Investing In the Wonderful Business

Another blast from the past.

(Continuing on the wonderful compilation of Warren Buffett's sayings done by Bud Labitan called "The Warren Buffett Business Factors" but unfortunately the link I had recorded is broken.)

The Wonderful Business

Time is the friend of the wonderful business, the enemy of the mediocre. You might think this principle is obvious, but I had to learn it the hard way. In fact, I had to learn it several times over. Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras - unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o - three years later I was lucky to sell the business for about what I had paid.

I could give you other personal examples of "bargain-purchase" folly but I'm sure you get the picture: It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. Now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.

That leads right into a related lesson: Good jockeys will do well on good horses, but not on broken-down nags. Both Berkshire's textile business and Hochschild, Kohn had able and honest people running them. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand.

I've said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. After many years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Truly a stock investment classic!

Warren Buffett's excellent comments highlights the folly of buying/investing in a company just because the price is cheap.

As commonsense would tell us that the cheap price does not gurantee us anything at all.

What one merely did is one paid for a business at a cheap price but obviously the more important thing is the type of business we paid for!

Buying a lousy stock at a cheap price - is never a sure win thingy.

The lousy could simply get lousier!

Anyway, this is another example of how one could benefit from learning from other people's mistakes. Buffett bought Berkshire because Berkshire was selling at a substantial discount from its book value, got fantastic people managing the company and even has some hidden gems in terms of unrecorded real estate.

So what went wrong for Buffett?

He made the folly of underestimating the poor underlying business economics of the textile business in Berkshire. By 1985 the textile business in Berkshire failed.

Quote:

"I knew it was a tough business... I was either more arrogant or innocent then. We learned a lot of lessons, but i wish we could have learned them somewhere else," he said.

Buffett once joked of Berkshire's textile business that the assets weren't worth what he tought they were, "but the liabilities were solid."

-- Of Permanent Value ( pg 157)

Lesson?

Buying a stock because of a low price versus NTA or low price versus book value is never a sure win thingy.

Berkshire Hathaway is a real example!

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Mistakes

Blast from the past.

Here is a past compilation of Warren Buffett's sayings done by Bud Labitan called "The Warren Buffett Business Factors" but unfortunately the link I had recorded is broken.

The Study of Mistakes

My pal Charlie has always emphasized the study of mistakes rather than successes, both in business and other aspects of life. He does so in the spirit of the man who said: “All I want to know is where I’m going to die so I’ll never go there.” You’ll immediately see why we make a good team: Charlie likes to study errors and I have generated ample material for him, particularly in our textile and insurance businesses. Irrespective of titles, Charlie and I work as partners in managing all controlled companies. We enjoy our work as managing partners. And we enjoy having you as our financial partners.

And one of the most quoted Buffett's saying:

To Win, first thing to do is not to lose. - Warren E. Buffett

Is the Study of Mistakes any different for traders? Take these famous quotes:

There is nothing like losing all you have in the world for teaching you what not to do. And when you know what not to do in order not to lose money, you begin to learn what to do in order to win. Did you get that? You begin to learn!

If a man didn't make mistakes he'd own the world in a month. But if he didn't profit by his mistakes he wouldn't own a blessed thing.

If i learned all this so slowly it was because i learned by my mistakes, and some time always elapses betweeen making a mistake and realizing it, and more time between realizing it and exactly determining it.

I was wrong; and the only thing to do when a man is wrong is to be right by ceasing to be wrong.

Losing money is the least of my troubles. A loss never bothes me after i take it. I forget it overnight. But being wrong - not taking the loss - that is what does the damage to the pocketbook and to the soul.

The recognition of our own mistakes should not benefit us any more than the study of our successes. But there is a natural tendency in all men to avoid punishment. When you associate certain mistakes with a liking, you do not hanker for a second dose, and, of course, all stock market mistakes wound you in two tender spots - your pocketbook and your vanity. But i will tell you something curious: A stock speculator sometimes make mistakes and knows that he is making them. And after he makes them; and after thinking over it cold bloodedly a long time after the pain of punishment is over he may learn how he make them, and when, and at what particular point of his trade; but not why. And he simply calls himself names and let it go at that.

Of course, if a man is both wise and lucky, he will not make the mistake twice. But he will make any of the ten thousand brothers or cousins of the original. The Mistake familiy is so large that there is always one of them around when you want to see what you can do in the fool-play line

-- Edwin Lefevre - Reminiscenes of a Stock Operator.

Or perhaps O'Neil's famous 19! (see Canslim: 19 )

I think this is the biggest thing for one to learn: Many people don’t admit even when they made a mistake(s).

When one does not admit that they have made the mistake in their stock selections, be it in investing or trading, then the mistake will just compound on itself, doesn't it?

The stubborn trader will most likely end up making the same mistake, over and over again, right?

And for the stubborn investor? Not admitting their mistake in their stock selection will turn their investment into a buy and hope.

Imagine one growing an mango tree. Once the mango bear nuthin' but sour mangoes, does it make sense to do nothing and hope the tree would one day bear sweet and juicy mangoes? Doesn't it make more sense to admit one's mistake? Perhaps it was in one's planting, care & maintenance of the tree. But what if fault simply lies in the initial mango seed?

And the classical investment teaching teaches us that investment takes time to bear fruit. But if the initial seed used was to plant our investment was poor, doesn't it make sense for us to admit the mistake? Be the man. Be the woman. Admit our mistake. And move on.

Else.... well simple. Say one is stubborn. Twenty years past. Couple of bull markets came and gone. And our end result? A miserable below average returns for a twenty year investment. How? Wait for another bull market?

So remember, one could easily make a mistake in one's stock selection. Recognising, admitting and then correcting the mistake is the only right thing to do!

Do remember this one famous teaching:

It takes a man a long time to learn all the lessons of all his mistakes!

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Mems Asks For Support!!

Published on BTimes, MEMS Tech asks for investors' support

• The board of directors has explained all the circumstances of the accounting woes to the shareholders, says MEMS executive director
  
  MEMS Technology Bhd, a microelectronics maker marred by accounting issues and a patent infringement complaint, has asked for investors' support as it faces a bumpy period ahead.
  
  In a shareholder meeting in Petaling Jaya yesterday that lasted almost three hours, directors and management dealt with a vocal crowd as minority shareholders demanded explanations on the cause of the accounting woes that have come to light late last year.
  
  The episode has tainted its public image as the Securities Commission said it started investigation on the firm's possible financial irregularities, resulting in the stock losing almost 70 per cent of its value since late November last year. MEMS Tech last traded at 12 sen yesterday.
  
  Executive director Tan Yeow Teck said its board of directors has explained all the circumstances of the accounting issues to the shareholders present at the meeting.
  
  "On hindsight, we believe this whole thing may not have happened if we've talked to the auditors up front," Tan said, referring to its external auditor KPMG, which raised concerns about certain transactions relating to the firm's revenue, property, plant and equipment last year.
  
  MEMS Tech's accounts had to go through a special audit due to the irregularities.
  
  KPMG did not seek re-appointment at the company's annual general meeting yesterday.
  
  Tan also said that it has written to Bursa Malaysia, requesting for the uplift of the GN3 status on MEMS Tech.
  
  "GN3 usually classifies those companies that are financially-distressed. Our circumstances are different," he said.
  
  As it was embroiled in the accounting issues, a competitor has filed a patent infringement complaint against MEMS Tech with the International Trade Commission. MEMS Tech is defending its position and the case may drag on until next year.
  
  "We hope to put this behind and move on. I believe the shareholders are supportive," chief executive officer Kathirgamasundaram Sooriakumar said.
  
  "The management has been stretched and stressed by events of the past few months but remains committed and motivated to entrench this exciting micro-electro-mechanical systems technology in Malaysia," the company said in a press release yesterday.

Comments:

Support is such a massive word in the investing world.

Yes, it's great to see that the board is finally admitting that they could have done much better to avoid this shambolic event.

However, for the minority shareholder to pledge their support, there are couple of issues worth considering.

1. Support means total trust from the minority shareholder. There was one glaring issue that needs to be considered which was mentioned in a posting back in Feb 2008, What now for Mems Technology?

• Previously blogged on Feb 2008, The said article on Mems
  
  For the first time since accounting problems emerged at MEMS Technology Bhd, new information has surfaced indicating that the company may soon get out of the quagmire it is in.
  
  The much-awaited special audit report, which was commisioned by MEMS and done by Atarek Kamil Ibrahim & Co, has been completed and presented to MEMS' external auditors KPMG.
  
  According to MEMS' chairman and controlling shareholder Datuk Ahmad Kabeer Nagoor, the (external) auditors have some queries on the report. He says these are being discussed by MEMS' independent committee. Ahmad Kabeer declined to elaborate, saying that more details will be revealed soon.

Now what was most glaring was how Mems traded that week.

Article was published on the Edge on Feb 11th. See how the stock surged 42%?

Now consider this, the said much-awaited report and clarification on what happened in Mems accounts wasn't revealed soon as mentioned.

And by the 25th Feb morning, the stock crashed early morning by as much as 18.7% to 13 sen.

Now the biggest issue for me is this one: Changes in Sub. S-hldr's Int. (29B) - AKN EQUITY VENTURES SDN. BHD.

See the hige disposal by AKN Equity Ventures on the following dates.

Disposed 11/02/2008 1,200,000
Disposed 11/02/2008 1,700,000
Disposed 12/02/2008 1,050,000
Disposed 12/02/2008 2,000,000
Disposed 13/02/2008 100,000

Big news article on the Edge and the stock surges and in the same time, big shareholder dumps their share!

How? Is this issue not a concern?

2. How is Mems doing now? I took a look at Mems finally released quarterly earnings early this month, A Look At Mems Technology Again

• Now that Mems had finally reported its earnings and resumed its trading, I thought I take a look at Mems again.
  
  Quarterly rpt on consolidated results for the financial period ended 31/1/2008
  
  Net earnings was only 1.434 million from sales revenue of 16.464 million. Only 1.434 million. This is utterly smallish eh?
  
  Let's look at the Balance Sheet.
  
  

  
  Trade receivables now totals at 34.998 million. Reported period is at 31st January 2008. Compare to the column on left, receivables were only 22.824 million. Which means receivables increased a whopping 12.174 million. Which is extremely massive when the company's net earnings is only 1.434 million for this reported period.

  Cash and bank balances as at January 2008 shrank to 9.874 when compared to July 2007's balance of 18.995 million.

  And the below table highlights Mems' liabilities:

  
  Total loans as at 31st Jan 2008 is at 43.355 million compared to a loan total of 34.267 million in July 2007. An increase of 9.088 million in loans.
  
  How?
  
  As it is what do you see?
  
  I see its net earnings as rather extremely small with low profit margins with a rather below average set of balance sheet. Receivables and debts are increasing while cash is shrinking!

How?

Considering these two issues, would you give your support to Mems?

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More On the Grand Saga

Here's an update to the The Grand Saga Issue posting.

Fellow blogger Dali, had published a great update: Grand Saga / Greed where another blogger, ST had highlighted again why the access road should not be blocked as published on http://insidesglong.blogspot.com/

This simple picture says it all.

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Bull!

In the book, Bull by Maggie Mahar, she gave a brief commentary (in blue italics) on John Kenneth Galbraith's , A Short History of Financial Euphoria

pg.12.

"For practical purposes," Galbraith wrote, "the financial memory should be assumed to last, at maximum, no more than twenty years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to come on the scene, impressed, as had been its predecessors, with its own innovative genius." (pg 87 of Galbraith's book)

During the period of delirious forgetfulness, no one wishes to think that his good fortune is fortuitous or undeserved. Everyone prefers to be believe that it is the result of its own superior insight into the market.

No wonder, then, that during such periods, doubters are silenced.

Very interesting comment isn't it? When the market is good, everyone thinks they are good!

By 1999, Byron Wien, Morgan Stanley chief domestic strategist, recalled one scene when an analyst stood in his office recommending a stock that was selling at over 100 times earnings.

"How do you arrive at your valuation?" Wien asked. "Show me the parameters you'r using." The young analyst just stared at the 64-year-old market strategist.

"When you're an older person, and you'r cautious, while the market is still going up, you're perceived as out of touch," Wien later recalled. "You just think that a stock is worth $20; you say that, at $30, it's overbought; then it goes to $40. You can begin to doubt yourself."

But Wien had a corner office with its skyscraper views of Manhattan. The young man standing in the middle of the carpet did not. More important, he did not have the thick skin that comes with trying to outguess the market while working your way up to such an office at Morgan Stanley. If Wien doubted himself, he did not show it. He waited for the answer. "The stock is worth what someone will pay for it," said the analyst, stating what seemed, to him, obvious.

The moment crystallized what Wien already suspected: They're letting the tape tell them what a company is worth. No wonder, when a stock took a dive, the analysts who followed it were just as surprised as everyone else.

They're letting the tape tell them what a company is worth!!

Do you let the market price tell you what a stock is worth?
Do you let the market price tell you what is and what isn't a good stock?

As can seen by this simple story from Byron Wien, and of course as mentioned precisely by John Galbraith in his book, A Short History of Financial Euphoria , at the peaks of the markets, whether it is a bull or a bear, folks have this self-belief that they are right, in regardless of what the actual situation might be.

Think of Jan 1975, in which Richard Russell in his newsletter made his finest call, in which the crash of 1973-74 had send the market rock bottom. The Dow was now cheaper than it would be at any time for the rest of the century. Eagerly, Russell trumpeted the good news. It was time to buy stocks, he told his subscribers. (pg 7).

But what was he greeted with? Nothing but hate mail!. "I don't want to hear about stocks!". "How dare you tell us that this is the begining of a bull market".

Or how about as in Wien's example? 1999. Analysts were rating a stock more simply because they knew others were willing to pay more for it!

And as Galbraith puts it: No wonder, then, that during such periods, doubters are silenced.

Ahh... very intresting comments from Wien again, isn't it? Analysts were rating a stock more simply because they knew others were willing to pay more for it!

"Markets go down because they went up," James Grant reminded his readers in the late nineties. "Where the free enterprise system shines is in its treatment of failure," he added.

"Individuals as individuals, are always error-prone... [they] also make collective mistakes. They overinvest, then underinvest. The underinvestment portion of the cycle is dealt with constructively, with new business formations, bull markets, and initial public offerings. The overinvestment problem is dealt with the emphasis on demolition: with bankruptcies, bear markets, consolidations, and liquidations... Without miscalculation there would be no price action, no capital gains, no losses and no commissions. "

Cycles, then, drive markets: three steps forward, two back. Without the alternating rhythms of expansion and contraction, rising prices and falling prices, there would be no movement. In Grant's terms, "A boom is just capitalism's way of setting up the next bust" (James Grant, The Trouble With Prosperity , pg 250)

... The great virtue of laissez-faire capitalism, say its staunchest admirers, is that it allows a boom to run its course, and then lets the bubble collapse. With the hissing sound comes a correction: investment mistakes are repriced and unprofitable companies go bankrupt. "The errors of the up cycle must be sorted out, reorganized or auctioned off," Grant observed.

"Cyclical white elephants must be rounded up and led away." Only then can a capitalist economy resume its progress. The correction clears the way for another cycle.

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Should An Investor Cut Loss?

Here's something from the past again:

As an investor, I reckon that it just does not make sense to me at all not to accept this cut loss theory.

Why should one cut loss?

Face the reality, on the average (let me stress the word 'average'), most companies in this region does not really have a true sustainable competitive advantage that allows the company to grow at a healthy pace for a long period (let me stress the term 'long period').

Hence, what we will have is companies having shorter period of fantastic wealth (ah.. how do i define shorter? 3 years? 5 years?). Sometimes this is the cyclical nature of the business or sometimes there is changes made either in the economics of that specfic industry or perhaps there is dramatic changes made in the companies management that might cause an end to a companies competitive advantage.

Simply put, we are more likely to see scenerios where good companies turning bad and also on occassion bad companies having a temporary bout of 'good' fortune.

Back to investing...

Now if and when an investor purchased shares in a listed stock, the possibility exists that the so-called persumed good business could turn bad.

Hence a simple commonsense question:

So if the company turns bad.. does it make commonsense for the investor to hang on to the share and hope the company have a change of fortune again?

Ahh.. it is always possible for that to happen but in the meantime just imagine what would happen to the share price while one is waiting for the companies fortunes to change?

Take a semi-conductor stock Malaysian Pacific Industry. (ah.. now it is much acceptable fact that chipmakers business is very much cyclical) During its peak, it earned some rm200 million (fy 2001) and a peak price of around rm57.00 in 2000. Back then, everyone was simply going goo-goo-ga-ga over chip stocks and hailing the bright investing prospects in the industry.

Now? 5 years later, current earnings is only some rm43 million. The stock price is only some rm10.00+-.

So if one had bought and HELD tigh-tight as per the Myth of Long Term Investing, then the end-result has simply been devastating. As some would call it as perhaps Value Destruction?

Hence, does it make sense to cut-loss once the companies earnings started to go bad?

And the second most important point is we are but normal buggers who are more likely to make investment mistakes.

Yes, I say it again... simple poor stock selection mistakes can be made by any of us.

And what does one do when one make a mistake?

Don't we want to rectify it?

And isn't the best way to rectify it is by stop being wrong.

And in investing, admit the mistake and accepting the mistakes made, sell and move on.

Holding on and hoping that a market bull will help us correct our investment mistakes isn't investing anymore, isn't it? Make sense or not?

So do you think that ze Cut-loss a big No-No for investors?

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Obersvations On the US Consumers

Blogged previously: Will the Markets Continue to Advance?

I paid attention to Tim Wood's observations on how the normal Americans are doing.

• Another item that is contributing to the toxic American economy is rising commodity prices and the stagnate business environment that rising commodity prices have caused. Let me give you a few examples. This past week I went to my local lube and car wash. The manager and I were talking while I was waiting on my vehicle to be washed. He told me that a year ago they would do anywhere between 80 and 100 oil changes in a typical day. But with the rising fuel prices, business has dropped to an average of somewhere between 50 and 60. As for car washes, he said that they were doing upwards of 400 a day. At present, business has dropped to between 60 and 100 per day.
  
  Another friend of mine is a boat dealer and sells bay boats and pontoon boats. This time last year if you went by his store, you could hardly talk to him because he was so busy. I remember needing something and literally not being able to get to him. He told me this week that June is his peak month and it was absolutely dead at his store. He said that he counts on the summer sales to help carry him through the winter season. He is now worried about making it through the summer. There was also another local business owner present and he too is also now feeling the exact same pain.
  
  In yet another example, I needed a trailer ball so I stopped in at a truck accessory store. It was also dead there and I quizzed the owner. He too was telling me how slow it had gotten. He said that recently he had 13 employees between all of his sales and installation people. He is now down to one sale person, a secretary, one installer and himself. He said that it is now costing him to keep the doors open. He had a beautiful black 4-door F-250. He said that it cost $170 to fill it up and he had it parked in the shop and is no longer driving it.
  
  Here’s another one. I went to the local mall with my wife this week. She knows the lady that runs one of the shops in the mall. This lady is looking for a job because sales are so bad that the company is not going to renew its lease this summer and will be closing the doors.
  
  In yet another example, I was talking to a lady at the local gym. Yes, I talk with everyone trying to get a feel for things. Anyway, she was telling me that they are now seeing gym memberships declining.
  
  I also know people at one of the local giant home improvement stores. Sales are down and I am being told that they are not refilling positions in an effort to cut overhead. This slow down is not just affecting the small business owner. It is hitting everyone.

Today, I noted that CNN carried one interesting article, Making a good living, but still feeling strapped

• NEW YORK (CNNMoney.com) -- Only a few years ago, Americans who considered themselves middle class were scrimping to pay for their kids' college education.
  
  Now, many of them are struggling to cover far more basic needs - gas and groceries.
  
  Take Stacy and Chuck Burris. The Pittsburgh, Pa., couple view themselves as solidly middle class. In recent months, however, they've felt anything but.
  
  Burdened by high cost of food and fuel, they are having trouble balancing their budget even though Chuck Burris earns a "comfortable salary" as a software engineer. The parents of five children, three of whom are grown, have essentially stopped eating out and entertaining and are considering canceling the annual family vacation to Maine. They keep to a Spartan shopping list and have planted a larger garden. Instead of buying their 12-year-old daughter summer clothes, they are turning her pants into shorts by cutting off the legs and getting hand-me-downs from family.
  
  Never before in previous recessions have they had to cut back like this.
  
  "We are struggling to stay in the same place," said Stacy Burris, 47. "You don't mind pinching pennies to send your kids to college. You do mind pinching pennies when it's simply to buy some eggs."
  
  Many others nationwide are feeling similarly strapped. Recent consumer sentiment studies and polls show that Americans feel worse about their financial situations and the economy than they have in decades, even as economists debate just where things stands. And people don't expect things to improve anytime soon.
  
  "Consumers are very financially stressed, more than what's indicated by the job and income statistics," said Scott Hoyt, senior director of consumer economics at Moody's Economy.com.
  
  Personal finances worsening
  
  High fuel and food costs, coupled with miniscule raises and shrinking home values, led more people to report that their personal finances have worsened than at any time since 1982, according to a recent consumer survey by Reuters and the University of Michigan.
  
  The future looks grim to them, too. Just one in five households surveyed expect their finances to improve during the next year, the least favorable in half a century. Three-quarters of those surveyed said they expected the nation's economic troubles to continue over the next year, the highest level since 1980. They predict the unemployment rate will jump by one percentage point to 6.0% by year end.
  
  A survey from the Conference Board released Tuesday found that only 13.4% of respondents said they expect their incomes to rise in the next six months, the lowest level since the study began 41 years ago. Their inflation expectation has hit an all-time high.
  
  Consumers' perceptions matter. Their dour view is prompting many to rein in spending and avoid incurring additional debt, with the fewest people planning to buy furniture, appliances and home electronics since the early 1980s, the Michigan survey found. The percent planning to take a vacation in the next six months also hit a record low, according to another recent Conference Board report.
  
  "Consumers are the ones in trouble here," said Paul Ashworth, senior U.S. economist with consulting firm Capital Economics.
  
  Looking at government statistics, however, things don't look that dire, which is one reason why economists are dickering over whether the country is in a recession. Unemployment is at a relatively low 5% and inflation is running at a modest 3.9%. The economy expanded at an estimated 0.6% in the first quarter, weak but still in growth territory.
  
  Most experts are predicting more bad times ahead, but there's still no consensus on whether the economy is facing recession. Federal Reserve officials lowered their expectations for growth, but still kept it in positive territory, according to minutes released last week from a recent board meeting. Moreover, many economists say that if there is a recession, it will be mild and short.
  
  Consumers, on the other hand, don't feel that way. Many are being pummeled by plummeting home values, a weak stock market and soaring grocery and gas costs.
  
  Feeling the pain at all income levels
  
  Hoyt of Economy.com argues that every income strata is feeling it. The wealthy are hurting from the roiling stock market, the middle class from falling home prices and working folks from rising prices.
  
  Food prices, for instance, climbed 5.1% over the past 12 months and April's 0.9% rise was the largest in 18 years, according to the Consumer Price Index. Gas, meanwhile, hit its highest recorded price of $3.937 on Monday, up nearly 21% from a year ago and 9.7% over the past month, according to AAA.
  
  Meanwhile, Americans aren't feeling flush. Home values have plummeted more than 14% in the past year, according to the S&P Case/Shiller Home Price Index, which tracks 20 of the largest markets. That's the sharpest rate in two decades. And wages are basically stagnant, rising only 0.6% between the first quarter of 2000 and the same period this year on an inflation-adjusted basis. Wages have actually fallen behind inflation for the past seven months, according to Jared Bernstein, senior economist at the Economic Policy Institute, a liberal leaning think tank.
  
  "Folks are having considerable difficulty making their personal family budgets given their pay and prices," said Bernstein, who recently wrote Crunch: Why Do I Feel So Squeezed? "The prices they face most commonly in day-to-day life are rising faster than both inflation and their paychecks."
  
  Their investment portfolios aren't doing well, either. The Standard & Poor's 500 index is down nearly 9% over the past year. And the value of Americans' stock and mutual fund holdings fell by $186 billion in the first quarter, the first drop since 2003's bear market.
  
  All this financial stress comes at a time when most Americans have the thinnest savings cushion to fall back on. They have been loading up on debt in recent years, drawing on the equity in their homes, in particular. The percentage of their disposable income that goes toward debt payments is at 14.3%, near the all-time high.
  
  "Consumers need to get their financial house in order," Hoyt said.
  
  Uncertainty hard to deal with
  
  Weighing even more heavily on consumers is uncertainty about where the economy is headed, said Ken Goldstein, economist with The Conference Board. It's unusual to have such slow growth for so many months and Americans don't know how to respond.
  
  "What's really pushing consumers into a funk is the fear of what's coming next," Goldstein said. "You can't be sure you know exactly where we are or where we're going. Consumers are afraid that the light at the end of the tunnel is an oncoming train."
  
  That's exactly how Chris Ackerman feels. He said that he and his wife, who live just outside Seattle, find that their paychecks no longer cover their rent, student loans and daily living expenses. That is forcing the young couple to turn to their credit cards to make ends meet.
  
  They've already cut out much of their entertainment and trips to visit her family and friends 30 miles away. If gas and grocery prices continue to rise, Ackerman, who works for an importer, said he'll have to stop contributing to his 401(k) plan. He doesn't see many other options.
  
  "The worst part is looking to the future," said Ackerman, 25. "What if everything keeps getting worse. That's the scariest part. Is my grocery bill going to double again? What will we do?

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Blast From The Past: Accepting Mistakes!

Got plenty of interesting comments on the posting, Is Paper Loss Not A Loss?

I thought i dig up an old posting of mine.

Enjoy!

~~~~~~~~

Anyone like William O'Neil's book, How To Make Money In Stocks ?

I am sure you will be puzzled how come an 'investor' like me would want to read such a book.

Well, a book is a book is a book. And there are some interesting stuff an investor can pick-up and learn from the book. (die lah... do i sound like a book salesman oredia???.. :P)

Anyway... here is a snippet from Chapter 9.

Bernard Baruch's Secret Market Method of making Millions

If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person if he has the sense to cut his losses quickly on the ventures he has being wrong.

As you can see, even the most successful investors make mistakes. These poor decisions will lead to losses, some of which can become quite awful if you're not disciplined and careful. No matter how smart you are, how high your IQ, or education, how good your information, or how sound your analysis, you're simply just not going to be right all the time....

You positively must understand and accept the rule number one for the highly successful individual investor is.... always cut short and limit every loss.

To do this takes discipline and courage.

The whole secret to winning big in the stock market is not to be right all time but lose the least amount possible when you're wrong. You've got to recognize when you may be wrong and sell without hesitation to cut short every one of your losses.

How can you tell when you may be wrong? That's easy. The price of the stock will drop below the price you paid for it! each point your favourite brainchild falls below your cost increases both the chance you're wrong as well as the price your're gonna pay for being wrong.

Ahhh.... I like the second and third paragph (highlighted in red) ..

Some investors can NOT accept the fact that perhaps they could have made a poor investment decision in the first place.

And when the investment turns bad and the financial datas giving us the clear and distinct signs that we are ABSOLUTELY WRONG in our reasoning...

What is the right thing for one to do?

Dont' we want to stop from being wrong?

Or do we want to continue to be wrong and hope that the market will one day correct us from being wrong? (Isn't this simply playing the loser game?)

So what is the right thing to do?

Acknowledge and recognize our mistake by ze CUT-LOSS.

Accept the fact that perhaps it wasn't investing or the buy & hold thingy that went wrong BUT it was our poor initial judgement that was wrong!

Our stock selection was simply flawed.

And we achieve this by SELLING the stock immediately!!

Do not wait for the market to help us correct our mistake.

When we are wrong, we have to accept this fact.

Acknowledge it and deal with it.

Do not turn the buy & hold into a buy & hope.

On the other hand, this other part...

how can you tell when you may be wrong? That's easy. The price of the stock will drop below the price you paid for it! each point your favourite brainchild falls below your cost increases both the chance you're wrong as well as the price your're gonna pay for being wrong.

Ahhh.... i do reckon that this is the most complex part of investing.

Sometimes the stock market simply does not agree with our investment decision!!

What do we do?

Are we right or is the market right?

This is where winners and losers are made in investing. Those who are precisely sure that their reasoning is correct, should not be afraid that the market does not agree with them. Instead, they should view this as an opportunity. An opportunity to invest more of the good quality stuff at the cheaper price. Same quality item but only cheaper.

But... butt.... buttt......

Where and what and how could such investor go wrong?

Well... determining whether if they are right or if they are wrong!

If right then the investor will surely reap their success!

But... if they are wrong.... such strategy is extremely dangerous for what they have only DOUBLED DOWN on their mistake.

Does this make commonsense? or issit simply silly billy to do such stuff?

Again...... i have to mention again..... this is Ze hardest part of investing.... cos when stock prices go down... sometimes.... investors start thinking with their heart and not their brains.... and when they fail to recognise their fault in their stock selection process, they are only DIGGING a deeper hole for themselves.

Tiok boh?


*
ps...
my buddy Liam or some call him LMF... recommended Chapter 8 wor... err... me too!... good stuff lah! ... but... i dun think it is too nice if i reproduce wholesale of what's written in that book.

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More Typical Poor Financial Reporting Again!

Published on the 26th May 2008: Kencana close to getting RM500m contract

• 26-05-2008: Kencana close to getting RM500m contract
  by Jose Barrock
  
  KUALA LUMPUR: Kencana Petroleum Bhd is said to be close to sealing a RM500 million contract for the fabrication of multiple well-head platforms from Shell Oil and Gas (Malaysia) LLC and Sarawak Shell Bhd, industry sources said.
  
  The platforms are to be used for the F-28 and Cili Padi petroleum and gas field developments, offshore Bintulu in Sarawak.
  
  Exploration of the Cili Padi field is being conducted by Shell Oil and Gas (Malaysia), a joint venture between Shell, state-controlled oil major Petroliam Nasional Bhd (Petronas) and Nippon Oil Corp. It is located about 153km off the shore of Bintulu.
  
  The F-28 field, operated by a joint venture between Sarawak Shell Bhd and Petronas’ unit Petronas Carigali Sdn Bhd, is located about 180km northwest of Bintulu.
  
  It is believed that a letter of intent (LOI) was given to Kencana in relation to this project last month. CIMB Investment Bank had, in a research report late last month, stated that the LOI had been given for the project.
  
  Assuming the LOI for the well-head platforms contract is converted into a Letter of Award, Kencana’s fabrication order book could be nudged up to the RM1.6 billion mark.

The classic nonsense of it is believed and according to sources yet again!

Come on, who are these sources man????

And given the history of poor reporting from this very same reporter, it was NOT a surprise for me to read that Kencana denies winning Shell contract this morning.

• KENCANA Petroleum Bhd, a Malaysian oil and gas services provider, denied a report in a local newspaper it won a RM500 million(US$154 million) contract from Shell Oil & Gas Malaysia LLC and Sarawak Shell Bhd.“Neither the company nor any of its subsidiaries has received any letter of intent,” Kencana said in a statement to the stock exchange yesterday. - Bloomberg

Now I just wonder why no action is taken against this reporter for all his continued 'according to sources' articles?

And doesn't it really renders our financial news useless when companies, such as Kencana here, denies what's written by the said reporter?

Sigh!

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Tong Herr's Earnings

Tong Herr reported its earnings last nite.

It wasn't impressive at all.

Net earnings of 4.444 million versus 18.942 million ago is rather very, very poor.

And this is what the company said.

• The Group recorded revenue of RM99.64 million and profit before income tax of RM6.22 million in this reporting quarter compared to RM97.70 million and RM8.1 million respectively, as recorded in the preceding quarter.
  
  The higher revenue and lower profit before income tax for this quarter are due to higher demand for the product and higher cost of raw materials purchased in the preceding quarters.

Now BusinessTimes posted an article on Tong Herr, Tong Herr to invest RM70m on production

• TONG Herr Resources Bhd will spend RM70 million this year to boost its capacity in Malaysia and Thailand on strong demand for steel fasteners.
  
  The Penang-based company will triple the production of nuts, bolts, screws and other threaded items at its Perai Free Trade Zone facility on mainland Penang by September, its chairman Tsai Ching-Tung said yesterday.
  
  "We have earmarked RM45 million for machinery and the construction of a facility adjoining our existing one," he told reporters after the company's annual shareholders' meeting.
  
  Tsai said Tong Herr will also invest RM25 million to expand its 7,000 sq ft Thai factory located at the Amata Nakorn Industrial Estate in Chonburi, adding that rising steel prices had very little impact on Tong Herr's bottom lines.
  
  For its 2007 financial year ending December 31, Tong Herr recorded its highest ever revenue of RM487.67 million while net profit jumped 31 per cent to RM73.22 million.

Two issues for me.

Firstly, the decision to want to invest rm25 million in expanding their Thailand factory.

Look at the following screen shot of Tong Herr's notes on its segmental reporting.

Its Thailand operations only contributed a net profit of 636 thousand for the current quarter. And the boss wants to spend another 25 million???????

Last year, it was reported that this Thailand plant had already cost 20 million.

And Tong Herr wants to add another 25 million??????

That's 45 million!!!!!!!!!!!!!!!!

For a plant that only contributes 636 thousand in net earnings!

Holy cow!!!!!!!!!!!!!

What kind of Return Of Investment are we talking about here?????????

Blows my mind away man!

And then we have the statement from Mr.Tsai that "adding that rising steel prices had very little impact on Tong Herr's bottom lines."

I am so utterly confused here.

Now steel is the main raw material for Tong Herr, right?

And you have the company stating the following:

• The higher revenue and lower profit before income tax for this quarter are due to higher demand for the product and higher cost of raw materials purchased in the preceding quarters.

The higher cost of raw materials has resulted in the company net earnings plunging to 4.444 million compared to 18.942 million the same period a year ago.

However, Mr.Tsai says "rising steel prices had very little impact on Tong Herr's bottom lines".

Huh????????????????????????????

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Do Not Cheat Yourself!

Here's an old posting which I had made a couple of years ago.


...... if i bring up this delightful investment piece from the book, Sun Tzu on Investing.

There’s an old Chinese story about an Emperor and his pet dog.

The Emperor awoke one day when he heard a loud noise. From his bedroom window he could see a large ox-drawn cart had run into a wooden flagpole used to raise the Emperor’s family crest high above the castle. The flagpole was ever so slightly tilted, but the damage appeared minimal and no repair work was initiated. Later that day, the Emperor was walking his dog past the flagpole and the dog stopped to, well, to do what dog’s do to flagpoles. Suddenly, with a loud snap the pole crashed down onto the poor dog before he could even lower his raised hind leg, killing him instantly.

What the Emperor and his attendants couldn’t see was damage hidden below the surface. The flagpole had leaned ever so slightly, but it was enough to cause a critical break in the structure just below ground level. Obviously, the dog got the raw end of this whole deal. But let us pose a simple question: If you were trying to assess blame for unnecessary risks in this situation, where would you place it?

You could blame the workers employed by the Emperor to erect a flagpole for choosing a pole with a weak spot and concealing it below the ground. Or you could blame the Emperor, although it may cost you your life, for his vanity in demanding such a tall flagpole to fly his family crest above the castle. Maybe the fault was with the deliveryman who carelessly backed his ox cart into the pole causing the imminent damage. We could also blame the dog for marking too wide a territory! The story illustrates how difficult it can be to assess where risk originates. To the dog it mattered not how or why it happened, or even to who the blame should be assessed--just the fact that it happened.

When it comes to equity investing, you are the dog. If there are risks being taken by companies you hold, you are the one who will suffer the most direct damage. That’s the cold, hard truth. The thing is, those who are taking the risks may not recognize them as such, or may be purposefully concealing them from you. All the more reason for you to be extremely careful in selecting the companies you choose to invest in, and the integrity of the managers.

Enron Corp, a leading Houston, Texas-based global energy giant employing over 6,000 people was dramatically exposed during 2002 as its executives and its professional consultants had been going to great lengths to hide some of the risks that the company was assuming from its shareholders. But even without their efforts to cover their trail of secret off-balance-sheet high-risk investments, one would guess that 99% of the people who bought Enron stock never attempted to sort through Enron’s financial footnotes searching for risks. Had they done so, they would probably not have identified the key risks, as even some of the smartest accounting minds in the world have disclosed that Enron had been a black box--i.e. a complete mystery to them. But the point is that millions of intelligent shareholders (including a good number of global professional fund managers) accepted the blue-chip status of this massive business without performing any due diligence tests, they accepted broker advice and analyst buy recommendations, when the sad reality was (despite audited financial reports to the contrary) that the company was literally on the verge of financial collapse.

We are never going to have all of the information necessary to assess all the risks inherent in equity investments. Despite moves to improve corporate transparency, companies are under no obligation to reveal their internal operations to outside investors. To do so would require making some sensitive information public when good business acumen dictates keeping it as a secret to preserve competitive advantages. However, we are each obligated to at least consider potential risks and ask the right questions. If not, like the Emperor’s dog, we are sure to eventually be crushed under the weight of our own ignorance.

Investing is all about risk. The more risk you take, the higher your potential returns. And this is all correct, except for the fact that it is exactly wrong. Investing is all about perceived risk. Where you as an investor have an advantage is only in situations where you can correctly assess that the market has overestimated (or underestimated) future risks or returns. That requires foreknowledge. Remember Sun Tzu’s words, Foreknowledge cannot be gotten from ghosts and spirits, cannot be had by analogy, cannot be found out by calculation. It must be obtained from people, people who know the conditions of the enemy.

Foreknowledge only comes from asking the right questions of the right people. Occasionally, we all miss a key piece of information and suffer an unexpected loss on an investment. These situations can be minimized by investors who refuse to accept broker and analyst opinions at face value, insist on asking their own questions of management, analyze a company’s financial footnotes on their own, and purposefully list every possible downside risk involved in a business--even a business they have already invested in and consider a favorite holding. The most difficult risk to assess is the risk of a negative unexpected event affecting one of your favorite stocks, the very stock you have been buying and recommending to all your friends.

A truly excellent piece.

What is most interesting about the write-up is the very last statement.

The most difficult risk to assess is the risk of a negative unexpected event affecting one of your favorite stocks, the very stock you have been buying and recommending to all your friends.

How?

Your Favorite stock, the very one that you have been banking on, the one that you recommend to all your friends, has a serious flaw stemming from a negative unexpected event.

How?

What are you going do about it?

Are you going to accept that your investment is very likely to go bad, accept the defeat and move on?

Or are you going to continue digging in the hole that you found yourself in?

Or maybe you might tell me that a Paper Loss Is Not A Loss?

Or are you telling me that you are going to adopt a Buy And Old strategy?

Never heard of this strategy before?

This is where you buy a stock which only you think it's good (but apparently the market doesn't think so) and you hold on to the stock till you get older and older waiting for any sort of positive return of investment!

Why is holding long term bad?

In a much older posting, I posted Is Ze Market for Suckers? Think of the following scenario.

• You can have as long a term horizon as you want, but like most other long term plans we have, most peoples lives dont match up to their “horizons”... And boy oh boy, if life hits you hard when the market is down, you make a withdrawl and you wont ever catch up.

Is that scenario not possible?

You can hold on to your investment for as long you want and deny that the paper loss is not a loss and you can hope that one day you might recover your paper losses but as they say, life is never fair and one might day, you might just need to sell. And when that happens, is the paper loss real or not?

So let me ask, are you cutting your loss or are you cutting your profit?

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More On Warren Buffett's Views on Recession

The question was rather straightforward.

Asked by Germany's weekly magazine, Der Spiegel, if US could still avoid a recession:

• "I believe that we are already in a recession. Perhaps not in the sense as defined by economists. But people are already feeling the effects of a recession. It will be deeper and longer than what many think."

And this is creating massive headlines.

US already in recession, says world's richest man Buffett

• Buffett, the 77-year-old chief of the Berkshire Hathaway holding company, blamed financial institutions for introducing instruments "they can no longer control" and said the "genie can no longer be put back in the bottle."

Some headlines are even more drastic, Buffett Calls For Colossal Recession

And the following article was posted on CNBC, Banks Are to Blame For Subprime Debt Crisis

• The banks exposed themselves too much, they took on too much risk .... It's their fault. There's no need to blame anyone else," he said.
  
  Buffett, dubbed the world's richest person by Forbes magazine, said he believed the situation in financial markets would not deteriorate further.
  
  "I don't think the situation will get worse in financial markets. General conditions in the business world will get worse, but it will only last a while," he said, adding he had no idea when an upturn would come.
  
  Buffett gave the interview on a recent visit to Madrid, as part of a European tour including Switzerland, Germany, Italy and Spain on the look out for new investments.
  
  He said the idea of the trip was to increase awareness amongst European businesses of his holding company Berkshire Hathaway , which holds stakes in businesses ranging from American Express American Express to Coca-Cola.
  He said he wanted business owners to think of him when they were looking to sell.
  
  "We want to buy big companies that earn at least 50 million euros ($78.6 million) before taxes, and there's more of those in Europe than in other parts of the world," he said.
  
  He would not be drawn on what companies in particular he was looking at, other than saying he was not interested in distressed businesses.
  
  The day before, Buffett was quoted in the German magazine Der Spiegel as saying the US is already in a recession and that it will be longer as well as deeper than many people expect.
  
  He said the United States was "already in recession" and added: "Perhaps not in the sense that economists would define it" with two consecutive quarters of negative growth.
  
  "But the people are already feeling the effects," said Buffett, the world's richest man. "It will be deeper and last longer than many think."
  
  But he said that won't stop him from investing in selected companies and said he remained interested in well-managed German family-owned companies.
  
  "If the world were falling apart I'd still invest in companies," he said.
  
  Buffett also renewed his criticism of derivatives trading.
  
  "It's not right that hundreds of thousands of jobs are being eliminated, that entire industrial sectors in the real economy are being wiped out by financial bets even though the sectors are actually in good health."
  
  Buffett complained about the lack of effective controls.
  
  "That's the problem," he said. "You can't steer it, you can't regulate it anymore. You can't get the genie back in the bottle."

Well, this isn't hardly any breaking news for Buffett had already stated his recessionary reasonings. ( See Is iCapital Views Consistent? Is Warren Buffett a Lousy Ecomist? )

In this year's Berkshire Annual Meeting, Warren Buffett had already fielded questions on this issue. ( see previous posting here! )

• Q3: Sam from Fort Lee. Recession, stock market up in April. What next?
  
  WB: I could expand on that question, but I couldn’t answer it. Charlie and I haven’t the faintest idea where it goes next week, next month or next year. We are not in that business. It isn’t our game. We see 1,000s of companies priced every day. We ignore 99% of what we see. Every now and then, we find an attractive price for a business. When we buy it, we would be happy if market was closed for a few years. Wouldn’t get a price quote daily on a farm. We look at expected yield, cost of taxes. If you buy a farm, you would look at cost of fertilizers, what a farm produces relative to purchase price, price per acre, production per acre, etc.. We make judgments.

And the following article was published in early May, Buffett Says US in Recession, Banks to Face Pain

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Oil & Commoditities: Speculation or Case of Supply/Demand?

Blogger Seng posted the following comments on the following posting: More Update on Timber Sector

• Actually, it's interesting to compare timber with oil, as prompted by raymond above.
  
  1. It's true timber takes 20-30 years to grow new and replace. But what about oil? 2 billion years to grow and replace? :-) I would say oil is a lot harder to replace than timber, once consumed.
  
  2. Yes, higher timber prices benefit direct producers more since their profit margins are geared. But I wouldn't write off the Oil & Gas players off so quickly, particularly those that are involved in E&P. Since one is comparing long term, imagine a world when more and more oil is consumed. Already, global consumption outstrips supply ("peak oil"). If exploration activities stops, how long will existing stocks & reserves lasts? What will happen to this world when globally, there is insufficient oil? I shudder to think of it, because it is almost certain we will see ridiculously higher levels that will make $120 looks very cheap in comparison. If there is a global shortage, countries will certainly go to war to control oil for their own consumption. The world then may look more like Mad Max than what we know today. So, it's clear that Exploration activities can never stop. The world cannot afford such a scenario to eventuate. It must pursue alternative energy sources as well, but that has its own political problems. I think Raymond may be underestimating the potential impact of global oil shortage on the Oil and Gas industry.
  
  3. On the other hand, if there is timber shortage, somehow, I don't think countries will bother going to war for it. Alternative building materials already exist in abundance.
  
  Of course, this is extremely long term view, and I personally don't invest based on such super-long term considerations. (Some might disagree with me and argue that this might happen sooner and within my lifetime).

Following this, Seng highlighted the link to Michael Masters's testimony on the the driving factor behind the surge in commodity prices before US Senate Committee on Homeland Security, http://hsgac.senate.gov/public/_files/052008Masters.pdf

Now this article has generated lots of comments. One was written by one of SeekingAlpha contributing writer, Philip Davies, Commodities Prices: Speculation Exposed

• The most exciting thing that happened Tuesday was the testimony of Michael Masters to the Senate Committee on Homeland Security (who have sweeping powers) as he spilled the beans and gave the Senate a very detailed inside view of exactly how speculators are the primary cause of high commodity prices.
  
  Don't look for any commentary on this in the WSJ or most media outlets, you would think this entire investigation isn't going on as you watch CNBC wearing their Oil $130 party hats this evening!
  
  What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.
  
  With very bold categories in his presentation like "Index Speculator Demand is Driving Prices Higher" Masters lays out a simple and compelling case that illustrates how over $250Bn of speculative money has poured into the commodities markets since 2003, driving the average cost of commodities indexed up 183% WITHOUT ANY SIGNIFICANT INCREASE IN ACTUAL DEMAND.
  
  It's not just oil, there is a chart on page 4 of his presentation that shows how on Jan 1st 2003 sugar futures stockpiled totaled 2.3Bn pounds. On March 12th of this year, speculators had stockpiled 48Bn pounds of sugar. Soybean oil went from 163M pounds to 4.5Bn pounds, corn from 242M bushels to 2.4Bn bushels, coffee from 195M pounds to 2.4Bn pounds. wheat from 166M bushels to 1.1Bn bushels. Even cattle and hogs have had 10-fold increases in speculation. This is your "demand," 10 month supplies of commodities removed from the markets over 5 years and held by speculators who point to the "demand" as evidence of a tight supply - A TOTAL CROCK!
  
  Speculators "consumed" as much additional oil as China in the past 5 years (848M barrels) while gasoline stockpiles have risen from 1.1Bn gallons to 3.5Bn gallons and natural gas stored by speculators has gone up from 331M BTUs to an insane 2.3 Billion BTUs. Aluminum - 10x, Nickel - 5x, Zinc - 10x, Copper - 7x, Gold - 10x, Silver - 15x — Madness!

And of course, my favourite newsletter from John Mauldin has written a piece too, Whither the Price of Oil? (subscription required.)

• Those Nasty Index Speculators
  
  Are institutional investors in the form of large commodity index funds the reason behind the current rise not just in oil prices but in the prices of seemingly all commodities? Michael Masters, a long-short hedge fund manager, in testimony before the Congressional Committee on Homeland Security and Governmental Affairs, said:
  
  "You have asked the question 'Are Institutional Investors contributing to food and energy price inflation?' And my unequivocal answer is 'YES.' In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action."
  
  You can read the entire testimony at http://www.mcadforums.com/forums/files/michael_masters_written_testimony.pdf, but let's hear the basics of his argument:
  
  "What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.
  
  "These parties, who I call Index Speculators, allocate a portion of their portfolios to "investments" in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as "Index" Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices - the Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index."
  
  These index funds are composed of a number of commodities. While oil is the biggest component of the various funds, they also have exposure to grains, base metals, precious metals, and livestock. When you buy one of these funds you are buying a basket of commodities.
  
  Why would an investor want exposure to a long-only index of commodities? Perhaps for portfolio diversification, as commodities are uncorrelated with the rest of the portfolio, or as a way to play the growing demand for commodities of all sorts from emerging markets, as a hedge against inflation, and so on. Mainline investment consultants began to suggest a few years ago to their clients that they get into the commodity market on a buy and hold basis, just like they do with stocks and bonds.
  
  And they have done so in a very large way. As the chart below shows, at the end of 2003 there was $13 billion in commodity index funds. By March of this year, that amount had grown 20 times, to $260 billion. Masters also shows that this corresponds with the stratospheric rise in commodity prices. In many commodity futures markets, index speculators are now the single largest participant.
  
  
  
  Is Correlation Causation?
  
  There is no doubt that the rise in the investment in commodity indexes and the rise in prices correlate significantly. But does correlation necessarily mean that there is a direct cause and effect? Masters says it does. (Later we will look at arguments against this view.)
  
  As an illustration, he shows that the rise in demand for oil from China in the past five years has been 920 million barrels of oil per year. But index demand (the word Masters uses) for oil has risen by 848 million barrels, almost as much as another China.
  
  And Masters gives us facts that are interesting. There is enough wheat in the index speculator "stockpiles" in the US to feed every many, woman, and child all the bread, pasta, and baked goods they can eat for the next two years - about 1.3 billion bushels. Yet wheat has soared in price.
  
  As the prices of the indexes have risen, the demand for the indexes has grown. And these indexes are not price sensitive. If a billion dollars is invested in a given week, the index funds simply buy whatever allocation of futures contracts is needed to make up their index, at whatever price is offered.
  
  For the first 52 trading days of the year, demand for commodity index funds grew by more than $55 billion, or more than $1 billion a day. And as Masters points out, "There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.
  
  "Index Speculators' trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits."
  
  And now we get inflammatory:
  
  "Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged."
  
  What about position limits? Aren't there real limits to the amount of a physical commodity that a fund or speculator can accumulate? Masters points out that there is, but the CFTC has given investment banks a loophole, in that they can sell unlimited size positions in the OTC swap markets if they hedge the positions.
  
  So, a hedge fund could buy $500 million worth of wheat, which would be way beyond the actual market position limit, through a swap with a Wall Street bank, without having to worry about position limits. And there is no doubt that large purchases of any commodity will drive up prices, at least in the short term.
  
  What does Masters think Congress should do? Prohibit pension funds from commodity index buying, close the swaps loophole on speculative positions, and make the CFTC (Commodity Futures Trading Commission) provide more transparency as to who is buying commodities. That would stop those nasty index speculators from driving up food and energy prices. Prices would come back down and we could all go back to driving our SUVs without having to worry about the cost.
  
  Well, then, maybe not. It is not that simple. While there is no doubt that excess demand in the form of index buying can have a very real effect -on prices, it is not the whole story.
  
  What an index funds does is buy a futures contract for a given commodity when money is first invested. Say that contract is six months out. When the contract is one month from expiration or delivery, the index fund sells that contract and buys another contract six months out. They sell before the contract could have an effect on the cash price of the physical commodity. The cash price is determined by supply and demand.
  
  Let's look at supply. Masters mentioned wheat. Yes, the index speculators have built up a large futures position. But that is not the same as a large physical position. With demand soaring abroad and droughts crimping supply, the world's wheat stockpiles have fallen to their lowest level in 30 years, and stocks in the United States have dropped to levels unseen since 1948. That could go a long way to explaining rising wheat prices.
  
  Corn? The USDA is expected to report corn stocks for the year ending Aug. 31, 2009, to fall to 685 million bushels, according to analysts surveyed by Thomson Reuters, down 47% from 1.283 billion bushels in 2008. The corn crop season ends on Aug. 31. (They expect wheat and soybean stocks to rise, for which we can be thankful.)
  
  Bob Greer, executive vice president at PIMCO, rebuts Masters arguments in a very cogent paper recently sent to me. He argues that index funds do not affect the price but may contribute to volatility.
  
  "Some market observers have tried to tie the level of inventories to index investment, most notably in crude oil. Their arguments take one of two forms:
  
  "1) The indexer's act of selling the nearby and buying the distant contract forces the futures curve to be upward sloping (future price is higher than nearby price). This creates an incentive to own inventories and earn the "return to storage" represented by the slope of the futures curve. The act of increasing inventory keeps the commodity off the market, thus decreasing supply.
  
  "2) A variation of the above argument is that the short seller, who takes the other side of the indexer's purchase, needs to protect their position by buying and holding the physical commodity.
  
  "It would be nice if either of these arguments were true, in which case, the developed world would not be hostage to the Organization of the Petroleum Exporting Countries (OPEC). Any time we needed to increase crude inventories, we need merely to bring in more indexers, and the inventory would appear. In fact, the explanation for inventory levels of any commodity is much simpler. If, in the cash markets, production exceeds demand, inventories will rise. Otherwise they will fall. That is why, in six of the last eight years, global wheat inventories fell, regardless of index investment (USDA). That is why from 2006 to 2008, crude oil inventories declined and the crude oil curve went from upward sloping to downward sloping, in spite of increasing index investment (EIA). Furthermore, the second argument above breaks down when applied to non-storable commodities such as live cattle."
  
  Further, Greer shows a chart from Deutsche Bank which highlights the fact that many commodities which are not in the index fund portfolios have risen higher than exchange-traded commodities (rice, for instance). Look at the chart below:
  
  
  
  Greer concludes with these important paragraphs:
  
  "Regarding intrinsic value, commodity futures prices converge to cash prices, and cash prices are set by the level of demand to consume physical goods such as steak, gasoline, and Wheaties. The price setting mechanism is not based on possibly erroneous assessment of a financial statement, nor on irrational exuberance. In commodities there is an outside measure of intrinsic value--the cash market--that is not dominant in equity, real estate, or tulip bulb markets. As actual commodity prices go higher or lower, they reflect consumption requirements for actual products, many of which are not very storable.
  
  "This is a sharp contrast from internet stocks or vacation condos, which are subject to speculative bubbles. Unfortunately, our conventional wisdom regarding factors that create bubbles is rooted in asset classes like stocks and real estate, asset classes that have fundamentally different characteristics than physical and futures markets.
  
  "Coincidence is not the same thing as causality. It is a coincidence that commodity index investment has increased in the last few years just as commodity prices have increased. If there is any causality, it is the other way around. Rising commodity prices have caused an increased interest in commodity investment. And it is certainly causality that fundamental supply, demand and inventory factors have driven commodity prices in many markets higher, whether or not those are markets in which index investors participate. This is the same causality that has driven commodity prices both higher and lower for many decades."
  
  Where Will Oil Prices Go?
  
  So, let's look at the fundamentals for oil. While a large part of this week's rise in oil was short covering (you can tell that from open positions), the supply of oil was down 7% from last year, even with demand beginning to fall. But there is an interesting footnote to that statistic, which we will visit later. Look at the chart below from http://www.economy.com/:
  
  
  
  Notice that supplies turned down sharply this last month, while the momentum of falling supply had been dropping since January. That is to say, the change in crude oil stocks was a negative 10% in January and was a little over -4% a month ago, falling to -7% today. But this is in the face of demand slowing. Today we learned that gasoline usage was down 4.2%, as prices are finally changing American driving behavior.
  
  Jakab Spencer noted in his always interesting Dow Jones column that there is a disconnect between the New York Stock Exchange and the New York Mercantile Exchange, just one mile apart. The NYSE is pricing in $75 oil in oil stocks, while the futures market is surging over $135, and there are calls for near-term $150-a-barrel oil. The stock market is telling us that oil, at least in futures terms, is in a bubble.
  
  And frankly, if you listened to their testimony, and more importantly pay attention to their actions, oil company executives simply do not believe that the price of oil is going to be $135 a barrel for the next few years. If they did, they would be punching more holes in the ground in places where it might be expensive to get the oil to market - but at $135 a barrel it would be profitable.
  
  And then there is an odd circumstance in the oil picture that I think may suggest that we could see a break, and perhaps a violent one, in the near term for the price of oil.
  
  Where Are All the Tankers?
  
  For a few weeks now, observers have noticed that Iran is leasing tankers and storing oil in them. At about $140,000 a week or so, that is expensive storage. At first, conspiracy theorists were wondering if they were preparing for some kind of war or attack. But more conventionally, it may be they are having problems selling their oil. Their oil is not very high-quality, and there are only a few places that can take it and refine it. India, China, and the US are among the countries with refineries that can take Iranian oil. (And yes, George Friedman of Stratfor tells me some of it does end up in the US from time to time.)
  
  India's refiners are telling Iran they no longer want their oil, preferring the higher-quality oil that is readily available in the area. So Iran has to decide whether to send it to China or "repackage" it so that it can end up in the US, while they try to get refiners in India to change their minds. Thus, they are leasing tankers to store the oil they are pumping.
  
  I called George about six this evening and asked him about the Iranian situation, as that is a lot of oil that could come on the market at some point, as well as a possible reason that oil supplies are down. George has analysts on top of this situation.
  
  He told me, "John, it's more interesting than that. It is not just Iran. Today we started checking on how many tankers Iran had, and soon discovered that there is a serious tanker shortage. Lease prices have soared in the past few weeks. It is clear there are a lot of speculators betting that oil is going to rise to $150 or so and are willing to pay very high prices for keeping the oil on the seas waiting for higher prices. It is a speculative boom."
  
  He then told me about flying into New York in the early '80s. Outside the harbor were 30 or so tankers just sitting, waiting for prices to continue to increase as they had been doing for some time. When they did not, they all tried to get into the harbor at the same time, and of course they couldn't. It was the top of the market. Prices dropped, and the owners of the oil had to go to the futures market to hedge what they could. I had heard that story, but George saw it with his own eyes.
  
  Almost everyone (except the stock market) is convinced oil is going higher in the near term. As I noted above, this week's rally was partially due to short covering by large institutions and companies which had sold production far into the future at much lower prices. They finally threw in the towel and took off their hedges.
  
  Is it 1980 All Over Again?
  
  We may be getting ready to stage a very interesting economic experiment. Is Masters right that prices are driven by speculation, or is it supply and demand? Follow me on this one. I am not saying that this will happen, but it is an interesting scenario.
  
  Many developing countries subsidize the price of oil to their citizens, so they do not feel the pain of higher oil prices. But the headline of today's Financial Times is that Asia is finally getting ready to cut their subsidies as oil rises to $135. The awareness that they need to allow market conditions to prevail is finally being acknowledged, as they cannot afford the subsidies. This is going to help drive down demand for oil over time.
  
  As demand starts to fall, let's remember that the storage facilities for oil waiting to be refined are a finite item. If all those tankers end up needing to find a home at the same time, even as demand for oil is going down, you could see the price of oil go down rather quickly in the short term.
  
  If you are leasing tankers to deliver oil that is already hedged in price, you want to get it to port as soon as possible so that your lease payments stop as soon as possible. You only hold it on the high seas if you think the price is going up by more than your carrying costs (the cost of money and leasing the tanker). If you start to lose money, you sell your oil on the futures market and get it to port as fast as you can.
  
  Now, here is where it could get interesting. Oil is the biggest component of the commodity index funds. If oil drops and looks likely to go lower, then the massive buying of these funds we have seen in the past few months could dry up. As Dennis Gartman says, it takes a lot of buying to make the price of something to go up, but it only takes a lack of buying to make it go down. And if there is net selling?
  
  If we see money start to flow out of the index funds (and ETFs) because of momentum selling, that means the funds are not only selling their oil components, but also the grain and metal and meat. If the index funds are the key component in the rise of prices, we should see the price of all commodities go down in tandem and in sympathy. If oil is the only thing going down as index funds go down, then it is a supply-related issue.
  
  But what if index funds continue to grow? If there is an abundance of oil, it will eventually show up in the spot price, as storage will be lacking, no matter what the longer-term futures prices do. The market will soon tell us whether index funds are a major factor. I tend to think that even while index fund buying is bullish, it is not the major factor that is the driver of commodity prices. And even if it is significant in the short term, in the long term fundamentals will drive the true price.
  
  If it is simply index speculation, it will end in tears when the fundamentals catch up.
  
  Let me say that I believe the long-term price of oil is going much higher. I was writing about $100 oil two years ago. $150 and $200 oil is in the cards at some point in the future. If you have not read the Outside the Box from last Monday, you should. My friend David Galland points out that Mexico, which supplies 14% of US oil, is likely to be a net importer of oil by the middle of the next decade, as their internal demand increases and production decreases. Iran will be a net importer within six years for the same reasons. Russia's oil exports are down this year, as are Mexico's. Energy costs are going to rise in the next decade, and maybe much sooner.
  
  You can click on the following link to read the Outside the Box on where oil exports are headed in our future. And Casey Research does some top-notch analysis of energy investments (not just oil) in a very reasonably priced letter, if you are inclined to invest in individual stocks.
  
  As for today, if I was in a long-only commodity index fund, unless my time horizon was very long I would be watching it closely and have some close stops. And I might wait until I saw what the price of oil was going to do. If you have some profits, then you might want to think about taking some off the table. Just a thought.

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