretty sure I left some things out, but you get the point. Cameco's Cigar Lake is faced with the problem of number 2. They have delayed production from '07 to '11, that is a whopping four years. However, I also believe that number 3 is just as important, the highway system in many of these countries is very poor. Uranium by itself is just uranium, if you are mining 1000 miles from a mill, it doesn't matter what cost structure you have, you will not realize the profits. Denison has a mill, one of the very few in the U.S., the only operating one, because the other three are on standby. According to this article the process to build another mill takes about 7 years, maybe less but no less than 5. Unfortunately, this isn't an industry that improves its' productivity every six months, like tech.

Depending on your investment style, the hurdles above do not bother me one bit. So lets say you have the three location descriptions under control, have a permit to mine, in a friendly country, your competition is very little. Why? because I don't remember the last time there was a surge in Geology majors at major university. I don't think that anyone during the past 25 years at the age of 17 or 18 said, "Hey I think uranium mining is going to make a comeback", or any other mining for that matter. There is limited supply of talent in this industry, and the supply is in demand from other mining companies like coal, copper, oil sands, etc.. If you are an operating mine that happens to produce, you are in a sweet spot, and the saying "Those who having will prosper, and those who don't won't" rings true.

Secondly, those who have this talent are in their 50's, and after one of the worst bear markets, many mining companies disappeared. The few that survived, their balance sheet had something to do with it. When I listed in the previous post the amount of production for the past three years, the production in '04 was higher than '06. Now the estimate for '07 is in, RBC capital states that they have reduced their expectations from 117 to 112. Because get this, "There were difficulties and delays in many mines, including: "Langer Heinrick, Dominion Rossing, McClean Lake, Rabbit Lake, White Mesa, and Olympic Dam." This doesn't surprise me one bit, and neither does the next warning, "Kazakhstan remains the biggest unknown for uranium production in 2007 and beyond...[they] should be able to meet their 18 million pound target, but could struggle to meet 2008 targets as multiple projects are scheduled to come online and labour and resources could be stretched thin." The only word I will change from the previous quote is "Could" to "Will." So the four year production, three actual, and '07 a guess looks like this:

2004- 104.6 pounds (actual)
2005- 108.1 pounds (actual)
2006- 104 pounds (actual)
2007- 112 pounds (estimate)

Take it for what it's worth, but if the price of whatever I was producing increased from 15 and change in 2004 to a high of 136 (now 90) in '07, and the increase in production was a whopping 7%, there is something wrong with that picture. Also noteworthy is that 90 is the spot price, not the long term price, which during all this free-fall talk of spot moving from 136 to 90 has remained at 95. I mentioned in the last post, "Long-term pricing has not moved lower; in fact, I wouldn't be surprised if spot prices move lower than long term pricing by a difference of $1 or $2 based on historical pricing. The parabolic move in spot could be as Denison pointed out, hedge-fund buying." Now, the difference in spot versus long term is 5 in long-terms favor, the prediction was right, and that is why even after continued decline in uranium mining businesses I continued to make sensible purchases.

The choice to sell usually has one price, but uranium has two (long term and spot). Cameco is locked in legacy contracts, Denison and Uranium One have very little exposure, they choose which price to sell. The August 14th RBC update stated "The long-term market remains active with 9 buyers looking for a total of 26 million pounds." The August 21st RBC update stated "The continued lack of actual, reported, spot transactions also frustrated the market observers. With only 3 deals totaling 100,000 pounds of material versus an annual spot volume of 20-25 million pounds." The 3 deals in total represent between .4% and .5% (2o mil. and 24 mil., respectively) of spot volume, not total volume. If I did the same calculation for total volume, well...I'm just not going to do that.

The E-Mail and Voicemails

Last Thursday, Mr. Market was a nervous wreck and he was willing to sell businesses at a lower price than the day before and the day before. At one time, the Dow was down close to 350 points. Now usually I'm pretty occupied with my job and don't get the time to check up, but I decided to check my e-mail, and saw this from my former boss, whom I will withhold his name and business. For qualification purposes, he is a hedge fund manager and is very well informed. The e-mail was this:

"I've left mesages, no response, you must be busy. Listen to them. DNN is down to $7.60 right now...I would liquidate out of everything you hold, we are free falling."

After reading it, I checked some of my holdings, and found out that Mr. Market was giving me the opportunity to purchase current holdings at unreasonably low prices. I subsequently made purchases in uranium mining businesses. They included on a daily basis for the past month:

8/16/07- DNN- 7.55
UUU- 9.09
8/15/07- DNN- 8.22
UUU- 9.84
8/10/07- DNN- 8.92
8/7 /07 - UUU- 10.70
8/6/07 - DNN- 9.08
7/26/07- DNN- 10.07

Both DNN and UUU have been positions for over a year, so my cost at original purchase are lower, and because of the recent buying, both have increased by 100%. Once again, I offer the same disclosure as I made in the previous Uranium post:

"While there is selling, and it may continue for weeks to come, I will be a buyer, opportunistic and aggressive. These purchases offer a high margin of safety and I have great confidence in my analysis and judgment."

Later that night, on the 16th, I listened to the voicemails, there were three of them with similar messages as the e-mail. These are signs that I look for and while I shy away from making market predictions as a whole, I don't make purchases on market direction, but rather on businesses that offer a high margin of safety selling at a price that meets my buying regimen. The extraordinary proclivity that these businesses have fallen by over 50% over the past three months, while being producers of a commodity with high barriers of entry (emphasis added) is ________(fill in your own positive or negative adjective).

Listening to the Denison conference call, Peter Farmer (CEO) said something along the lines of "I can't believe that a company that is doing so well is getting treated so badly." The Uranium business also enjoys another benefit, the fixed costs can be leveraged to earn outstanding returns on cash flow. Both DNN and UUU will experience growth in free cash flow in the next few years when production increases.

Purchase Inquiry

There are certain requirements that should be looked at when purchasing anything that has to do with commodities, just like any other industry. Don Coxe stated his requirements recently:

1) Something tangible, real
2) Not subject to being created electronically
3) Absolutely needed by the most dynamic economies in the world, not in trouble for creating assets.

Without sounding humorous, I consider the United States, France, Canada, China, and India dynamic economies; the latter two more so. I also know that I left a few dynamic economies out, but those are the ones off the top of my head. Now here is where you have two choices to consider: 1) invest China and India, or 2) invest in what they need. What they need is more reliable, just my opinion.

Indeed, once again I am short on time, and knowing that I left off important details on DNN and UUU which I promised to do in this post, please excuse me. These blogs write themselves and even though my intentions were to expand on these two businesses, it didn't. Maybe next time!

Until next time, I hope you enjoyed this post, if you have any questions or arguments for/against what I write, please e-mail me. I enjoy intelligent and rational discussion, with the operable word being intelligent.

Thank you,

S.K.

Successful Investors

"Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgment, they respond to market forces not with blind emotion but with calculated reason. Successful investors, for example, demonstrate caution in frothy markets and steadfast conviction in panicky ones. Indeed, the very way an investor views the market and its price fluctuations is a key factor in his or her ultimate investment success or failure"

Seth A. Klarman, Margin of Safety

Having cursed myself with last weeks post regarding the inability to find any value:
1). I can’t find any value in the marketplace. Businesses are selling at a price that does not meet my required margin of safety.

This week was an answer to my call and for that reason alone I made a few purchases. However, they were not purchases in any conventional sectors or industries in the marketplace, but rather in commodities. It was an easy purchase for the most part and I look for continued weakness to purchase more. The commodity in question is U3O8 (uranium) and the purchases of businesses were Uranium One (sxr.to) and Denison Mines (dml.to or dnn).

I believe both businesses allow for a high margin of safety, growth in profitability, a solid underlying commodity, and one even has a moat! When I scan for value, I don't try to anchor myself to the "likely" candidates of Sir Buffett or some of the other famed value investors, I stick to what I know. In fact, some would agree that Sir Buffett is one of the greatest commodity investors of all time based on his description of the insurance business. Insurance is unlike a Hershey chocolate bar where a customer tells his (in)significant other "I want to purchase Mercury insurance as opposed to White Mountains" because insurance is purchased based on price. So... Sir Buffett's insurance operation is a perfect example of a commodity business.

Furthermore, Sir Buffett's recent purchases have a commodity theme , think Posco, Burlington Northern, Conoco Phillips, PetroChina. One of my pet-peeves is when I hear or read that he doesn't invest in commodities. I would be remiss if I didn't mention his purchase and subsequent selling of 129.7 ounces of Silver in 1998. Meaning, any value investor can invest in a business with a solid underlying commodity provided it allows for a high margin of safety.

Next week will be dedicated to gold, but this week Uranium is the order of the day. Uranium the commodity has increased from $7 in 2002 to $133 in June, and now at $110, a decrease of around 17%. Uranium businesses have fallen by an average of 40-45%. Uranium has two prices, the short-term (spot) and the long-term, while the short term has fallen, the long-term has stayed at $95. One other note, at the beginning of the year, Uranium spot was at $70.

This is an industry that has had little to no investment in assets or people (skills) for over 25 years. Most of the reserves are in very politically safe, stable countries, they include Canada and Australia. Moreover, there are 435 reactors in over 30 countries with a demand of 173 million pounds of uranium. There are also 28 nuclear reactors under construction that will be operable while another 64 reactors are planned for future generation of electricity. Because nuclear reactors are very environmentally friendly and offer a very low cost alternative for many undeveloped parts of the world there will be demand. So, we know the demand side of the equation, unfortunately the supply side is a little tricky.

Uranium production has been lower than demand and much of the additional supply to reach an equilibrium has included recycled uranium and surplus inventories. Highly Enriched Uranium ("HEU"), the source for weapons has been another major source (Russia, Component 1). Additionally, Cigar Lake, the prized asset of Cameco has been beleaguered by excess flooding, to the point where the mine was originally set to come online at the back-half of this decade ('08) has been delayed to ('09) and now ('11, Component 2)

Component 1, I believe that Putin, once his position as the president of Russia is over will set up a position as Energy Minister for himself to take advantage of great assets. Russia has made their intentions clear that post 2013, they will use remaining stockpiles for their own use (read: strategic source for China). Naming Russia as one of your main suppliers is the equivalent of picking a homeless guy off the street and asking him to help you out to pay your debt. The debt being your demand for uranium.

"How do we know this is not Palladium?" -asks a Ford stockholder

About two years ago I successfully invested in a palladium company because of their supply/demand issues. Coincidentally, at one time the commodity was trading at very cheap prices and then there was a run-up because Russia (50% of supply) decided to delay and disrupt production. Palladium is used in catalytic converters to reduce smog. The commodity goes crazy, rising from a low of $150 to $1,100 in a '79 like supply shock oil manner. Because all the major car companies used the metal for smog devices, Ford Motor Company in an act of desperation purchased future contracts at $1,100 and subsequently lost over 1 Billion dollars (B with 9 Zero's). Uranium is not palladium because demand has been rising with new nuclear reactors in construction. But most importantly, because Russia doesn't control the majority of production, Canada and Australia do. Here is the list of the top Suppliers:

Canada (27.9% of world production)
Australia (22.8%) being the largest producers
Kazakhstan (10.5%)
Russia (8.0%)
Namibia (7.5%)
Niger (7.4%)
Uzbekistan (5.5%)
United States (2.5%)
Ukraine (1.9%)
China (1.7%)

(Notice how the top to main producers represent a little over 50% of production)

France produces around 80% of their energy source from Nuclear energy, but they are not a producer, and neither is India who has embraced this source of energy. Meaning, demand is there!

Component 2, Cigar Lake has been a disaster and for good reason, mother nature. This disaster will delay production and if it is worse, we may be without a huge source of supply. Wouldn't that mean that Cameco's pain is another companies pleasure? The reduced supply would encourage more producers to increase production to realize higher prices, basic law of supply and demand. I will quote a little from the July, 30 Cameco conference call:

"Cameco operates in an industry that requires a long-term perspective, built from a position of strength...while the uranium spot market is showing weakness during a thinly traded summer, the long-term market fundamentals remain solid, driven by an industry with increasingly bright prospects...last week's decline was aggravated by the down draft of the general market, the strengthening Canadian dollar, and the drop in the uranium spot price...the industry average spot price at quarter end was 135.5, which was up more than 40% from the $95 at the end of the first quarter, and almost triple from a year ago, at which time it was just under $46. This dramatic increase was driven by relatively small spot volumes often sold by auction...we are into the summer months, which is typically a period of weaker demand...there is presently more supply than demand in the spot market...it is not expected that 2007 spot volumes will be more in the 20 million pound range, considerably less than the 33 million pounds transacted in the spot market last year...longer term, nothing has changed in respect to the underlying fundamentals of the uranium market...It is also important to keep in mind that the market continues to be heavily reliant on several large sources of supply and if things do not unfold as presently forecast, then we could see some very large swings in price!"

Spot vs. Long Term

The long term price is at $95, an increase of 12% from the first quarter and double the price from last year. Cameco stated "Historically, long-term prices have been at a $1 to $2 premium over the spot price...largely due in large part to the buyer's willingness to pay a slightly higher price in order to lock in a future price at a time where there was no concern about future supplies. The future supplies were assumed to be a given. The rapid increase in the spot price fueled by auctions resulted in the spot price exceeding the term price by about $40."

The increase of spot over long term was unrealistic and somewhat of an anomaly. Most producers have a choice of selling a spot or long term. Usually, if you sell uranium at long-term price, you sell at 95% of the long term price. However, spot prices could come down and because I don't predict market direction if it comes down, producers will simply sell at long-term price. In which case, they would still realize amazing profits. The worlds operating reactors demand 173 million pounds per year, this figure does not include the 28 under construction or the 64 planned.

Production figures:
2004- 104.6 pounds
2005- 108.1 pounds
2006- 104 pounds
average (105.5, a deficit of over 60 million pounds)

The top two main country suppliers represent over 50% of production, but according to the Denison annual report, "Seven companies accounted for over 78% of primary production, while the six largest uranium mines produced over 58% of the aggregate global production." This is a mini-OPEC with a deficit of supply/demand, short-term gyration in spot prices don't/shouldn't represent a scare.

Denison expanded in their annual report on the spot vs. long-term price:
"The spot market is the market for uranium purchased for delivery within one year. Over the period from 1996 through 2004, annual spot demand averaged just under 20 million pounds UsO8 or about 12% of the annual world consumption, but has jumped to about 35 million pounds over the last two years as utility inventories commence to be rebuilt and investors and hedge funds have entered the market as significant buyers. The remaining component of the supply is the term market where uranium is bought and sold under multi-year agreements between nuclear utilities and uranium producers/suppliers. By way of definition, the long-term uranium price reflects the initial base price under a newly-negotiated multi-year uranium agreement with deliveries commencing 12-24 months in the future and extending for 3-4 years thereafter."

"The sale of Denison's uranium has traditionally been through long-term contracts and not on the spot market, [because] prices in the long-term market have normally been higher than those in the spot market at the time the contracts are entered into and are normally less volatile. However, when market prices are increasing rapidly, as has been the case over the last several years, prices received under the legacy contracts cannot match such increase. As a consequence, prices are being renogotiated based on market related pricing formulas, or the legacy contracts are being allowed to expire in accordance with their terms so that uranium can be sold on the spot market or at prices related to the spot price."

I didn't intend to write this much on the fundamentals of uranium, instead I wanted to focus on the two companies I have been purchasing the past two weeks. However, it serves a purpose, tomorrow there will be part two, expanding on the fundamentals and diversification of the two companies.

Conclusion for today: for businesses with the underlying commodity of uranium as their core source of revenue, it doesn't make sense to lose an average of 40% value when the spot price of uranium is only down 17%, but most importantly when Long-term pricing of uranium is your selling point (price). Long-term pricing has not moved lower; in fact, I wouldn't be surprised if spot prices move lower than long term pricing by a difference of $1 or $2 based on historical pricing. The parabolic move in spot could be as Denison pointed out, hedge-fund buying. Knowing that hedge-funds are momentum players and that energy companies would have been Ford-like to purchase all of their need future supplies on the spot is more proof that there is value in this area. One other reason to believe that hedge funds would be sellers now as opposed to buyers are the enormous holding cost of uranium compounded by no leverage in holding uranium (the commodity). That is why, some uranium businesses are down by an average of 40%, commodities as a whole are still treated as an asset-class for the purpose of diversification. When the market falls, portfolio strategist from the majors and TV pundits pound the table and demand that you "sell your risky assets."

While there is selling, and it may continue for weeks to come, I will be a buyer, opportunistic and aggressive. These purchases offer a high margin of safety and I have great confidence in my analysis and judgment. For the same illiquid reasons that I purchased deep out-of-the-money puts on the XLF expiring in '09, this is a sensible move for me.

Thank you,

S.K.

Financial Engineering

‘Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.’ Buffett '91

A rare occurrence indeed, posting two consecutive weeks in a row and hopefully more to come if time permits. This week the subject will be the unproductive and ineffective type of engineering: financial engineering. The engineering field is very respectable and is efficient in that there is a purpose and a finished product. Often there are issues with the finished product, but most importantly, they come with time. For example, this past week’s tragic collapse of a bridge in Minnesota was a long time in the making. However, because it happened, bridges all over the country will be inspected and engineers will make adjustments to ensure more durable bridges.

Business is about profitable growth, not growth in size (market cap) and the eventual creation of value (for shareholders). Do not be fooled by the voices in the media that tout the record earnings growth because they are a little mythical. First, much of the business world believes that earnings per share (“EPS”) are the most important number to judge a company by. Moreover, Wall Street wants predictable earnings from the many companies that report on a quarterly basis. Thus, the creation of value is given 3 months to blossom! Furthermore, most of the upper management of companies manage earnings as opposed to managing the company.

Second, the fall of the Dollar has allowed many multinational companies that do most of their business outside of the States to record amazing growth in profit. It has certainly been a great currency arbitrage for multinational companies, but it is not their fault, rather it is another smoking sign. A basic example would include a company reporting a 7% increase in net profits for the year, but if the dollar has fallen 8%, profits actually contracted.

So what happened is that most CEO's, CFO's turned to a new field by becoming financial engineers. The end result was to grow EPS at reasonable rate (determined by analysts) to make sure that their stocks didn't plummet. Every quarter, all the analysts estimate of EPS for the next quarter are averaged and that is the "number" that management has to make. Creative accounting is only one of the many tools used. An example includes the case of Cisco, a BW article in 2002 (here) talked about the hype. Here is an excerpt:

"That night, at the company's main San Jose warehouse, employees scrambled to load as many boxed-up machines onto trucks as possible, thus enabling them to be counted as "sold" for accounting purposes before the quarter ran out at midnight. "We had guys running with parts, trying to run them up to the trucks," recalls Larry R. Carter, chief financial officer, who monitored the action from a computer terminal in the warehouse that tallied shipments in real time. One harried staffer, in his haste, fell headlong to the concrete floor in front of Carter. Ten minutes before midnight, Chambers called Carter's cell phone from Davos, Switzerland, where he was speaking at an economic summit. "Did we make it?" Chambers asked. After a few more minutes of watching the numbers come in, Carter had to pass along the bad news: Cisco would undershoot expectations by a penny per share, its first Wall Street miss in 11 years."

"Did we make it?" And so it goes, but make no mistake, every 4 or 5 years a new way of "making it" comes around and exposes the destruction of value. I personally believe that for the past three years the way to "make it" was buybacks. Simply put, net earnings rose at a slower pace than earnings per share and it was an act that was rewarded by Wall Street analysts and media. The upper management figured that by buying shares of their own stock (put in treasury) earnings would increase; it was not organic growth by any means. In fact, the popular saying was that companies were participating in equity arbitrage, the act of dividing the E (earnings) by the P (price) and if the rate was higher than the 10 year treasury, to borrow (debt) and buyback shares of their own stock. Because you can right off the interest of the debt payments, you were rewarded for adding leverage.

"I’ve seen more people fail because of liquor and leverage- leverage being borrowed money. Donald Trump failed because of leverage. He simply got infatuated with how much money he could borrow, and he did not give enough thought to how much money he could pay back." Buffett

The innocent companies were penalized, if they had a solid balance sheet with little to no debt, a corporate raider would buy a small percentage of your company and order you to take on more debt and to use the proceeds by purchasing stock. Furthermore, because corporations are driven by net returns on capital after taxes, the tax write off of interest payments masked the EPS growth. That my friend is how and where the majority of earnings growth was made over the past few years.

Jeremy Grantham of GMO stated, “Corporate tax has always been a tax on efficiency- be less efficient, make less money, and you’ll pay less tax. The more reckless you are, the more you borrow, and the more interest you deduct, the less tax you pay.” It is the equivalent of driving with your seatbelt on and a cop stops you because you are too careful. So you get a ticket and because you obey the law you refuse to put your seatbelt on. The next time you are driving (w/o a seatbelt) the same cop stops you and asks why you have your open while you are driving, so he gives you an eye-patch to cover one of your eyes. This is not an exaggeration by any means, it was the rule in Wall Street until recently when Credit Spreads widened making buybacks too expensive because of a higher cost of capital (“COC”).

Now, I don't want to be misunderstood, there were and are many companies that purchased back their own stock at a discount, and that will create enormous shareholder value. Wally Weitz, fund manager of the Weitz fund in his latest quarterly letter stated, “Generally good ideas are taken too far.” True, he was talking about the idea of mortgage backed securities, but the statement has value.

Earlier this week, Procter and Gamble (“PG”) stated their plan to buy back up to $30 billion of its shares. For a company as safe and sound as PG, I think this will benefit shareholders a great deal. The company is always evolving and has great management that actually manages the company as opposed to managing the earnings.

Today’s post is more of a value-investing type of message than the previous one(s). This will be the order of the day for a while for three reasons:

1). I can’t find any value in the marketplace. Businesses are selling at a price that does not meet my required margin of safety.

2). I want this blog to have some value based on personal ideas/beliefs in order to create a personality towards businesses that we look at in the future. For example, most readers automatically know my views on the economic numbers because of this post.

3). I am still learning, although my un-audited returns for the past three years are above market returns, I want to learn as much as possible. The early posts are the foundation of a young investor’s beliefs and education.

Thank you,

S.K.

Heavenly Bodies With Un-heavenly Attributes

"I can calculate the motion of the heavenly bodies but not the madness of crowds” Isaac Newton

Sir Newton died a broke man and a virgin; no problem with the latter. Unfortunately he was caught up in the South Sea Bubble and so were many others. Last weeks actions were uneventful, but ( I ) don’t let CNBC and other major publications to change my opinion. I received a few calls last week wondering about the market action and my response was “so what”. Of course, readers of this blog are not surprised by the market action.

I was very forward with the liquidity problems in the previous two entries and I maintain my stance. Consequently, I placed my chips (read: money) on a free-fall in the financials because it was cheap insurance. I purchased out-of-the-money puts expiring in January ’09 on the XLF, the financials ETF. My only regret is that I didn’t purchase enough, the logic for the purchase was simple, the financials represent over 20% of the S&P, an inverted yield curve, liquidity drying up, and sub-prime issues would be sand paper action to their profitability. Currently that investment is up a little under 200% in two months time and I plan to hold it for a while. (Side note: Last week, Citigroup was down 7.4% and Goldman Sachs down 6.5%, both over 1.5X the market).

The Dow fell 4.2 % last week, which is nothing; there wasn’t a free-fall or a crash. It was similar to a person having 100 dollars in their pocket and purchasing a Big-Mac Value meal. As a devout, disciplined, shameless Sir Buffett fan, a value investor such as myself wants to see cheap stocks, because after-all: “Price is what you pay, Value is what you get!” For six months I have been whining about the limited opportunities in the market to a close friend and I welcome a little throbbing with open arms because it means I will pay a lower price for the same value.

The Junk Bond Debacle in 1989 had similar ingredients that Chrysler and Alliance Boots went through this past week. Banks are in the business of taking deposits and making loans to customers at a higher margin, when managed well they are enormously profitable. Last week, the auction of bonds to leverage Chrysler and Alliance Boots were not kindly met. Thus, banks that are in the business of deposits and loans are holding on to these companies in the meantime. This is not an enormously profitable venture when credit spreads are widening. If you can believe it and you should, six months ago Hugo Chavez borrowed at 6.7%. This is a remarkably low rate for a person who has threatened to default. These are “Criminal Lenders” according to Jim Grant and “For many ignorance is bliss.”

Currently, around 200 Billion dollars worth of deals are on bank balance sheets waiting to be leveraged. And 40 LBO’s (leveraged buy-outs) have been pulled thus far because of non-existent risk appetite. Moreover, foreclosures around the country have placed residential property on bank shoulders as well. This is a headwind for an industry that has been very strong the past few years. And because I am in the prediction mood, allow me to make a new one. The Enron/Worldcom/Tyco Etc. type of accounting that made for solid horror stories and great Court TV will have nothing on these “Criminal Lenders” and 15 to 1 leveraged stories. Because…

People that have homes will default on their credit cards, luxury spending, cars, (fill in the blank) before they default on their homes. Owning a home in the United States is a dream for many. Every administration touts the % of homeowners as a sign of our country’s prosperity and foreclosures are like prison as a last resort type of thing. So when you see footage of lawsuits with terminology such as NINJA (No Income/No Job) loans that were freely handed out, don’t be surprised!

On October 19, 1987 Sir Fisher stated in an interview, “The consumer has a high degree of loans outstanding that to me looks abnormally high in relation to his income.” That was right before the ’87 crash! I talked about this in the first post and I sincerely believe that although corporate balance sheets are flush with cash, the consumer is not. Tim Bond of Barclays Capital recently stated “It is the excess leverage of the lenders, not the borrowers which is the source of systematic problems.” There is an old saying, something along the lines of when the United States sneezes, the rest of the world catches Pneumonia and for some it’s Herpes.

Last week, When CountryWide CEO Angelo Mozilo stated that even the prime customers are having problems making payments and targeted 2009 as a change of tides, he wasn’t kidding. Suddenly, the quote by Wells Fargo CEO posted in the very first blog has more validity attached to the substance. More banks have “Real Estate Loan Exposure” that you can think and at some point liquidating the positions will be made at 50 cents on the dollar. The 725% increase in Southern California home foreclosures in the second quarter of this year is a verdict.

Since 1890, the market has fallen more than 300 points on 15 occasions, this past weeks’ 312 point fall was the 698^th worst in percentage terms. It is very important to put this in context and not be prey to Bubble vision’s (CNBC) baseless rhetoric. It is however important to know that Risk Appetite for leveraged transactions are non-existent. The only asset classes that went up were: 1) U.S. Dollar, 2) Crude Oil, 3) Treasury Bonds. One of the above doesn’t fit the bill.

To Conclude…

My father listens to Persian radio and there is a guy who always talks about the financial markets and liberally hands out advice. I don’t know him at all, but when passing by I often hear similarities in our stories and my father nods and raises an eyebrow to me as if this is something that I need to hear. And my reaction is always the same, “I told you this 6 months ago, Surprised?” That my friend is the story of Wall Street, where people put trust and belief in a person they have never met, and suddenly you have given access to your wealth. Thankfully, the guy is pretty logical, but the story has value.

So there you have it, I have condensed all of the previous weeks culprits to give you a macro version; something that I really don’t like doing because it is never-ending and unproductive. Top-down research is always inferior to bottom-up analysis. Originally, my intentions were to talk about Oil and possible investments, which is a topic that I love to research. In 2005 I completed a 25 page research paper about Uranium and Nuclear Energy with details of Hulbert’s Peak, I want to revisit it. Socrates said, “An unexamined life is not worth living.” Personally, I believe that an unexamined portfolio of investments is not worth owning and constantly question to death every company.

Rule of My Blog

Charlie Munger at the 2007 USC Law graduation stated: “A big whirlpool is not something you want to go into, and I think the same is true about a really deep ideology. I have what I call an iron prescription that helps me keep sane when I naturally drift toward preferring one ideology over another and that is: I say that I’m not entitled to have an opinion on this subject unless I can state the arguments against my position better than the people who support it. I think only when I’ve reached that state am I qualified to speak. This business of not drifting into extreme ideology is a very, very important thing in life”

That is why every subject talked about in this blog is carefully and mindfully stated, because it is not worth mentioning if I couldn’t support the other side, and I can. The market is something I love to read, discuss, and write about.

Thank you,

S.K.

It's The Economy, Stupid

Those four words shaped the 1992 Presidential election when Bill Clinton successfully unseated Bush Sr.. I was listening to NPR earlier this week, there was an interview with Dan Heath, the author of Made to Stick: Why Some Ideas Survive and Others Die. James Carville, Democratic party strategist, wrote these famous four words on a white board and instructed Bill to speak of the recession and make voters think, It really is the economy.

I have wanted to do a blog on this subject for while, it is the reason why I don't give a DAMN about most economic numbers that are reported. This includes CPI, Unemployment, you name it. Often times, friends of mine will use numbers reported by major media outlets to support an idea, this is called Confirmation Bias. Robert Reich, in his personal memoirs wrote: "That they found in their polling that if you could overstate economic growth, understate inflation, tell people things were better that thy really were, it could help you win in a tight election." For the same reason that Mr. Kudlow defines God as "3% inflation and 4% unemployment" numbers are manipulated to overstate economic growth and understate inflation.

Bringing me to the topic of today’s advice, Do not be fooled! Often times I come across an article that really changes my perspective, I came across one early last year titled "Shadowing Reality" by John Williams, a practicing economist doing private consulting for the past 25 years. Originally, I wasn't surprised much, but I recently re-read it, and came to appreciate it more. For the sake of being un-bias and staying true to purpose of this blog (value investing) today will be the only time this blog has anything to do with politics. I apologize for the minor U turn today, but I think it serves a great purpose.

I will quote Mr. Williams frequently.

The two types of manipulation include:

1. "A systemic manipulations where methodologies are changed. Again, the methodologies almost always have an upward bias in growth and a downward bias in inflation- and that's not coincidental.
2. The other type of manipulation is when someone does something to the numbers to make them come out a certain way at a certain time."

That makes sense and I think most people realize that when CPI is around 3%, it is comical and there are reasons.

"Real unemployment right now-figured the way that the average person thinks of unemployment, meaning figured the way it was estimated back during the Great Depression- is running about 12%. Real CPI right now is running at about 8%. And the real GDP probably is in contraction. There are in-fact reasons for the disconnect between official statistics and what the populous is feeling."

This is true because:

• "Elements of the CPI actually have roots that go back to 1888, when an index was created to measure the effects of a tariff act, and it was used in WWI to help in set wage scales for shipbuilders." and
• "Government thought process [is] "Well, we can get rid of the bad news here, or make it look a little better, and that might help us in the next election."

This is the part that gets really interesting, how every administration since Kennedy has tweaked numbers here and there to overstate economic growth and understate inflation, so let’s start!

• Kennedy Administration (61-63) - "[They] redefined "unemployment" and created a category of unemployed called "discouraged workers." if you were unemployed and you'd given up looking because there was no work to be had, you were counted a discouraged worker- but taken out of the unemployment count. They still counted you, at least until the Bill Clinton admin."
• Johnson Administration (63-69)- "One of my clients was an economist at the Commerce Department during the Johnson years and he says that when ever Johnson got the GNP report, he would look at it- and if he didn’t like it, he'd send it back. And he would keep sending it back until the Commerce Department got it right!"
• Nixon and Ford Administration (69-77) - "Mr. Nixon did not like the Labor Department. His thought- I don't want to get accused of insensitivity here, but quoting the NYT on this- Nixon thought there was a 'Jewish Cabal' at the Bureau of Labor Statistics."
• Carter Administration (77-81)- "Inflation was understated" (as a side note: this is greatly due to some of the problems we face now, back then oil shot up because of political turmoil)
• Reagan Administration (81-89)- "There were mythological changes made to the GNP- and there was an actual over manipulation of the trade data following the stock market crash in '87. At the end of that year, as the dollar was crashing, manipulating the trade data was part of an effort to turn the dollar to the upside. There had been a series of real bad trade numbers, and they psyched out the markets by coming up with a really good trade report. It amounted to a massive intervention but they succeeded in bottoming out the dollar and successfully turned the market. It was a very dangerous time and I guess you could justify that intervention on the basis of national security or economic security."
• Bush I administration (89-93) - He had a real tough reelection campaign. He had a recession weighing against him, what happened is that a senior commerce department official went to an old friend, a high-level executive in the computer industry, and said, "Gee, we've got to get the President re-elected. We want you to boost your sales reports to the Bureau of Economic Analysis." That happened. It spiked the GDP numbers. I knew people involved in getting it done, ones on the outside of the Bureau of Economic Analysis. And I've confirmed separately with people inside the bureau of Economic analysts that it happened."
• Clinton administration (93-01)-
• On Unemployment
• "Well, we really need to define discourage workers, so if anyone has been discouraged for more than a year, we're just going to take them out of all the number, take them out of the workforces completely". In doing so, they knocked about 5 million unemployed out of the broader measures of unemployment. Today there are seven or eight unemployment measures that are published each month.
• On CPI
• "They changed the weighing method of the CPI. It had been constructed using the arithmetic weightings, which meant doing things the way most people would add and subtract and divide. The BLS changed it to a geometric weighing, which has the benefit that if something goes up in price, it automatically gets a lower weight, and if it goes down in price, it automatically gets a higher weight. That change was implemented over a period of several years. The rationale was that it was a way of approximating the substitution effect. But it isn't. I mean it is just a pure mathematical game."
• On Unemployment
• "There was a period during the Clinton admin. When month after month, 250K jobs were being created, exactly 250K. They'd play around with the initial reports a little bit, but after a month or two you could look at the raw numbers and you could see the monthly changes were exactly 250K over two month they were exactly 500,000. The chances of the numbers coming out like that on a random basis were something like on in 10 million."
• Bush II administration (2001-2009)-
• On CPI
• "They introduced what they called the chained, or C-CPI-U, as an alternated CPI measure. And this measure, the C-CPI-U, is a direct measure of the substitution effect. It is running a half a percent-to a percent blow the official CPI-which is running, oh, about 2.7% below where it was before the weighing changes were made in the Clinton Administration. All in all, if you were to peel back changes that were made in the CPI going back to the carter years, you'd see that the CPI would now be 3.5% to 4% higher. The difference that it makes is significant: if the same CPI were used today as was used when Jimmy Carter was President, Social Security checks would be 70% higher.
• On Social Security ("SS")
• "Back in the mid- 1979's, what were then the big 10 accounting firms (Now 4) decided in good public spirit that they would help the federal government set up its books on an accrual basis so that it could prepare financial statements and report its business the same way that a company does, but something was throwing the statements off-accruals for SS, SS got thrown into the footnotes. Every year since then, these statements have been published, and to the credit of the Bush II administration, the recent ones have even included indications of what the social security numbers would look like, if they were included in the accounting, similar to the way corporations show pension and retiree benefit liabilities."

If the subject is manipulation, no matter how incompetent he is, it would be a travesty to leave him out of this post, he would be Mr. Greenspan.

• There was a very deliberate effort in the early 1990's under the auspices of Michael Boskin, who at the time was the head of the council of Economic advisors, in conjunction with Alan Greenspan, who, of course, was Fed Chairman, to "fix" the CPI. The story, very simply, was that CPI was supposedly overstating inflation. The pitch was that if people go out to shop and find that buying a steak is getting expensive, they buy hamburger instead. Therefore, their cost of living is really less than it would be if they always had to buy a fixed basket of goods, which is what the CPI was originally designed to measure. That was the whole purpose of the CPI, to measure the change in the cost of a fixed basket of goods over time. You'd have a steak, a loaf of bread, and a gallon of milk, whatever. You'd price them out one year and then you'd price out exactly the same goods the next year. You'd look at the difference in the cost and that was your annual rate of inflation. It was a measure o how much the cost of a consistent and constant standard of living was going up. What Boskin and Greenspan argued was, "We should allow for substitution here because people can buy hamburger instead of steak, when steak goes up." the problem is that if you allow substitutions, you aren’t measuring the cost of living, your measuring the cost of survival. You can keep substituting down and have people buy dog food instead of hamburger. The reason substitution of the items in the CPI basket became a hot topic in Washington at the time- and it was talked about very openly- was because the CPI was (and is) being used to adjust social security payments to compensate for increases in the cost of living, and tamping it down would hold down Uncle Sam's outlays."
• "When it comes down to it, Mr. Greenspan fueled the remarkable credit and stock market expansions of the 1990's, which turned into bubbles, because he knew that there was a basic problem in the consumer not having adequate income to sustain economic growth from more traditional sources; he used the stock market to try to fuel the economy."

The next interesting part was the Hedonic Adjustments; I know Bill Gross wrote an expanded version of this a while back.

• The BLS says the price really isn't going up, as long as the product has been improved in the interim, because you're getting greater benefit from it. After they finished with their hedonic adjustments, the "price" might even be down, particularly for things like computers and other electronics. My favorite example of this, even though it has gotten a little old, is just a perfect illustration of how government works. Sometime in the 1990's, I don't remember the exact timing; federal air pollution regulations were put in place that mandated adding a certain additive to gasoline, which increased the price of gasoline by 10 cents a gallon. Now, because air quality was supposed to be improved by this additive, that 10 cents per gallon price rise was NOT counted in the CPI. That was a hedonic adjustment for the improved quality of the gasoline. The irony is that they later discovered that the additive did not work as advertised and had to pull it out of gasoline- and I'm pretty sure the price of gasoline didn’t go down by a dime a gallon when it was pulled out. " this is also because:
• When gasoline prices go up at the pump because of rising oil prices, they are very slow to show up in the CPI, yet when oil prices come down, immediately you see a drop in the CPI and the downward pressure on the gauge. Gas stations are generally slow to lower prices, but very quick to raise them.

So there you have it, I think anyone who reads this blog has above-average intelligence and should not be fooled by some of the numbers that are reported on a daily basis. I want to add a few thoughts that are more current.

With crude oil above 70, currently the OPEC countries have made statements regarding how mad they are of all the Green talk (renewable energy, ethanol, etc.). Thus, they have made plans to reduce capex (capital expenditures). This is important because now they have two headwinds coming at them from two different directions:

1. Profit tax, which in my opinion is just stupid.
2. Green energy

This means that numbers reported from here out will try hard to understate inflation, but I actually believe that now they are out of control because the Agricultures have joined the price increase party. For the past three years, farmers had a favorable view from the public because of the introduction of ethanol, that is about to change. Consider this, raw foods through April had increased 26%, and by May: 31% for the year, that means that processed foods will undoubtedly increase soon and the consumers will be hit in the pockets. But please, don’t wait for the CPI numbers to portray the true landscape.

Lastly, my last blog post Cancer and Random Gleanings had the number of lenders imploding (82) in relation to the Subprime mortgage problems. I want to update that number, currently it stands at 92! Take it for what its worth, three weeks ago I stated that problems were not over, and by luck I was right. Since then, the problems of Bear Sterns have hit Wall Street in the gut at a 12 to 1 leverage, they have yelled "Fire" in the movie theater, and we shall see who gets a chance to leave.

I also stated, "Currently, Financials represent a little over 20% of the S&P 500, with I.T. another 15%. I think that the financials could really feel some pain in the coming months and this isn't a forecast, I'm willing to go out on a limb and make it a guarantee. I think their models, based on credit spreads are not weighing the risks of credit contraction with enough emphasis. There is also that subprime mess that has been checked off as a non-concern, but with Mortgage rates rising, will be a problem." Because I thoroughly believed my research, I purchased some Puts on an index that tracks all the financials a week after. My search was for the most illiquid contracts as far out (Jan. 2009) deep out-of-the-money. Currently, it is up 30% net commission, this was an insurance purchase.

Have a great weekend everybody, hopefully I can get a chance to write another post next week. I will close with this quote:

"Liquidity is ultimately a coward. There's always too much when it's least needed and it's nowhere to be found when needed the most."

Thank you,

S.K.

Cancer and Random Gleanings

Mr. Market (the idea preached by Sir Graham) and later from the letters of Sir Buffett is clearly at an irrational level. I don't say this because I try to time the market, but rather because there are little to no opportunities to buy a business at a discount that guarantees a margin of safety. Fortunately for us (individual investors) we have three options: 1)Buy, 2)Sell, 3)Do nothing. Some people with great reputations as investors are clearly concerned, this includes the likes of: Jeremy Grantham, Sir Buffett, Prem Watsa, Wilbur Ross, and a plethora of other "smart guys."


Imagine for a moment that you go to the doctor for a routine check-up only to find out that you have some type of cancer, at this point it is life or death. The doctor assigns you to a specialist for you type of cancer and you are given a maximum of six months to live. Three months passes, now fourth, and on to the sixth and you are still alive. Because you are alive doesn't mean that you have beat cancer, it is still a life or death issue, but to the average person, the longer you live, the higher odds that you have beat cancer. There are many fallacies with this logic, but nonetheless, it is still a coin flip result, head-life, tails-death, or vice versa.

I use this thought process to better understand the market at critical junctions, it makes a great deal of sense to me. Many of these smart guys that I mentioned above have remarked of the lofty, excess levels before this year started. Because, none of their predictions have come true does not mean that the market has beat cancer, it is still a concern. The more things change, the more they stay the same, no matter how willing present financial architects are, the math is the same. Leverage is still a financial catastrophe waiting to happen.

"Liquidity is ultimately a coward. There's always too much when it's least needed and it's nowhere to be found when needed the most."


The two requirements for any bubble: 1) Excellent economic fundamentals, 2)Large amounts of liquidity leading to high levels of leverage. According to the above quote, high liquidity leads to higher levels of leverage, and this isn't marginal, it is exponential. If you are 1-to-1 and suddenly because of high liquidity you are able to have 2-to-1, you have greater exposure. I will not tamper with the idea that we have excellent economic fundamentals, but I don't think that many of the economic indicators used by Wall Street to gauge Main Street are transparent. We are first a service economy (70%) and second a manufacturing, yet many Wall Street indicators are manufacturing based. (as a side note: I am really excited about next weeks blog because I will touch on the many meaningless, yet manipulated economic indicators.)

The only thing I have ever learned in relation to the U.S. economy is to Never Underestimate the U.S. Consumer. I learned this lesson the hard way and I sincerely believe that once you understand/appreciate the statement above, you will have mastered the subject of economics. The (U.S.) consumer is The primary force behind growth in the economy and sustainability. The three funding sources on tap from the consumer are: 1)Rising income, 2)Debt expansion, and 3)Saving liquidation (Williams, John). Lets step back and look at each of these sources of consumer growth.

1)Rising Income- At the higher end (top 20%), I don't think this is a problem, but the lower end of the bracket is clearly feeling some pain. Rising gas prices, energy, food represent a higher percentage when the denominator stay the same.

2)Debt Expansion- This is probably one of the harder elements of this puzzle to gauge. However, having been an intern at a Credit Card agency for two Summers ('03 and '04), I can tell you that the balloon is at a critical point. Meaning, I don't think it can expand anymore. And while we are on the topic, the talking heads on Wall Street use this excuse that I would hate for anyone to be fooled by. The conventional wisdom now-a-days is "Corporate balance sheets are flush with cash" which is true, but the rebuttal is that Consumer balance sheets are flush with debt, that is my argument. Most of the cash on corporate balance sheets have strings attached to the footnotes on their annual report, so I don't buy it.

3)Saving Liquidation- Probably the only oxymoron in this post, don't laugh. One source of untapped economic growth for China is savings liquidation because of their high savings rate (50%). However, if our trade deficit and budget deficit say anything about our saving habits, it is that we are non-believers.


Having analyzed these three integral parts behind growth in our economy from the consumer, I am still unwilling to bet against the consumer and that says a lot because logic and common sense is at odds.

Next, as a value investor I don't really care about the market indices, as long as I find value, concerns are unwarranted, but that doesn't mean that I should be oblivious to certain flaws. Currently, Financials represent a little over 20% of the S&P 500, with I.T. another 15%. I think that the financials could really feel some pain in the coming months and this isn't a forecast, I'm willing to go out on a limb and make it a guarantee. I think their models, based on credit spreads are not weighing the risks of credit contraction with enough emphasis. There is also that subprime mess that has been checked off as a non-concern, but with Mortgage rates rising, will be a problem. As of today, 82 lenders have imploded. So, yes, it is a concern.

The only CEO from a major bank that I respect and trust is Richard Kovacevich from Wells Fargo, (and I think he deserves an entire post!) but he had this to say in December '06, "I am not a forecaster of the future; I'm a historian. And history says this will blow up. It always has. And there will be some blood on the street." Now, I want you to do an exercise, get a sheet of paper and list the CEO's who would say something like this and still keep their jobs. Sir Buffett has great respect for Mr. Kovacevich, and I should say it is warranted. It doesn't take a genius to make a prediction about the financial sector with Richard on your side.


Finally, just because Mr. Kovacevich's prediction is 6 months due, does not mean the cancer is cured, in fact high chance that it has reached more excessive levels. Personally, I want to see some volatility because I am itching to buy at discount levels not seen today.

(Disclosure: I do not own any shares of WFC)

I hope you enjoyed the first installment, please e-mail me with any suggestions.


Thank you,

S.K.

Introduction

Hi,

My name is Shahin Khezri, I live in San Antonio, Texas. Graduated from UTSA ("University of Texas at San Antonio") with a B.B.A. in Finance. I started investing (read: speculating) at the age of 13, now that I am 22, I believe that finally, through trial and error I have closed in on the learning curb gap. The purpose of this Blog is to outline investment ideas, that make sense.

I consider myself a Buffett fanatic and a Fisher believer. Thus, many ideas that are posted on this site will have little to no use to market technicians and market timers. By saying that, I have purposely shrank the audience to better accommodate feedback in a thoughtful manner.

Originally, I wanted to have well over 30 ideas to post about before I started my blog. I intend to write at least once per week. Please e-mail me at Skhezri@gmail.com with any ideas that you believe would represent some interest.

Thank you,

S.K.