Dubai debacle

I don’t know what surprised me more about the debacle in Dubai last week, the fact that such a big deal was made or that anyone was surprised it happened.

Dubai World, a Dubai government-backed development group, said they wanted a 6 month pause in paying back a $60 billion loan. This may seem like a lot of money to you and me, but its chump change in the big scheme of things.

The financial crises over the last 2 years tended to be focused on multiple trillions, not billions. Added to this, Dubai is the second largest of 7 United Arab Emirates (UAE), with Abu Dhabi being the largest. Abu Dhabi’s sovereign wealth fund is over $300 billion in size, so bailing out little brother wouldn’t cause it to even break a sweat.

So, what was the big deal that tanked global markets? It simply shows that the credit crisis is not truly over and everyone is still sitting on pins and needles, despite their protests that everything is A-okay.

Credit markets are not healed, and the tremendous bad debt burden has simply been shifted from the private sector to government. The market sold off, in my opinion, because many expect credit problems to happen in the fullness of time and they were worried this was the first of many tremors.

This raises my second point. Why was anyone surprised?

Dubai only gets 6% of their gross domestic product from the petrochemical business. It decided to borrow a ton of money to build islands (shaped like palm trees and the earth), the tallest building in the world, an indoor ski mountain in the desert (I wish I were making this up) and vast ports so that it could become the world’s new Hong Kong. This was Field of Dreams writ large–build it and hope they will come.

Unfortunately, not enough people came.

What a startling surprise! Someone borrows to build a tremendous real estate project only to find there’s no real end demand for it. Sound familiar?

What did surprise me is that anyone didn’t expect this.

Just think what could happen if another entity, say commercial real estate in the U.S., has trouble rolling over debt and doesn’t have a rich big brother to bail them out, or that rich big brother (Uncle Sam) is so saddled with debt he can’t help without going into bankruptcy himself!

We saw what happened when a measly $60 billion defaulted for 6 months, what will happen if a bigger problem arises?

It is for this reason I’m de-risking my clients’ and my portfolios. Things look calm on the surface, but underneath the earth is trembling. Taking risk now may work well for a short time, but not over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Jeremy Grantham “has almost never been this dire”

Jeremy Grantham heads one of the best quantitative, value-oriented firms out there, Grantham Mayo and Van Otterloo (referred to as GMO for short). In his quarterly letter (www.gmo.com, you have to register to read their letters, but it’s worth it and I’ve never received a bit of unsolicited email from them), Grantham puts forward the same message he’s been delivering for some time: the market is grossly over-valued.

Grantham has been preaching this for some time, but his record in being right, though almost always early, is excellent. Heeding his words back in the late 1990’s would have saved you a lot of heart-ache if you were invested in the tech and telecom bubble.

Grantham’s theme in the past focused on a reversion to the mean of corporate profit margins. In this letter, he doesn’t spend much time on that subject, but he does take private equity, corporate tax rates, global financial markets, subprime mortgages, etc. to task. He simply sees too much risk taking out there and predicts it will end poorly.

I’ll just quote Grantham here because he says it best, “To conclude, I have been trying to come up with a simple statement that would capture how serious the situation is for the overstretched, overleveraged financial system, and this is it: In 5 years I expect that at least one major “bank” (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.”

Wow, that’s quite a prediction!

He goes on to say, “I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck.”

He’s not mincing words there, either.

What’s his suggested solution? In a word, “anti-risk.” He doesn’t take much time explaining what that means, but I think I can guess. Some investements will do a lot better than others if or when risk becomes a four-letter-word again. That may include shorting the market, buying commodities or gold, buying Treasury securities, or finding business managers who can benefit greatly in a market situation characterized by a lot of risk aversion.

In this last category, I’d put companies like Berkshire Hathaway, Leucadia and Fairfax Financial, companies that have a lot of cash on hand or are short the market and are waiting for a risk averse market to put their money to work. In the interest of full disclosure, I own positions in all three of these companies both personally and for clients.

A more risk averse market like we are facing usually scares people to death. In contrast, I see such situations as golden opportunities to buy when blood is running in the streets. In addition, I’ve purchased securities that I believe will do well even if the market does fair poorly.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

“Reasoning correctly from erroneous premises”

The quote above is from John Locke, but I found it second hand from Nassim Taleb’s The Black Swan. Supposedly, it’s Locke’s definition of a madman.

In my opinion, this quote accurately describes the state of the art in academic finance and economics.

Although it may be hard to believe, the Nobel prize has been given out repeatedly to very smart people who are exemplars of the above quote.

As a result, the field of finance, economics and investing is populated with folks who seem to unquestioningly follow such teachings.

That’s why most people are over-diversified and think risk equals volatility. The result is that most investors are under-protected from low probability, high impact, negative events and over-protected from low probability, high impact, positive events.

When a couple of Nobel laureates who exemplify the quote above followed their own advice, they lost almost all of their investors’ money and nearly caused a temporary collapse in the world’s financial system (if you think I’m exaggerating, read When Genius Failed by Roger Lowenstein).

Despite this paradigm shifting result, most market participants go right on assuming that erroneous premises can be followed with rigorously correct reasoning (and lots of higher math and Greek symbols).

Which reminds me of an apt definition of insanity: “doing the same thing over and over again and expecting different results” (Albert Einstein).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Warren Buffett is looking for a successor

Every March, Warren Buffett (Chairman of Berkshire Hathaway) comes out with his annual letter to shareholders. For any true devotee of value investing, this is required and eagerly anticipated reading.

The letter came out last Thursday, and I poured over it with green pen in hand to underline important sections. One section in particular was particularly interesting to me. Buffett is going to pick a much younger successor to take over investing operations when he retires.

Buffett said,

“…I intend to hire a younger man or woman with the potential to manage a very large portfolio, who we hope will succeed me as Berkshire’s chief investment officer when the need for someone to do that arises. As part of the selection process, we may in fact take on several candidates.”

How will the greatest investor in the world go about picking the right person? Paying attention to how he looks for a money manager reveals important criteria we can all use in picking investment managers or even specific investments.

He goes on to say,

“Picking the right person(s) will not be an easy task. It’s not hard to find, of course, smart people, among them individuals who have impressive investment records. But there is far more to successful long-term investing than brains and performance that has recently been good.”

Right off, he highlights that a smart person with a good record isn’t enough. He’s emphasizing that brains and a nice 3 year record are insufficient criteria for choosing a money manager.

He continues,

“Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.”

He’s highlighting the irrational behavior of markets, and how big, wrong bets can tank a recently good-looking record. He’s looking for someone who avoids risks, not someone who can shoot out the lights. In avoiding risks, he wants a successor who doesn’t assume risk solely by looking in the rear view mirror at either past events or, even worse, statistical data which doesn’t capture and cannot capture future risks.

Some managers have great records because they’ve taken great risks. You don’t want to find out they were taking huge risks after your portfolio has been mauled. As Buffett puts it, you can’t tell who is swimming naked until the tide goes out.

Next, he says,

“Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.”

He’s looking for someone with the right temperament for investing, someone who is independent-minded, level-headed, and understands both individual and herd psychology.

Look at his criteria:

1) intelligence and a good record aren’t enough
2) he wants someone who avoids risks, not just a manager trying to shoot out the lights
3) he’s looking for someone who doesn’t just look at the past or statistical models in making decisions
4) he wants someone who is independent, level-headed, and understands human and group psychology

Is this the criteria that most financial planners or investment books and periodicals advise? Not in my experience. But, I think Buffett clearly understands what works, and most sellers of investment advice don’t.

What I think he’s saying is that it’s more important to pick a manager with the right attitude, process and temperament than a manager who is brilliant, seemingly confident and can show a stellar record. Now, that’s advice we can all use.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.