A note: we realise the LEX column isn’t free, but it’s worth every cent.

“He has opined on the wonders of modern capitalism but he also has been prescient about its weaknesses. Among these are perverse management incentives, deceptive accounting and a general under-appreciation of risk. More than his folksy wisdom though, the way Mr Buffett has managed Berkshire, a conglomerate in the business of taking large, calculated risks, is instructive. Even at the depth of the crisis, it was never in danger of going under and played the profitable role of backstopping companies such as Goldman Sachs and General Electric.”

(…) “In spite of fame that could send a stock soaring on mere whispers of his involvement, his entreaties on thrift, prudence and governance fell largely on deaf ears.” (…) “Anything Mr Buffett says about risky behaviour on Wednesday will have to wait for another crisis to become conventional wisdom.”

Q1 2010 report excerpts

The last few months were a period of much study and few operations. Following a time with plenty of clear opportunities, since the last quarter of 2009 we have found ourselves in a phase with few new situations in which we could have great convictions.

During the first quarter of 2010, we took part in six conferences in Brazil and the USA, including some focusing directly on investors and some to do with companies themselves and sector professionals. There were over 200 presentations and there were advances both in getting to know companies and sectors better and in identifying potential new opportunities. In the short term, however, we did not find any that would fit the “easy as falling off a log” category (high value and low price) that we like so much. As the historic Peter Sellers character would say in the fantastic film “Being There”, “there’s a time for planting and a time for reaping”.

We take the opportunity to thank readers for their participation and suggestions in the Buysiders.com website, IP’s blog. We have recently started using Investidor    Profissional’s    pages    in    Facebook and in Twitter to publicize the new articles released in Buysiders.com. This is still an embryonic use of these tools, but it may make things easier for those who are already well acquainted with them.

PROSPECTS: Brazil

Lately, in addition to all the efforts applied to studying specific companies and sectors, we have allocated more than the habitual amount of time we dedicate to macro and political questions. In fact, we have “worked” more than ever and studied much more than the historical average. Mainly thanks to the maturity reached by the IP model, we have spent less time on commercial and managerial issues.

It is important to make it clear that we have not changed at all our fundamental belief in the way we should operate. Much to the contrary. But we always seek to take care not to allow the “execution mode” to prevent the basic assumptions from being revalidated from time to time. And recent times have clearly called for a revalidation. What is the risk of a swerve towards a more populist agenda, where property rights are less respected? After all, we have lived with movements like the “landless people’s movement”, and with growing rumors of coercion against certain companies and entrepreneurs, as well as restrictions to the press and controversial constitutional amendments proposed by the government. We have the example of “Chavismo”, which has not been repelled by the Brazilian government, indicating a lower degree of aversion than we would like to a regime that is so primitive and harmful to society.

What are the risks involved in the renewal of concessions, or in the creation of new and yet heavier taxes, rates and “contributions”?

Our conclusion up to now? If we have not reached (and are not even close to) an “all in” position, like the famous Warren Buffett declaration regarding the US economy (…) we are moderately optimistic regarding the Brazilian economy in the medium term. By fits and starts, the institutionalization of Brazilian politics is taking place. Even the worst elements are not succeeding in perpetrating greater and more lasting damage to the extent of annulling the advances achieved in the last 16 years (…). Our fears of a greater and longer negative discontinuity in the fundamentals are relatively low.

President Lula is an example of the fact that, with a certain degree of common sense, even historical opponents of a liberal capitalist society end up surrendering to most of the evidence contrary to their ideological beliefs. The government’s efforts to continue the initiatives of the previous Administration in order to make the real-estate market viable are another example. This is a sector that keeps the economy spinning, but one which did not have “wealthy sponsors” (…). Fortunately, the logical thing happened and things are moving.

In economic terms, in addition to the (already commonplace) commodities, the domestic market development case becomes better consolidated day by day, based – by order of solidity and importance – on the demographic profile, the formalization of the economy, credit expansion, and a not-so-bad political scenario.

Companies and their businesses do not exist in the void, and whenever we identify “clouds of change” on the horizon, we pay much greater attention. So far, so good…

So we should explain why we do not “fill up the bucket” in view of such good fundamentals for the Brazilian economy, and manageable disturbances. As always, we have to weigh up the asset price factor. The present levels, in general, already take into account a large portion of the prospects listed. Turbulence does happen, and when it does, many people panic. The best moments to fill the bucket are these: good fundamentals plus panic caused by the situation of the moment. Until then, we maintain our positions in companies that not only have fundamentals that lead them to consistently surpass market expectations, but also have a good cash reserve.

PROSPECTS: Global

We remain quite cautious. The improvement observed in the symptoms are a result of the “liquidity flooding” measures taken since the 2nd half of 2008 – and not of a frontal attack on the fundamental causes that weakened the markets. Populist policies in the main economies continue to set the tone of governments. They all seek an exchange-rate depreciation as a way to improve their trade balances and boost their economies. Obviously, in a scenario like this, this brings us to a race towards the bottom.

Economics is far from being an exact science. The FED, still the great protagonist of the world economy, seeks a narrow path between the precipice of depression and the “dragon” of inflation. In difficult situations like this, the stronger aversion tends to prevail. “Helicopter” Ben was given this nickname because of his thesis in relation to Depression, where he concluded that the solution was to “print” money until the economic agents lost their fear and returned to economic activity. It makes sense, but the risk is obvious. A loose monetary policy brings inflation, with a few years’ lag. The most likely scenario at the moment is that of constant growth in the inflationary risk in the USA, borne by many people who focus on the American Government’s gains arising from the depreciation of its debt – largely fixed-rate, in Dollars. In a scenario like this, the majority lose. Or rather, feel in their pockets the costs of the party, the incompetence, hypocrisy, and irresponsibility of the past. Those with greater power to adjust prices and hold long-term fixed-rate liabilities gain – or suffer less. (…)

An interesting exercise is to try building a counter- case. What could go so right as to neutralize the clouds on the horizon? We imagine events that would radically alter our general perception:

1. Reduction in conflicts based on religious extremism.

2. Radical productivity gain in the healthcare sector – which every day consumes an ever greater part of societies’ resources – in line with what happened to the production of clothes and food.

3. A pick-up in the speed at which knowledge and education are disseminated. This is where we see the strongest driver and the one most often present, which has made itself keenly felt in the last two decades with the advances in telecommunications in general, and the Internet in particular.

4. Improved public governance systems. The predominant government models today seem to us clearly deficient and a much greater threat to the well-being of mankind than the famous global warming, for example (which, if true, reflects a flaw in public governance itself). A reduction in the general hypocrisy is the greatest target to be pursued and the event that would bring the greatest gains to mankind.

Unfortunately, for certain problems, the speed of progress seems to be lower than what is needed to avoid more acute crises, which are historical catalysts for many necessary changes.

Obviously, the short list above says much more about our lack of capacity than about the real probabilities of results. One of the determining factors for advances in History lies in the fact that some societies and civilizations sometimes change on account of a single individual. But, for each case like the US rally of the eighties and nineties, there is a USSR, just to mention the biggest and most recent examples. After all, “lost civilizations” is a very commonplace expression (about 494,000 quotations in Google in 0.28 seconds…).

“Let’s hope for the best but prepare for the worst…”

Last but not least, for those interested in an inside view of the crisis, in the value of an independent view and in yet another report on the general institutional blindness (to say the least), we strongly recommend the videos and articles written by Michael Lewis when publicizing his book “The Big Short” (which we also emphatically recommend). The links to the relevant videos and articles can be found on Buysiders.com.

FOOD FOR THOUGHT

The Italian political scientist Antonio Gramsci was, as is well known, a great thinker. Gramsci’s Marxist convictions do not invalidate many of his ideas and observations. One of his lucubrations is about the significance of the dominant power exercised through ideology and culture, where the values of the bourgeoisie become the “consensus”. Everyone then identifies with this consensus, helping to maintain the status quo. Although Gramsci was obviously referring to the class struggle between the proletariat and the bourgeoisie, one wonders whether this has not been replaced by (or at least is not comparable to) the present situation between the big shots of corporate America (including, of course, the big banks) and the “rest”, here including most investors? Or people in government versus those they govern, in general?

MISCELLANEOUS

“The problem with socialism is that eventually you run out of other people’s money.” – Margaret Thatcher

“Only the paranoid survive” – Andy Grove

“If you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before.” – Martin Barnes

“The best way to think about investments is to be in a room with no one else and just think (…) What you are looking for is some way to get one good idea a year. (…) Wall Street makes it money on activity. You make your money on inactivity” – Warren Buffett

Seth Klarman

We highlight below a few quotes from the always interesting annual report by Seth Klarman about what lessons investors should have learnt from the 2008 crisis, with which we agree 100%:

• “Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.”
• “Risk is not inherent in an investment…Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.”
• “Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.”
• “A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.”
• “Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.”
• “Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.”
• “To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.”

On tour to promote his book “The Big Short“, Michael Lewis interviews have been popping up all over the Internet. You can find some of the best inside. Required reading is this excerpt from the book at Vanity Fair’s website. Great stuff, we especially liked this bit: “I hated discussing ideas with investors,” (Mike Burry said), “because I then become a Defender of the Idea, and that influences your thought process. Once you became an idea’s defender, you had a harder time changing your mind about it.”

Have a great Easter Sunday!

UPDATE: Mike Burry wrote an op-ed in the New York Times recently on how he saw the crisis and why the Fed should have seen it too. We especially like this bit: “I demanded daily collateral settlement — if positions moved in our favor, I wanted cash posted to our account the next day. This was something I knew that Goldman Sachs and other derivatives dealers did not demand of AAA-rated A.I.G.”.  Not only did he get the intellectual challenge right, but he also followed through quite well in terms of execution. Impressive enough, and all by himself.

VIDEOS

Bloomberg Television interview (42:37):

CBS’ 60 Minutes segments:

- Inside the collapse, part 1:

Watch CBS News Videos Online

- Inside the collapse, part 2:

Watch CBS News Videos Online

- Wall Street misfit (on Mike Burry):

Watch CBS News Videos Online

- The $8.4 Bi bet:

Watch CBS News Videos Online

Enter Greece and other European “peripheral” countries. Investors are finding it hard to simply exit “crisis mode” after the traumatic events of 2007/ 2008. We won’t fall into the trap of discussing Macro issues – not our core skill anyway – because the main issue here is that volatility, that friend of the long-term investor holding a lot of cash, is on the rise. This post collects some very interesting articles by the Financial Times on the subject of Greece’s (and Europe’s) woes, just as food for thought.

Why the Financial Times, a paid source? Because it’s the best coverage of European markets and economies. We highly recommend this source.

LINKS:

Greece part of unfolding sovereign debt story – Jan. 29th, 2010 – Mohamed El-Erian, CEO of PIMCO (world’s largest bond investor) discusses the EU’s options in light of the Greece situation. The major takeaway is that there is no easy solution, and therefore no solution without its scares and fits of panic.

Tipping the scales on global rebalancing – Feb. 2nd, 2010 – Bond investors are increasingly jittery and why the US and Asia seem safer than Europe.

Medicine for Europe’s sinking south – Feb. 3rd, 2010 – Economists Nouriel Roubini and Arnab Das write about how Greece is the front line of a larger battle for European stability – and again the tone is pessimistic since no easy solution appears in sight.

EC: A toothless regent in Greece? – Feb 3rd, 2010 – FT’s Money Supply blog on the obviousness of how the European Commission’s lack of powers ultimately leads to situations such as Greece’s. Will these debacles lead to increased scrutiny and – more necessarily – intervention?

Record volumes for sovereign CDSs and Portuguese bonds hit as Greece fears ease – Feb. 4th, 2010 – Greece’s plan is greeted with skepticism and pragmatism – bond investors have apparently decided that the next country in “the line of shame” is Portugal.

The issue here is not exactly what he said, since the reports that came in so far are rather sketchy and we haven’t yet gotten our hands on his presentation slides, speech transcript and so on. So based on the snippets that did come out, it’s easy to criticize and a cynical blog writer even argued that perhaps Wall Street was acting rationally because…

“(…) who says the purpose of the financial system is ‘to manage risk and allocate capital at low transaction costs’?  Surely that is not the lesson of the last 10-12 years, where allocating capital in magnificently stupid ways has lead to great reward – or at least the lack of any real negative consequence — for those involved.  Creating large amounts of risk leads to a ‘too big to fail’ institution… and then there is nothing greater, since you will be ensured limitless life support. In short –  he is right, but he is wrong.”

And still others will remember that Mr. Stiglitz co-authored a paper in 2002 basically stating that the risk of Fannie Mae or Freddie Mac defaulting was zero. But the point is that he’s trying to focus on the lessons that we should already have learned – because now we have another “golden opportunity”. We’re skeptical because one has to take incentives into consideration, and this seems to always get lost in translation.

Mr. Stiglitz has a book coming out in January, so until then we’ll have to make do with the links to a few of his latest articles below. He’s definitely in a somber mood.

LINKS:

Wall Street’s toxic message – Vanity Fair, July ’09 – Can the crisis in the US financial system lead other nations to follow other models, thus potentially creating threats to global stability?

Capitalist fools – VF, January ’09 – The title is a great summary.

The US$ 10 trillion hangover – Harper’s Magazine, January ’09 – “Paying the price for eight years of Bush”

James Surowiecki (author of “The Wisdom of Crowds“) interviews Joe Stiglitz for the New Yorker, Sept. 28th ’09: