4th Quarter 2009 Newsletter
Berkshire Hathaway Berkshire will acquire BNSF this year. BNSF is one of two large western railroads and one of four large railroads in the United States. This acquisition will increase Berkshire’s already strong assets and stable cash flow. As Warren Buffett says, buying BNSF is a bet on the future of the United States. As trucking gets more expensive, due to increased fuel prices and deteriorating highways, shipping by rail will increase. More competition is unlikely since no one is going to build another railroad thousands of miles long. East West Bank The FDIC asked East West Bank to acquire United Commercial Bank after the FDIC determined that United Commercial did not have sufficient capital to survive. The transaction was completed on November 6. East West made the following announcement: In connection with the Acquisition, the Bank entered into a loss-sharing arrangement with the FDIC that covered approximately $7.7 billion of United Commercial Banks {sic} assets. The Bank will share in the losses on the asset pools (including single family residential mortgage loans, commercial loans, and foreclosed loan collateral) covered under the loss-sharing arrangement. Pursuant to the terms of the loss sharing {sic} arrangement, the FDIC is obligated to reimburse the Bank for 80% of eligible losses of up to $2.05 billion with respect to covered assets. The FDIC will reimburse the Bank for 95% of eligible losses in excess of $2.05 billion with respect to covered assets. The Bank has a corresponding obligation to reimburse the FDIC for 80% or 95%, as applicable, of eligible recoveries with respect to covered assets. The acquisition almost doubles the size of East West Bank, creates a presence in mainland China and a branch in Hong Kong. East West Bank is now the largest commercial bank headquartered in southern California. It is the only Chinese American focused bank with full service banking offices in the U.S. and China. The FDIC action is an endorsement of the strength of East West. Apparently the stock market agrees. The stock price increased by 86% since the announcement of the acquisition, versus 5% for the stock market as measured by the S&P 500. Performance of Scott Value portfolios and the Stock Market As measured by the S&P 500, the market is up 5% for the fourth quarter, 26% for the year, including dividends and 63% from the bottom as of the close on March 9. The aggregate bond index had a total return of 5% for the year. In a normal portfolio of 80% stocks and 20% bonds, the combination of the two indexes had a return of 22%. Scott Value Investing portfolios had an average total return of about 23%. The economy As expected, unemployment rose to over 10% and may get worse. It is likely to take years for employment levels to reach the levels we had a few years ago. Most economists expect mild economic growth in 2010. Housing prices have stabilized, however, this may be temporary. Another 10% decline is needed to reach the historic trend line and, of course, housing prices may overshoot the trend line. A variety of temporary factors are holding up housing prices: 1. The Federal Reserve is buying mortgage backed securities (MBS), but has announced it will discontinue buying MBS around the middle of the year. Long term interest rates, including mortgage loans. will probably rise. 2. There is a temporary lull in mortgages converting to full rates. Over the next two years, there will be a large increase in option (pay what you want) adjusted rate mortgages converting to higher payments and fixed rates causing another surge of defaults. 3.The tax credit for first time home buyers expires July 1, 2010. Corporations and individuals will likely continue to reduce debt and banks will still be reluctant to lend. If this prediction becomes true, the Federal Reserve will keep interest rates close to zero and the government will need to stimulate the economy since it will be the only source of economic growth. If politics stops additional stimulation, a prolonged stagnation may occur. Shareholders Service Group Fees Your account(s) is with Shareholders Service Group. I pay for your SSG monthly and quarterly (large accounts only) reports. SSG may charge your account the fees listed below. Most of the time only the first two fees are incurred. Equity trades under 1600 shares $15.95 Mutual fund trades $25.00 Many mutual fund trades are paid for by the mutual fund Bonds trades $2.50 per bond, $40 or $50 minimum Transfer out ACAT (to another broker-dealer) $50.00 Foreign custody $2.00 per month (for those owning Toyota Industries) Wire fee (overnight money) $18.00 (transfer to checking account is free) IRA over $10,000 Free IRA under $10,000 $35.00 Roth IRA recharacterization $25.00 Retirement account termination $90.00 Tax services If you have a taxable account or you withdrew money from your IRA in 2009, SSG will send you a tax form in February. I also prepare tax returns. If you are not yet a tax client, please consider hiring me. I will send you a tax organizer at your request. My website for my tax services is www.1040.com/scottvalue/ It has some useful information. Please take a look. I always welcome new investment clients. May the new decade bring you prosperity, good health and happiness. Please call if you need to talk. October 2009 letter Dear friends and investors, The recession may be over according to the Federal Reserve and many economists. Unemployment is likely to keep rising into 2010. Housing prices have actually increased a little. The Federal Reserve announced that it will keep interest rates low for "an extended period." The stock market as measured by the Standard and Poors’ 500 is up 17% year to date and 15% in the third quarter. It has increased 56% from its low point in early March 2009, which is a typical V-shaped increase from a bear market bottom. Changes to investment portfolios I have observed Fairholme almost since it began 10 years ago. It made no major errors back in the dot-com bubble nor in the more recent financial services bubble. What’s more it has the same investment philosophy as I have. SVI sold Intel, Carmax, and Canadian Superior Energy. I suspect that the high growth days for information technology, including Intel are over. Although Carmax will do well, I think Energy Transfer and Fairholme are better opportunities. Canadian Superior is a victim of too much leverage at the same time as natural gas prices declined. Redwood Trust Overall, SVI clients outperformed the market by about 3% year to date adjusted for the mix of about 79% stocks and 21% cash and bonds. Among the most widely held stocks by my clients, the best returns for the third quarter were Terex with a 72% gain, General Electric with a 40% gain and Cemex with a 38% return. All three companies are in the infrastructure business. SVI reoriented portfolios in October of 2008 to increase exposure to infrastructure enterprises. Year to date, the best returns were Suncor with a 64% gain, Cemex with a 43% return and Terex with a 32% gain. The worst returns for the quarter were Redwood Trust with a 5% gain, Johnson and Johnson with a 7% return and Pfizer with a 10% return. The worst performers on a year to date basis were Nara with 26% loss, Pfizer with a 10% loss, and General Electric with a 3% loss. Including dividends, sometimes with substantial yields, total performance was better than indicated here. While headlines report the big debate over health care, Congress is also debating how to regulate the financial industry. It appears that the organizational structure of the financial industry will remain about the same as it is now. The Federal Reserve, the Federal Deposit Insurance Corporation (FIDC), the Securities and Exchange Commission (SEC), and the Commodities Future Trading Commission will continue operating as they have. However, the National Credit Union Administration may be merged into the FDIC, the bank regulator. Congress will likely establish the Consumer Financial Protection Agency to regulate consumer financial products such as mortgages and credit cards. Members of Congress are concerned that the Federal Reserve may already have too much power, so other agencies may help limit systemic risk. I believe there is a need for the federal government to regulate insurance companies that pose systemic risk. The states now regulate insurance companies. They failed to prevent the collapse of AIG and limit it’s systemic list. Also, many states failed to protect consumers from health insurance companies. Since the states do not want to give up their power, there will be a fight and the outcome may not be beneficial to consumers or the insurance companies. The present system is inefficient, resulting in less choice and higher costs. At present representatives who sell and buy securities for a commission only have to recommend suitable investments. Congress may upgrade the standard to be closer to the fiduciary standard of investment advisors, like myself. Under the fiduciary standard the advisor must put the client’s interest before the advisor’s interest. Best wishes for a pleasant autumn and holiday season. Roger Scott July 2009 Dear friends, I hope you are enjoying the summer. My family just returned from Yellowstone and Glacier National Parks. We stayed in Forest Service cabins at $30 per night. The first one had no electricity or water, but had a nice wood stove. The second cabin had electricity and a well pump outside, so that was nice step up in luxury. We saw a lot of wild life in Yellowstone and mountain goats in Glacier. We got a lot of sun on hikes because the 1988 fires had burned so many trees. If you want to see some pictures or videos, e-mail me and I will send you some. If you are considering buying a new hybrid car and you are a Washington resident, you should possess the car by the end of July to avoid paying sales tax. You also may receive a federal government subsidy of $3500 or $4500 if you trade in a car with 18 miles per gallon or less. Call me for details. The stock market ended the second quarter of 2009 up 1.78% over the end of 2008. After fees, our investment portfolios did about the same. You may find a substantial improvement in your portfolio compared to the end of the first quarter, March 31. The market increased by 15.2% during the second quarter. In the second quarter, I sold Home Depot and McGraw-Hill, the leading college text book publisher, among other businesses. I was prompted to sell McGraw-Hill when Amazon.com began selling the third version of Kindle, an electronic book device. The new Kindle is in a larger format appropriate for reading magazines and textbooks, and some colleges have agreed to use the Kindle for textbook use. I see this as the beginning of a decline in McGraw Hill’s dominance of the lucrative textbook market. With college textbooks costing more than $100 each and becoming obsolete within two or three years of purchase, time is ripe for a rebellion by students and colleges. My rationale for selling Home Depot is in point 1 of the next paragraph. A mutual fund manager and some economists are talking about the new normal which consists of the following: Reduced consumer spending. Implications include a slower economy, less debt and increased savings. More government involvement in the economy, including economic stimulus and regulation. Tougher credit for businesses and consumers. A large portion of economic growth and profits in the years up to 2007 came from excessive debt, especially from individuals and the financial sector of the economy. With the new normal, I expect slower economic growth. Furthermore the recently released high unemployment figures have cast doubt on the previous consensus that the recession will end in the last half of 2009. However, the United States economy will recover and prosper and so will American stock prices. Since many of you are retired or want to retire soon, I am researching companies that issue high dividends with a substantial chance these dividends will be stable or increase. I am also looking at methods to increase exposure to Asia because I believe Asian economies will grow faster than the slowing American economy. You might already own Toyota Industries (Japanese auto and materials handling company) and/or POSCO (Korean steel company). Also, you might own one of two mutual funds with large investments in Asia. If you need some financial planning help, please call me. If you want daily access to the status and performance of your account holdings on line, please let me know. Please enjoy this wonderful summer. May your wealth and happiness increase. The sixth of April of 2009 Friends and clients, Review of economy It appears we have avoided a depression. Looking at past recessions here and abroad, Alan Hess, University of Washington business professor, thinks we likely have reached the bottom of the recession and will pull out of it by the end of the year. In spite of a 70% increase in the money supply, he says high inflation will be avoided because the Federal Reserve, under the guidance of Ben Bernanke, will slow down the growth of the money supply as the economy recovers. As a lagging indicator high unemployment will last into 2010. Hess says future interest rates are unpredictable. To get us out of this recession, the U. S. Government has committed $4.6 trillion as an investor, $1.8 trillion as an insurer and $2.4 trillion as a lender. Congress passed a $787 billion stimulus bill and is now considering a large increase in the annual budget, all to return us to a growth economy and avoid deflation. After reading five books on the Federal Reserve and Ben Bernanke, I have concluded that Bernanke will avoid deflation at any cost. Deflation is feared because with decreasing prices, consumers and business owners indefinitely defer purchases, seeking a lower price. After some reflection, I identify three basic causes for the mess we are in: 1. excessive leverage (debt) by both consumers and the financial sector, enabled by cheap money; 2. derivatives, a method for businesses to hedge their bets and for others to speculate; and 3. short term incentives. Let me give examples of some long term incentives that would replace short term incentives. Corporate boards award executive bonuses in the form of restricted stock that could not be sold for five and ten years. Half the commission for mortgage brokers is deferred for five years and is only paid if the mortgage is still paid on time. Stock market In the first quarter the stock market continued to have exceptionally high volatility, reaching a low on March 6, down 25% from December 31. As of April 1 the market is up 21% from the March 6 bottom but is still 9% below the December 31 level. Scott Value Investing portfolios Canadian Superior is up three times its recent low, and Carmax is up more than two times its recent low. Cemex, General Electric, Nucor, POSCO and Suncor all increased in market value by more than 50% from market lows. In the 4th quarter of 2008, I purchased three infrastructure companies. On April 3 POSCO is 40% over purchase price, and Nucor is 27% over purchase price. Terex is 10% below purchase price. I erred in buying Redwood Trust and Canadian Superior. Both have suffered from permanent loss of intrinsic value. Redwood Trust recently raised new capital, diluting our ownership of the company. However, I believe the new money will increase the value of our stakes, albeit not up to our purchase cost. Canadian Superior will have to sell assets in a down market to satisfy creditors. On the other hand, Berkshire Hathaway has increased in intrinsic value due to the huge amount of cash it had on hand and the ability of Warren Buffett to answer the call for help from good companies needing urgent help. Berkshire invested $5 billion in Goldman Sachs and $3 billion in General Electric. In return it is receiving 10% per year and has the right to purchase stock in these companies at the price existing at the time of the offering. With hours to go before having to file for bankruptcy, Constellation Energy received a large infusion of cash from Berkshire and a deal to buy the company at a fraction of its intrinsic value. A French company offered a better deal which Constellation accepted, but Berkshire still gained $1 billion, a high return on a short term investment. Berkshire also invested $1.8 billion in wind energy through its two utility companies. The best investment What investment is guaranteed, has no downside risk and will increase in value faster than inflation, especially in recessions? The answer is the Washington State’s Guaranteed Education Tuition program or GET. You buy units in GET at today’s tuition levels and your student beneficiary receives money for college at whatever tuition rate the University of Washington is charging at the time the student attends any U.S. Department of Education-recognized college or university. It remains your asset until it is used by the student. I urge you to tell any friends with children or grandchildren destined for college about this best investment. It is has been very good for us. Privacy policy is below and your invoice is enclosed. As usual, your fee is withdrawn from your account at Shareholders Service Group (SSG). Enjoy the spring once it really arrives. If you have any questions, please call me. Privacy Statement For Scott Value Investing Scott Value Investing is committed to safeguarding the confidential information of our clients. We hold all personal data provided to us in the strictest confidence. Indeed, we require your specific permission before we will discuss your identity, affairs or investments with anyone external to the firm, except as required by law. The information we compile includes that provided by you in our meetings, received during phone calls and e-mail, collected from your previous advisors and from statements and other sources that you give us. We have never disclosed information to nonaffiliated third parties (such as brokerage firms, credit card or insurance companies), except as required by law, or in carrying out the duties for which you retained us. We do not anticipate any change to this policy and, in the unlikely event that we were to change it, will contact you prior to such an alteration to give you the option to protect your data. Our policy with respect to personal information is as follows: We limit access to information to only those employees who have a business or professional reason for knowing it and only to nonaffiliated parties as permitted or required by law. For example, federal regulations permit us to share a limited amount of information with brokerage firms in order to transact business on your behalf, and federal and state regulators, in the course of inspecting us, may also have access to your data. We maintain a secure physical office, and my computer is protected to ensure that your information is not placed at unreasonable risk. Unaffiliated third parties (Shareholders Service Group) require access to your personal information to open and maintain your accounts with them. They are responsible to safeguard the information you provide them and have or will soon provide you with a statement of their policies. If you do not receive satisfactory privacy statements from them for accounts for which we provide advice, we will gladly discuss the matter with them on your behalf in the hope of resolving the issue.. We do not provide your personally identifiable information to mailing list vendors or solicitors for any purpose. Disclosure of private client information is an offense subjecting employees to termination. We will maintain your files, with your data, as long as you are a client and for as long thereafter as law and the CFP Board of Ethics and Professional Responsibility may require. After this required period of retention, all such information will be appropriately destroyed. The fifth of January 2009 Friends and clients, Greetings to you for the new year. May it be prosperous and joyful! Review of 2008 For investors, 2008 was a shocking year, especially September, October and November. We had a substantial upturn in November, but it didn’t feel like it because the earlier downturn was so large. We found that markets were not self correcting, and we found that super-paid corporate executives were often incompetent. Didn’t we already know this after the scandals of the dot com boom and bust in 2000? The worldwide economic downturn and credit crisis had two main causes: too much and unwise borrowing by financial corporations and individuals; and the packaging of often worthless debt into complex securities that people could not comprehend. The credit crisis was enabled by lax regulation and the reliance on formulas to the exclusion of common sense at the rating agencies. The investment banks were leveraged 30 to 1, and as assets declined in value by more than 3% Lehman Brothers was forced into bankruptcy. Bear Stearns and Merrill Lynch avoided bankruptcy only by accepting massive government assistance and becoming subsidiaries of traditional banks. Just before Christmas we learned that Bernard Madoff lost $50 billion of his clients’ money in the largest Ponzi scheme in history. So how are my clients protected from their advisor (i.e., me) stealing their funds? The primary line of protection for my clients is the fact that I use an independent custodian to hold client funds. Currently Shareholders Service Group is our custodian. It is the custodian’s responsibility to keep client funds safe, which is achieved by limiting the advisors power over client accounts. All I can do is: make trades in the account; receive copies of monthly statements, tax documents, performance reports and trade confirmations; and deduct my fees directly from the account Unlike clients in Madoff’s funds, you can determine the market value of your investments at any time. Each client receives statements directly from the custodian, confirming the location and safety of the assets. SIPC insures your funds against fraud and bankruptcy of the broker-dealer holding your securities. We recently learned we have been in a recession since December 2007. The stock market lost 38% during the past year and is down 43% from its high on October 11, 2007. The low in 2008 was on November 21, down 53% from the October 11, 2007 high. There was almost no place to avoid the carnage. Bonds, foreign stocks, commodities and real estate were all down by large amounts. Overseas stock markets decreased more than those in the United States. Infrastructure companies’ stock prices were driven to low levels in October along with a stock market that at times looked like panic selling was occurring. Some institutions and individuals were forced to sell securities in order to raise cash. Although I sold some companies that I believe were selling for about ½ of intrinsic value, I bought other companies that were selling for 25 or 30 cents on the dollar. The new companies have more upside potential with a high margin of safety. Anticipating foreign and U.S. government response to revive economies, for larger accounts, we bought infrastructure companies. General Electric is a world leader in turbines, windmills, healthcare equipment, jet engines and railroad locomotives. We bought GE a little early and it is down 21%. We bought POSCO, Nucor and Terex near the bottom price of the year and their stock prices are up 43%, 35% and 38%, respectively, from purchase price. POSCO engages in the manufacture and sale of various steel products primarily in South Korea. It offers hot rolled products (used in the manufacture of structural steel for building construction, industrial pipes and tanks, and automobile chassis) and plates (used in shipbuilding, structural steelwork, offshore oil and gas production, power generation, and mining, as well as in the manufacture of earthmoving and mechanical handling equipment, boiler and pressure vessels, and other industrial machinery). Nucor Corporation and its subsidiaries engage in the manufacture and sale of steel and steel products in North America. It operates in two segments, Steel Mills and Steel Products. POSCO and Nucor are two of the largest steel companies in the world. They both have loads of cash. POSCO is based in South Korea and Nucor is based in the United States. Terex Corporation manufactures capital equipment for construction, infrastructure, quarrying, mining, shipping, transportation, refining, and utility industries worldwide. About 70% of the company's total sales now come from outside the United States. It is the most diversified manufacturer of such equipment. It has a very strong balance sheet and is still selling for at a low price. I expect exceptional gains from the infrastructure stocks over the next few years. Performance Although most portfolios in 2008 performed better than the stock market, this is not acceptable since the losses were substantial. Like me, you prefer absolute returns each year. Purchasing infrastructure companies at the end of October helped improve overall performance. Most of you will receive a quarterly performance report in late January or around the first of February. Economic outlook We already know that this recession will last longer than average since it already is over a year old. I assume deep reductions in economic output the fourth quarter of 2008and the first quarter of 2009 and expect the recession will last through the end of 2009. A massive stimulus program from the Obama administration may end the recession earlier. The worldwide economic recession and credit crisis is likely to have a lasting effect on consumer and investment behavior. I suspect growth in consumer spending in the United States will be lower for several years due to consumers paying off debt and building up savings. This makes retail companies comparatively less attractive. Stock prices for retail companies reflect this view. Investors will value safety over growth, which will help 3M, GE, POSCO, Graco, American Express, Berkshire, Pfizer and other holdings because of their financial and market strength. I think it is likely that a new Congress and a new President will increase infrastructure spending to stimulate the economy and to increase energy independence by building alternative energy facilities, such as wind mills and solar energy farms. At the same time, the developing world will resume rapid development of infrastructure. Hence the purchases mentioned above. Oil prices reached a high of more than $130 per barrel in July of 2008 and ended the year at about $41. As a commodity the price of oil is volatile. The assumption that world oil production has peaked or will peak soon increases volatility even more. Worldwide production in 2007 was 86 million barrels per day. Continued low oil prices (resulting in reduced exploration and production and increased consumption) will cause a shortage of oil in just a few years, which will cause another large spike in oil prices. Since most new production requires $70 per barrel to justify exploration and production cost, most new projects have been deferred. New development delays could keep four million barrels per day off the market. With rapid growth of developing countries the demand for 100 million barrels per day will occur in a few years. Since the supply will not be available, prices will return to high levels. If you have been planning a long road trip, the summer of 2009 or 2010 may be your last chance to travel using cheap gas. For more information see http://www.wtrg.com/prices.htm. Housing prices reached a high of 31% over trend line at the peak. The United States is nearly back to trend line on average. Government officials can’t agree on what policies would work to find a floor to housing prices. The decision will likely be made by the Obama administration. This may be very difficult because millions of option (meaning pay whatever you want) adjusted rate mortgages convert to minimum payments in 2009. Option mortgage defaults may exceed 50%. Ultra low interest rates and giant government deficits created to get us out of this economic crisis may cause high inflation and a weaker dollar three to ten years from now. Accordingly, you may see some adjustments in your accounts over the next year or two. This economic crisis is one and a half years old. President Bush has done little to reorganize and reform the regulation of the financial industry. Mortgages, derivatives, large insurance companies, credit default swaps, investment banks and hedge funds are either not regulated or are lightly regulated at the federal level. They need to be regulated at the federal and sometimes the international level. Reform will have to come from the incoming President Obama. Stock market outlook "Be fearful when others are greedy, and be greedy when others are fearful." Warren Buffett Ben Graham invented the concept of Mr. Market to explain changes in the stock market. Think of Mr. Market as a manic depressive. Sometimes he is wildly optimistic and will only sell his assets for a high price; other times he thinks the world is coming to an end and will practically give away his assets to get them out of his hands. I can’t predict the stock market over the short term, but history provides some guidance. Major stock market declines have been followed by rapid upturns: Decline Year of bottom Increase within 1 year Within 3 years -20% 1957 +38% +54% -29% 1962 +39% +77% -49% 1974 +58% +78% -34% 1987 +27% +65% -53% 2008 ? ? In 3 out of 4 cases, most of the gain was in the first year. So far, it looks like the normal V shaped bottom (already up 22%). I do believe that it is highly likely, based on stock market history, there will be substantial returns from this low point so that people who wait for the end of the recession will miss most of the gains. As it always has, the stock market will reach new highs. It may take some time, but it will happen. Conclusion I am reading Warren Buffett’s biography, Snowball by Alice Schroeder. It is a privilege to be a contemporary of perhaps the greatest investor in American history and to learn from him. I am also reading The Last Campaign, a history of Robert Kennedy’s 82 day campaign for the Presidency (cut short by his assassination) in 1968. Bobby Kennedy stirred the hopes of oppressed minorities and poor people because they knew he cared. Robert Kennedy and Barrack Obama received strong support from blacks and whites, conservatives and liberals, intellectuals and ordinary people. Both attracted great crowds during their campaigns. Both appealed to our hopes and dreams rather than our fears. Presidential political campaigns and history would have been more gentle if Kennedy had been elected. I look forward to a President we can be proud of. Your quarterly fee statement is attached. SSG will collect the fee. Thank you for your patience. As stated above, substantial profits are likely from this point. I am preparing income tax returns again. If you would like me to send you a tax organizer, please let me know. I am limiting the number of tax clients to 25 so that I can know my tax clients well while maintaining my priority on managing investments. I am available to meet with your relatives and/or your friends for a free investment consultation and/or to prepare tax returns. October 2, 2008 Dear investors and friends, Our Investment Portfolios The subprime/housing/credit crisis is now in its 16th month. The stock market is down 20.7% since the start of the year. My clients are down about 14.1%, on average, about 6% better than the market. While this is unsatisfactory, my value investing style has protected most of you from market rates of decline. This year a few of our companies have gains: Wilshire Bank (up 60% year to date and up another 13% on October 1), Pioneer Resources, and Covidien. Financial and retail stocks hit their lows on July 15, 2008. Since July 15 East West Bank has increased in market value by about 75% and Wilshire Bank by about 55%. Lowes, Carmax, The Home Depot, and Ryland are up about 20 to 30%. Berkshire is up 15%. Redwood Trust and American Express remain at about the same price as they were on July 15. We have some very strong companies with high returns on capital such as Graco, Johnson & Johnson, McGraw-Hill, and 3M. We have a world growth company, Cemex, that is selling for a very low price. Home Depot again (after dumping a lousy CEO) has good management, high profit margins and a low price. Energy Our energy stocks have declined along with decline in oil price (from $140 to $98 per barrel as of October 1) and gas price. I suspect more price decline to come perhaps down to a floor of $70 due to a temporary supply increase and decreasing demand. If prices decline below $70, exploration will slow. I believe that oil prices will increase again after the recession and the world- wide economic slow down ends. High oil prices will increase supply for a short time and slow demand, but, we are at or near peak oil. By 2015, when OPEC can again control prices, I think we will have very high oil prices, perhaps $250 per barrel. Some oil producing countries plan to produce oil at a long term sustainable rate which is good for them and the world. There is no close substitute for oil (a high energy source that is easy to move around because it is a liquid). The demand for using natural gas for use in cars is a bad idea because it is a feedstock for chemical products such as fertilizer. When the world runs low on natural gas, we could have a major crisis in food production. Our major energy investment is Suncor which produces oil from the tar sands of Alberta, Canada. In 2012, Suncor will produce ½ of 1% of the world’s oil. Producing oil from the tar sands is a dirty process that harms the environment and contributes to global warming. Oil production from Canada will increase over the next decade and will provide much oil for many decades, as compared to declining production in most other places. Our alternative is to import more oil from countries which are not our allies. I prefer importing oil from our ally Canada while we develop alternative energy. We should institute a massive program to develop alternative sources of energy – wind, thermal, solar, tidal and nuclear. (I don’t like the risks of nuclear energy either, but it beats global warming.) This will keep more money at home, extend the life of oil and gas, and make us less dependent on countries which may turn on us when we need help. You might ask, why not invest in alternative energy? There are problems with finding the right investments. Most companies are too expensive because many others want to invest in alternative energy. Also, when new industries (think railroads, radio, TV, computers) develop, a large number of companies are formed and most fail. It is better to wait and pick a winner as the industry nears maturity. However, right now one company stands out to me: General Electric, which is a leader in wind mills, turbines, and infrastructure. The stock price is now quite low. Credit Crisis On September 11, I wrote an e-mail to clients stating: "Expect to see more bank failures, including one or more large investment banks. There are only two strong investment banks left. The rest could fail." That did happen, including the fall of insurance giant, AIG. On Monday, September 29, when the House of Representatives failed to pass a "bailout" bill, the stock market declined by 9%, implying that investors believe that a large government program to end the credit crisis is necessary. I think no action would result in a credit freeze that would lead to widespread business failures, especially small businesses, which employ the most people. I expect to see more bank and hedge fund failures. Companies and banks worldwide will de-leverage balance sheets over the next few years resulting in slower growth. I hope that United States citizens will save more, which slows growth in the short term but is better for the health of the country in the long run. (As individuals, we have saved little for a long time.) Housing prices peaked at 31% over the trend line and a similar amount over the normal ratio of housing prices to rent levels. Housing prices are down 18%, so we still have 13% to go. If Congress does not pass a bill, we may have a difficult recession and housing prices may decline below trend line. That possibility is one reason there is almost no market for mortgage related securities. Until we can estimate the floor for housing prices, we can’t determine the value of mortgages. With another decline of 7%, we merely have to hold housing prices steady for two years for the trend line to match home prices. This recession will not end until housing prices stabilize, and the bear market will not end until the market can see the end of the recession (often anticipated six months before the end) and the end of the credit crisis. Once that happens, I anticipate large gains in our portfolios. I think you will be glad we stuck it out. However, it will take some time. Our credit crisis is not just caused by the bursting of the housing bubble and the malfeasance of the financial industry. For decades we have run unsustainable large current-account and trade deficits. Our financiers are China, Russia and the gulf states. As Nouriel Roubani said in New York Times Magazine article on 17 August 2008, "These are rivals, not allies" and "Once you run current-account deficits, you depend on the kindness of strangers." He also predicted the government must back up $1 trillion in high-risk mortgages or the banks and other owners of said mortgages. It is now happening. If the "bailout" bill passes, I think most or all of taxpayer money will be returned providing the program is properly administered. I think it is likely that AIG will return most or all of the $85 billion loan we (the U.S. government) made to it. We own 79.9% of AIG. We are charging 8½% for the entire $85 billion line of credit even when it is not being drawn. AIG pays 8½% plus LIBOR (London interbank rate) on the funds drawn. Berkshire wants to buy a couple of the wonderful assets of the company. Next year we will see more regulation of financial institutions. Most credit in the past few years is not offered by banks. Any organization offering large amounts of credit, including investment banks and hedge funds, is likely to be regulated like a bank. Minimum capital ratios will be required. I expect that credit default swaps and other derivatives and any organization that holds large quantities of derivatives will be regulated. Our incentives are wrong in many businesses and professions. Badly designed incentives were a major contributor to this crisis and prior financial crises. Mortgage brokers were not rewarded for negotiating sustainable mortgages; a fix would be to defer ½ of their income for five years. Hospitals should not be paid for correcting avoidable errors. (Medicare is now correcting this problem.) Corporate executives should not receive stock options; instead they should receive restricted stock, meaning they can’t sell the stock for a fixed number of years. Restricted stock rewards long-term thinking. Investment bank employees should not receive half of the income they generate while receiving no penalty for failures. Berkshire Berkshire bought Constellation Energy, another utility, at a fire sale price. If the sale is approved, Berkshire will own electric utilities in the West, the Midwest, the East and England. Berkshire also bought $3 billion and $5 billion of preferred stock yielding 10% from General Electric and Goldman Sachs, respectively. In each case Berkshire also obtained rights to buy common shares at a price about 5% below the market price on the day of the announcement. Only Berkshire could get such sweet terms. Berkshire will probably find more great deals. SSG Services Your account is insured by SIPC, meaning that you are protected against fraud and bankruptcy of your broker-dealer, Shareholders Service Group and Pershing, LLC. If you wish to access your account on the internet, please let me know. If you did not receive an e-mail on September 11 and you have an e-mail account, please provide your e-mail address to me. If you anticipate withdrawing funds in the future and you want the funds quickly, you could call and ask me to send you a form to sign. The form allows Shareholders Service Group to deposit funds directly in your bank account. If you anticipate donating a large amount of funds to charity and want to defer the contribution while controlling investments, I can refer you to donor funds. Thanks and Please Make Referrals Our equity investments are selling for less than intrinsic value. Some have much more upside potential, so I will realign some portfolios as financial stocks increase in value. Sir John M. Templeton died recently. He said: "Buy at the point of maximum pessimism." I think about now is the point of maximum pessimism. If you have a friend or relative with money in or out of the market, please tell him or her about my services. The next few months may have the most gain. People who wait until it is clear we are in a bull market miss most of the upside and take the most risk. At this point there is not much risk if you buy companies with low price earnings ratios, sustainable high profit margins and strong balance sheets. I will have a drawing in April for the gift of a dinner for you and a companion if you provide a referral by the end of March. This is an exciting time to be a value investor.
Comments from Roger
Stocks purchased in 2008
August 2006 | Oil prices
Beyond Oil and other books argue that the world is at or near peak oil production. This belief is likely a factor in the present high prices. However there are other reasons, including extensive instability in oil producing regions. Although oil prices remain high, the natural gas price has returned to about the average 2003-2004 price in the United States. Oil futures are higher than present prices, which is contrary to historic trends when oil prices are high. The result is hoarding of oil which helps keep the price high. Current prices are more then $30 per barrel higher than production costs, which normally is not sustainable. This fact and the possibility that demand may decrease due to an economic downturn, may cause prices to decrease. Once hoarders perceive that prices may decrease they will release their oil which may mean dramatic decreases in oil prices. Expect volatility in oil prices and thus in oil company stock prices. If the world is at the peak production of oil then volatility and prices substantially higher than production costs will continue for decades until alternatives are ramped up.
I suspect we are at or near peak production. Therefore, if you own Suncor, I recommend keeping it. I cut down the size of holdings in some portfolios because of the risk that I might be off by a decade or so. One U.S. government agency is predicting the peak in about 2040. If the price of oil comes down to $40 per barrel, it will be a chance to get more clients in oil.