It might not feel like it, but yesterday marked the Dow’s return to normal.

Normal valuations that is.

A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, “In Defense of Extraordinary Claims”, I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high:

Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.

That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century.

That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: ’96, ’97, ’98, ’99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than ’65.

As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 – 2007.

We were in unchartered territory.

Not any more.

Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.

So at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.

That may not sound like much to those weaned on the 1982 – 1999 bull market. However, it’s a lot better than the “new paradigm” market that began in 1996. Since we broke into unchartered territory twelve years ago, we’ve done something like 3.4% in point terms.

And over the last ten years: zilch.

Here’s what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained:

Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached "a permanently high plateau" now that a new paradigm has taken hold.

I won't dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won't enough investors wise up to this fact and cause the so-called "equity-risk premium" to disappear.

If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future returns to fall short of historical returns. But, there's no logical reason why normalized P/E ratios must revert to the mean – future returns can be adjusted down, allowing current prices to remain high.

That's true. In fact, the Dow could theoretically trade around a normalized P/E ratio as high as 40-50 without making stocks so unattractive as to completely eliminate them as a possible long-term investment (all of this assumes the equity-risk premium can disappear).

At around 50 times normalized earnings, the math gets terribly unforgiving. As a result, it's hard to imagine any likely circumstances under which a market trading at close to 50 times normalized earnings could be a viable investment option – though it's theoretically possible if long-term interest rates are very, very close to zero.

But, at lower normalized P/E ratios, such as 30 (and certainly 20) stocks could still compete with other investment opportunities. Stocks might lose most (or all) of their edge over other asset classes; but, stock prices wouldn't necessarily have to fall – they could simply offer much lower returns than they had in the past. This could continue indefinitely – in theory.

I say "in theory", because that seems a rather unlikely scenario. There is absolutely no evidence for it in the data. Before 1995, the Dow's normalized P/E ratio had ranged from 6.88 – 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41.

So, a permanent jump to normalized P/E ratios above 20 would be quite a departure from the past. Could the leap be permanent? Could these new, higher normalized P/E ratios become the new norm?

Maybe. If we really are in a new era, the old historical return data isn't relevant – it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we aren't in a new era, the old historical return data is relevant – and normalized P/E ratios must fall.

And they have fallen. Like a rock.

And saved us a lot of time.

Eight and a half years by my calculation.

Without a severe multiple contraction, the Dow would have had to move sideways for something like eight and a half years to give us the same future return increasing effect of the fall from just under 14,280 to just under 8,580.

Of course this only makes sense if you believe as I do that in the long-run your returns in stocks are derived from the relationship between the price you pay and the earnings power you get for your money.

What about earnings power impairment?

Won’t the current financial panic and the (possible) resulting global recession cause a major contraction in earnings power?

Not really. Actual earnings will be impaired. However, “normalized” earnings won’t move much (certainly nothing like the 40% drop in price) – unless we see conditions considerably worse than anything post 1935.

The Dow has been outperforming its expected earnings for a very long time (since the early 90s). That was never going to last.

The Dow’s actual earnings overshoot and undershoot its “expected” (i.e., 15-year normalized) earnings quite frequently; however, the overshooting and undershooting have tended to cancel each other out over long periods of time as you can see here:

From 1935-2005, the percentage difference between the Dow's actual earnings and its 15-year normalized earnings ranged from (62.12%) to 65.14%. The average (mean) difference between actual and normalized earnings was 0.44%. The median difference was 0.09%.

The swings have been huge, but their net effect has been small. Basically, the Dow’s EPS chugs along at about 6% a year. Although it has managed some remarkable hot and cold streaks (none longer than the one that’s ending now) it’s basically a mirror image of underperformance and overperformance.

The Dow gives you 6% earnings growth. What you get depends on what you pay.

Starting today, you’re paying par. You haven’t had that chance in over ten years.

What do I mean by par? Since the Dow is now at (actually a bit below) its average 15-year normalized P/E ratio for 1935 – 2005, your long-term returns should match the Dow’s long-term EPS growth.

Both should be around 6% (ex-dividends).

Long-term future returns should once again be similar to long-term historical returns.

Could the future be different from the past?

Maybe.

But I wouldn’t bet on it.

The last ten years turned out to be nothing new.

Just a detour on the road to normalcy.

P.S.

All this brings up an interesting question – and I know a lot of people may not agree with my strict either/or dichotomy between a price drop or a stock market that does nothing for many years – but assuming the Dow’s normalized P/E had to revert to the mean for it to offer its historical returns once again…

Which would you rather lose: Forty percent or eight and a half years?

I wrote a response to Jason Zweig’s column on Ben Graham and bank stocks. Now, Tom Brown of Bankstocks.com has done the same. I have to admit, Tom’s article is better than mine. Both take Zweig to task for his explanation of why Ben Graham wouldn’t be a buyer of bank stocks today. However, Tom’s post does a better job of presenting the opportunities and challenges in analyzing bank stocks today:

Zweig’s premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution’s assets--particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock’s valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true.

Graham saw every investment as a black box – and that didn’t trouble him. A lot of investors spend a lot of their time worrying about the inner workings of the companies they own – Graham never did. He didn’t look inside the “system”, i.e. the company itself; instead he looked only at the outputs – the financial statements. He spent almost no time worrying about a business’s management, corporate culture, or future prospects. He didn’t worry about competitive advantages. He looked to the balance sheet first. When he moved on from there to consider earnings, his usual approach was to rely heavily on the past record in an attempt to discover what “normal” earnings might look like.

Graham was a rear view mirror guy. His margin of safety was based on making purchases at prices that would’ve worked well in the past. He liked sure things. For instance, he knew that NCAV stocks were sure things – and subsequent research continues to support that claim. I mentioned NCAV stocks in my previous post, because they are perhaps Graham’s most characteristic investment category. They combine elementary arithmetic and logic in a potentially lucrative but almost certainly safe investment operation. Also, unlike much of what he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV investments during his Wall Street career.

Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham’s principles were.

What Graham Practiced

In the Intelligent Investor, Graham lists the five successful techniques his partnership employed from 1926 – 1956: arbitrage, liquidations, related hedges, net-current asset issues, and control investments.

Control Investments
Graham does not discuss control investments in any of his books; however, GEICO is a well-known example of a Grahamian control investment.

Arbitrage
Buffett has discussed this techniques in some detail. See especially Buffett’s discussion of Berkshire’s purchase of Arcata shares. Both Buffett and Graham had stellar results in the arbitrage field, as Buffett explains in his 1988 letter to shareholders:

In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%.

That’s a long history of success. From 1926-1988, unleveraged arbitrage returns from Graham’s partnerships, Buffett’s partnerships, and Berkshire averaged better than 20% a year. Since some leverage was employed, actual returns over this sixty-three year period were even better than 20% per annum. Arbitrage works.

Liquidations
Liquidations are the simplest type of investment there is. You simply buy the stock below the expected final payout and wait for things to wind down. Buffett has invested in liquidations several times – most are not well-known. For a recent example, see Comdisco Holdings (CDCO). For a less recent example, see the Kaiser liquidation (from the 1970s).

Net/Nets
Net current asset issues are not well-known, even today. However, the technique itself is well-known. Jonathan Heller of Cheap Stocks created an index to track (some) NCAV stocks. Since inception the Net/Net index has outperformed the relevant benchmark. However, it is a very young index.

Related Hedges
Related hedges are not appropriate for individual investors. They belong to a category of techniques that Graham employed with some success, but which have subsequently become far less fertile ground for investors, because modern theory and practice is better able to efficiently price a variety of more complex securities. Basically, Graham would go long a certain company’s convertible senior security and go short that same company’s common stock. If the stock rose, he would take a small loss. If it dropped sharply, he would make a nice gain. Obviously, these related hedges would provide a performance boost when the rest of Graham’s portfolio was struggling (since stock prices in general would be falling) and vice versa.

The first real coup of Graham’s career belongs to this category of mispriced special securities. Graham was a low-level employee of Newburger, Henderson, and Loeb when he brought up the idea of investing in the bankrupt Missouri, Kansas, and Texas Railway. The company’s bankruptcy plan gave owners of the old common stock the right (but not the obligation) to buy shares in the new company. This went mostly unnoticed at the time – or, if it was noticed, speculators were not using the old common stock as a way to play the new MKT. As a result, the old stock traded at just fifty cents. Graham figured that during a strong period for railroads the old common stock could easily rise three or four dollars – while the maximum loss on each share would still be just fifty cents. The firm bought into Graham’s idea and ended up making $15,000 on its $2,500 investment in less than a year (this was back in 1915 when $15,000 was real money – perhaps something like $300,000 today).

Graham’s partnership was a prototypical hedge fund. For starters, Graham actually hedged. He was short some securities and long others. For a while, he tried a basic long/short value approach, where he went long clearly cheap stocks and when short clearly expensive stocks. However, he found riding out the speculative surges in the stocks he was short to be an extremely unpleasant experience. He also found, over time, that he wasn’t especially good at finding stocks to short – certainly not good enough to get a better overall result (an investor has to be a lot more skilled at going short than going long to make it worth his while to short– if volatility and consistency aren’t as important to him as long-term results). Also, since Graham was always invested in an unusual mix of cheap stocks, liquidations, and related hedges, he was able to deliver rather consistent results without resorting to a more conventional long/short strategy. Eventually, Graham took the technique of shorting overpriced stocks out of his repertoire.

What Graham Preached

This is where Zweig comes in. Very little of what he writes has anything to do with what Graham practiced; generally, he writes about what Graham preached. These two things are quite different.

Why?

Graham liked rules, methods, and standards. Whether he was writing for professional security analysts or amateur investors, his goal was the same: to provide a practical, workable approach to the field of investments. He may have underestimated the common man; but, I doubt it. Even in The Intelligent Investor, he included a small section describing the actual techniques employed by his partnership. He also gave a separate set of rules for the enterprising investor to follow.

Graham didn’t divide investors by their risk appetite; rather, he divided them by their work appetite. Those who would work harder and be more businesslike – more like true professionals – would naturally come closer to the methods Graham himself employed.

So, if we were to use Graham’s own actions as our sole source for determining what he would do today, we’d have to say he’d invest in almost nothing that makes it into Barron’s, The Wall Street Journal, CNBC, or Bloomberg.

Graham would mostly do what he always did. There are still some NCAV stocks today; arbitrage still exists; liquidations still occur (e.g., I participated in what was essentially the liquidation of an Icahn controlled company last year – Atlantic Coast Entertainment Holdings, see Joe Cit’s post for details).

But, wouldn’t all of this be too small for Graham?

Yes and no.

No, Graham never needed big cap ideas, because Graham always kept his partnership small – much, much smaller than it could have been. He could have managed a lot more money; he was always much more famous than his assets under management would lead you to believe. He returned capital gains instead of allowing them to accrue in his favor. Overall, he tended to keep his operation very small by any standards – and infinitesimally so by the standards of today.

However, yes, Graham would need some other ideas. The most likely answer is that he’d rather change venues than change standards. Therefore, I doubt he’d be investing in even moderately pricey names in the United States whenever there were opportunities to buy ridiculously cheap stuff abroad. He’d probably have been in Korea after the Asian contagion; he’d certainly have been in Japan at some point, where there were some overcapitalized and underpriced public companies.

I know these aren’t exactly the most exciting answers. It’s a lot more interesting to argue over whether or not Graham would be buying bank stocks today than it is to consider what he’d actually be doing in modern times. My best guess is that if Graham were around today we’d consider him a very strange, very boring investor with a taste for odd and obscure securities in unappealing industries and out of favor countries.

Grahamian Theory

So where does that leave us regarding Graham and bank stocks?

All we have to go on are Graham’s principles. And this is where I think Zweig failed in his most recent column. His reasoning is all wrong. It paints an entirely inappropriate, almost stereotypically stodgy picture of Graham. Zweig confuses the conservatism of modern financial advisors with the conservatism of Graham. They are two very different things.

Graham would not have avoided bank stocks, because of falling real estate prices. He would avoid bank stocks, because there is an insufficient margin of safety (many are still trading above book value). He might demand a greater discount to book, because many banks have businesses and recent records built upon boom times. Graham always wanted to see how a business had performed under a variety of different circumstances, and this need for a solid past record would be even more important for banks, because of the nature of credit “cycles”. However, the mere fact that something unusual or even unprecedented is occurring in real estate and thus in financials would not have deterred Graham. His conservatism was not of that sort.

He could buy in the midst of the storm. He could catch a falling knife. Quite frankly, these weren’t his concerns. If a stock was sufficiently cheap and a business cleared a series of hurdles regarding its past performance and current financial position, Graham would buy it.

Zweig seems to be arguing that you can’t really know anything about a bank’s current financial position. When applied to Graham this makes little sense. Graham worked at a time when there was less disclosure and more fraud than there is today.

Consider the case of Northern Pipeline. The company provided investors with almost no financial data. Graham found the stock was trading for far less than the value of its investments per share by digging up the company’s filing with the ICC (Interstate Commerce Commission). Had he not done so, he never would have known. Most investors didn’t know.

While the balance sheets of banks may prove inaccurate (both on the way down and the way up), this wouldn’t have stopped Graham, because Graham always demanded a margin of safety. The precise financial condition of a bank becomes more important as it becomes more precarious. Likewise, the precise earnings power of a bank becomes more important the higher the multiple you’re willing to pay. But, if (as Graham would), you insist on both extraordinary financial strength and extraordinary cheapness, the importance of both concerns lessens. It never vanishes entirely. However, you can put yourself in a position, where your analysis can be more wrong than many analysts and yet your investment results can be better. The key of course, is to add a margin of safety everywhere. You have to start with a strong past record and then you have to buy it on the cheap.

That’s why I brought up Valley National (VLY). Not because I think it’s the best bank out there, but because I think it’s the sort of place Graham would start if he were going to apply his principles to bank stocks. He wouldn’t look for the fastest growing, highest quality company. He would look for the stodgiest bank he could find as shown by the bank’s past earnings history, as well as its credit quality, historical losses, etc. He wouldn’t be looking at the management – maybe he should – but he wouldn’t. Graham would be looking at the numbers. If ever a bank like Valley National were selling at two-thirds of book, then Graham’s principles would clearly allow the buying of a bank stock.

Now, you might rightly argue that Valley National is trading nowhere near two-thirds of book and might never do so, while other banks – lesser banks (in Graham’s eyes) – are trading at lower price-to-book ratios.

That’s true. And that’s where Buffett and Brown come in.

Buffett and Brown

When it comes to bank stocks, Tom Brown may be closer to Warren Buffett than Warren Buffett is to Ben Graham.

Why?

Graham did not specialize in financial service stocks. Tom Brown does. Warren – strictly speaking – doesn’t. However, he knows a great deal about them and has a long history with them. True, Buffett probably knows more about insurance than he does about banks, but his knowledge of banks is probably more useful to him as an investor. Let’s not forget, Berkshire once owned a bank.

Buffett’s partnership also owned banks at times. For instance, he had a large position (10-20% of his portfolio) in a New Jersey bank (Commonwealth Trust) back in 1958. He bought twelve percent of the bank at an average of five times earnings. Buffett conservatively estimated the bank was worth $125 per share. He ended up selling it for $80 per share (a 60% profit) to free up capital for the partnership’s large investment in Sanborn Map (a Northern Pipeline style investment).

Why bring up something Buffett did fifty years ago – when his more recent investments, like Berkshire’s purchase of Wells Fargo are more applicable to today?

Because, in 1958, Buffett’s approach was closer to Graham’s than it is today. Also, his description of the Commonwealth Trust investment better resembles the way Graham might think about bank stocks, if he were forced into that field.

Buffett’s Wells Fargo investment is further from the way Graham would have operated, if only because Buffett’s thinking had moved further from Graham’s over the years.

Buffett and Brown approach bank stocks very differently from the way Graham would have. They are more focused. They do more of a 360 degree analysis. They place greater emphasize on intangibles. There are a lot of differences.

They may have the better approach. It may be better to find the right stocks – even at today’s prices – than to look for the most statistically conservative stocks at the most statistically cheap prices.

Graham was ill-suited to investing in banks. However, Zweig’s reasoning isn’t right. In fact, it’s downright confusing for investors who know little of what Graham preached and what he practiced. Very few investors wouldn’t be deterred by the “perfect storm” in financials.

Ben Graham was one of the few who wouldn’t be.

Whether Graham would have invested in bank stocks or not, he would have made his decision based on past results and current prices – not real estate prices, or the credit climate, or any other macro-concern. At the right price, Graham would buy past earnings today assuming they would eventually materialize again tomorrow – and (as Brown says) the stocks might well bounce back first.

So, again, Zweig may be right about Graham not buying bank stocks. But, his reasons are all wrong.

Simply put, a smart guy wrote a stupid article.

Welcome to the ninety-ninth Festival of Stocks. The Festival of Stocks is a weekly blog carnival dedicated to highlighting the best recent posts on stock market related topics.

I am proud to present this week's best entries to the Festival of Stocks. The articles are listed by category. I have included my review of Don Keough’s new book “The Ten Commandments for Business Failure” among the links below.

Enjoy.

Stock Analysis

Number Check on Sears by Circle of Competence

“With its market price declining daily, giving me the opportunity to pick up even more shares, I thought I’d present a very rough look at how the market is valuing Sears (SHLD) right now, putting reasonable numbers to a rather abstract investment idea.”

USG Earnings Conference and Notes by College Analysts

“From a purely operational standpoint, USG’s results were objectively poor but very good contextually. Wallboard volume shipments were down 11% quarter-over-quarter and plant utilization sits just under 70%; until capacity recovers into the mid-80%s, USG won’t have the operating leverage to put up big EPS numbers, and that day is still far off.”

United Technologies Dividend Analysis by Dividend Growth Investor

“UTX is a dividend achiever as well as a component of the S&P 500 and Dow Jones Industrials indexes. It has been increasing its dividends for the past 14 consecutive years. From 1998 up until 2007 this dividend growth stock has delivered an annual average total return of 17.20 % to its shareholders.”

A.H. Belo: A Value Stock or a Value Trap? by Lollapalooza Investing

The new Lollapalooza Investing blog provides a detailed analysis of A.H. Belo.

Have Your Cake…? By Bootstrap Investing

“I’ve actually been an owner of Cheesecake Factory shares for a couple of years now. But the recent market malaise (aka storm, destruction and rampaging bear as quoted in the financial press) has given us an opportunity to purchase shares at prices not seen since just after the new millennium.”

Commentary

“Dear Bill…” A Letter to Bill Miller by Cheap Stocks

“How is it possible that you are down 32% year to date, or 39% over the past year? Looking back, do you think that your positions were too concentrated in financials? Yes, Bill, I know hindsight is 20/20, and I sound a bit like Captain Obvious here, but Bear Stearns, Washington Mutual, Citigroup, Merrill Lynch, Freddie Mac, AIG, Countrywide? Where was your risk control?”

Jim Grant on the Absence of Outrage by Controlled Greed

Actually, I think people are so irked at $4.00 and up gas prices -- and worried about further increases -- that their focus is fixed there. And Grant suggests this could be the factor consuming populist anger at the moment.

My Strategies for Weathering a Bear Market by My Wealth Builder

Another way I hedge is to take some profits with a stock that has risen significantly, selling 20 to 50%, and sometimes 100%, of a position to lock in some gains. I recently did this with Potash and Google.

Not Quite Dogs of the Dow by Confused Capitalist

What I am looking for here is stocks that seem to be mispriced in my favor - in other words, the dividend yield is higher than might be expected, while the prospects going forward over the intermediate term (5 years or so) for the company remain decent or better.

Book Reviews

Book Review: Even Buffett Isn’t Perfect by Value Discipline

Dr. Janjigian's book gingerly attempts to criticize some of Buffett's mistaken investments and controversial points of view. I think the book is more successful with the latter than the former.

Book Review: The Ten Commandments for Business Failure by Gannon On Investing

But what I haven’t spoiled for you is the fun of seeing how Keough takes these trite little dictums and develops them through anecdotes. He makes passing reference to many of the most familiar business failures; Xerox, Ford, and IBM are all taken to task…. However, Keough’s best stories are his Coke stories.

They say you don’t know what you’ve got ‘til it’s gone.

I don’t know who they are; but I know of what they speak.

I recently lost a coffee place (not a Starbucks). It was a traumatic experience.

Last year, my eye doctor asked if I did a lot of reading at work: “Mostly SEC filings”, I said. “That’ll do it”, he replied, “You have what I like to call computer eyes”. And so, for the first time in my life, I became acutely aware of the occupational hazards of investing.

Now, a few times a month, I take a couple hours off to venture outdoors. Yes, I know the sun’s demonic rays cause cancer; but they also cure electronic induced ennui. Sounds fair to me.

There’s one coffee place I always go. I take my Kindle with me (hopefully there’s no such thing as Kindle eyes), order a double espresso (and since this isn’t a Starbucks I actually say the words “double espresso”), give the cashier three singles, get ninety-five cents back and drop it all in the tip jar (I’m not generous; I just hate change).

Then, I take a table (yes, it’s the same table every time – I told you I hate change) and stay there reading until I feel guilty I only paid three dollars and I’m hogging their table.

At that point, I usually stay another hour.

If my behavior is typical of their customers, it’s not entirely surprising that I should’ve come upon the sight I saw last week, though it came as quite a shock to me.

The place was empty. The tables gone. The signs gone. Everything gone.

This was a change. I did not like it. But I soldiered on. Off I went to the nearest coffee place (again, not a Starbucks). The trek was slightly less than half a block. There I found a handwritten sign in the window:

Closed for vacation. Back next month.

Another change. I did not like it. At that point, I realized it was a summer day, I was hot, and I probably didn’t want coffee anyway. So I walked another half block to a deli, bought a Cherry Coke, gave the cashier two singles, got eighty-three cents back and dropped it all in the tip jar (again, I’m not generous; I just hate change).

I haven’t related this most boring of stories to you for no reason.

Much modern writing (even some blog writing – wink, wink, nudge, nudge) drips with sarconihilism, that especially astringent strain of sarcasm bordering on nihilism. In such writing, not only is nothing sacred – nothing is above casual, comedic contempt. It is occasionally hilarious, often elitist, and indubitably dishonest.

It makes fun of life’s littlest pleasures, especially the ordinary. Starbucks is a frequent target; the coffee chain is nothing if not ordinary:

The green aprons, the blond wood, the safari-themed coffee art and the chalkboards. From Chula Vista, Calif., to Bangor, Me., all Starbucks are more or less the same. And that’s how the company wants it…But every store, as it turns out, is not quite the same. When a Starbucks opened on Broad Street here almost eight years ago, it was not seen as a bland new spigot of a corporate coffee-pot, but as a gathering place whose very existence would have seemed impossible a decade before, a symbol of a knocked-down city’s attempt to get up.

(Kareem Fahim - The New York Times)

The Broad Street referenced is in Newark, New Jersey. Starbucks announced it will close its Broad Street branch along with 599 other stores. The New York Times records the reactions: “They’re not going to close the one on Wall Street!”, “It’s the only nice place on the street”, “(Starbucks) is important for me...It’s important for a lot of people.”

There are actually three Starbucks in Newark (excluding the airport); the other two are in less unexpected locations: a college campus and an office complex. But, Broad Street was different. It was an outpost of civilization in an uncivilized place – if civilization is defined as the presence of life’s littlest pleasures, especially the ordinary:

There was no great mystery about the model. Starbucks, whatever it liked to claim, never really had the best coffee in the world. But like most chains it offered something else instead: reliability. You could drop into a Starbucks anywhere in the world and you would know what you were getting. It introduced the sort of café where you could sit around drinking coffee and reading the papers to countries where such places had never really existed before. In Britain, it was a big step up from Joe’s greasy spoon with Nescafé in a chipped mug. Likewise, to most Americans it was a step up from an old-fashioned diner.

(Matthew Lynn - The Spectator)

And so it was in Newark too.

Jason Zweig writes the Intelligent Investor column for The Wall Street Journal. I’m sorry to say this week’s column is especially unintelligent.

When asked whether Graham would be buying financial stocks today, Zweig says no, and gives the following reason:

You cannot even pretend to be protected against loss while real estate prices - - the wobbly foundation for most financial stocks - - are still crumbling.

False.

You can do more than pretend to be protected – and Graham would have. Crumbling real estate prices alone would not have deterred Graham. He liked to use long-term averages and estimates of what normal conditions would bring. He relied heavily on the past as an indicator of the future. Real estate prices will recover at some point. Even if they don’t anytime soon, land still has value and Graham would have done his best to conservatively estimate that value. He could’ve used estimates based on prices from many years ago, replacement costs, rents, or the value of unimproved land. Then he would have lopped off some of that price and – voila – there’s your margin of safety.

No. The crumbling real estate market wouldn’t have fazed Graham.

Graham wouldn’t have bought financial stocks for a very different reason: they simply aren’t cheap enough.

I know it’s hard to believe, but as Zweig points out, on average, financial stocks are still trading above book value.

Remember, 1.1 times book is still 110% of a bank’s equity. Graham bought net current asset value stocks at less than 67% of their net current asset value (NCAV).

A lot of people think NCAV stocks (or “net/nets”) are risky. Some may be. However, there was one study showing that net/nets sought bankruptcy protection less frequently than non-net/nets. That’s not as shocking as it sounds. Unlike low price to book stocks, low price to NCAV stocks have a built in tendency to be overcapitalized.

Why?

Because there’s no need to have a positive net current asset value at all. Many public companies don’t.

Take Anheuser-Busch. It has about $3.1 billion in book value and NEGATIVE $12.1 billion in net current asset value. Even if BUD’s stock price fell to two bucks a share tomorrow, it would not trade below its net current asset value, because it has no net current asset value. To have a net current asset value, the company would have to be overcapitalized.

Other companies, especially companies with very high inventory needs and rapidly declining sales, can trade below NCAV without actually having much financial wiggle room. However, most companies end up in NCAV territory with strong balance sheets and weak statements of income and cash flow.

The NCAV stocks that fail tend to do so in slow motion and through extreme pig-headedness. Had management wished to, they could have exited unprofitable businesses, stopped treating the company as their own personal piggy bank, or wound down the business at some point without ever facing insolvency. A bankrupt (former) NCAV stock is usually the direct result of a determined and dimwitted management.

I made this detour into the land of net/nets for a good reason. Graham liked to combine both safe and cheap. He didn’t necessarily look for a high-quality, low-price stock – he looked for businesses that could perform worse than expected and still see their share prices rise. When taken as a group, net/nets are both safe and cheap. Their current earnings and cash flow are usually very bad, their future prospects are usually abysmal – however, even the slightest improvement in their performance will lead to excellent results.

Graham was betting on stocks with extraordinarily low expectations; if he were betting on a horse race, the nearest equivalent would be betting that the worst horse in a race wouldn’t place dead last every time. He didn’t bet on long-shots (he wasn’t betting the horse to win), and he didn’t expect to make more than 50% from any one stock. But, he did expect to beat very low expectations.

The problem with financial stocks is that today’s expectations still aren’t as low as Graham liked. Buying a basket of bank stocks just above book value may be an excellent speculation, but it wasn’t Graham’s idea of an investment.

Given the right price, you could carry out an investment operation in financial stocks by relying on their past records (many banks have very long public histories) and diversifying. Zweig finally gets Graham right when he says:

If you are still tempted to bottom-fish for financial flounder, at least diversify.

Unfortunately, he goes on to say:

Consider Vanguard Financials or iShares Dow Jones U.S. Financial Sector. Each of these exchange-traded funds holds hundreds of financial and real-estate stocks.

You are to do no such thing. If you’re going to buy financials, don’t buy them indiscriminately above book value. You need a margin of safety – and you can't diversify your way to safety. That means you either have to buy banks that are a cut above the rest or you have to buy banks well below book value.

An example of a bank that’s a cut above (from a Grahamian safety perspective) is Valley National (VLY).

Unfortunately, it ain’t cheap. I nearly posted on Valley recently when the company’s declining stock price brought its dividend yield over 5% and its price-to-book ratio under two. Of course, that means the company (briefly) traded at just under 200% of its book value – not exactly Ben Graham cheap.

And that’s the problem. Many of the banks trading below book value don’t have long histories of safety, solidity, and reliability. While many of the banks that do have such records (the kind of records Graham would look for) aren’t trading anywhere near Ben Graham bargain territory.

If financial stocks fell another 40%, Graham would consider buying a basket regardless of the economic climate. Even if we’re heading into a depression, buying the 20 best financial stocks at 2/3 of book value would be intelligent investing. However, even if we’re heading into the broad, sunlit uplands of permanent peace and prosperity, buying a hodge-podge of financial stocks at 110% of book is unthinking investing.

Graham wouldn’t do it and you shouldn’t either.

So Zweig gets the answer right: No. If Ben Graham were alive today he wouldn’t be buying bank stocks.

However, Zweig’s reasoning is all wrong. Graham wouldn’t be deterred by real estate prices; he’d be deterred by stock prices. Bank stocks just aren’t cheap enough to provide a margin of safety – unless you’re sure most banks are worth much more than book – and Ben Graham wouldn’t be.

Zweig concludes with this indulgent advice:

Whatever you do, use only the money you were salting away for that trip to Las Vegas.

No.

Invest or don’t invest. But, don’t play games. Don’t dip a toe in the water. Don’t fool yourself into thinking you’re being prudent when you’re simply being indecisive. It’s one thing to make a single bad investment; it’s quite another to indulge yourself in a bout of sloppy thinking and indecisive decision making. Better to burn the money now than lose it in a way that will undermine your confidence in yourself or the seriousness with which you approach your investments.

Here is the matter before you: Is an adequate margin of safety provided by the purchase of a basket of bank stocks at an average of 110% of book value?

Yes? No? Maybe?

If yes, then invest.

If anything else, then forget about bank stocks altogether.

Review by Geoff Gannon

Yesterday, I scampered off (virtually) to Amazon.com, found Don Keough's new book, and clicked the “Buy Now” button.

Through the sorcery of modern book selling – one minute, nine dollars and ninety-nine cents later – Don Keough’s words were in my hands.

I froze.

Seeing the big, bold print of that title page on my Kindle, I froze. Here was a business book by Don Keough. Yet for some reason I expected the worst. The title was not encouraging: “The Ten Commandments for Business Failure”. It sounded like a book I’d read a few hundred times before.

Would this be a saccharine sleigh ride through Coca-Cola’s golden (Goizueta) years? Or just another listless list of managerial platitudes?

Evenly divided between anticipation, trepidation, and vacillation I pressed the “NEXT PAGE” button and embarked on my journey with Mr. Keough.

At least, I thought it was to be with Mr. Keough, until I read the first few words of the foreword:

"It has been an article of faith for me that I should always try to hang out with people who are better than I. There is no question that by doing so you move yourself up. It worked for me in marriage and it’s worked for me with Don Keough."

That voice, of course, is Mr. Buffett’s. Warren’s cameo will be appreciated by all business readers, but those of the investing ilk will savor it most. And this is a worthwhile book for investors – though only indirectly so.

Don Keough has written a general business book, not a managerial handbook. As he writes in his introduction:

“…there has never been a shortage of speakers and writers willing to dispense tried and true advice on how to succeed in business without really trying.”

This is not that book.

Nor is this the book for the starry-eyed entrepreneur, the middle manager looking to get ahead, or the executive who wants to become a “leader”. This is not a self-help book.

It’s a business book – and a damn good one. The lessons within provide insights into businesses both good and bad and are as useful to the investor as they are to the executive.

Keough knows the kind of book he’s writing and tells us at the outset who his audience is:

"While these commandments can be applied to any business at any stage in its development, they are mainly intended for businesses and business leaders who have already attained a measure of success. In fact, the more you have achieved the more the commandments apply to you."

His years at Coke made Keough extremely well-qualified to write a book on how to screw up a sure thing.

Keough’s advice is simple, maybe even trite:

"You will fail if you quit taking risks, are inflexible, isolated, assume infallibility, play the game close to the line, don’t take time to think, put all your faith in outside experts, love your bureaucracy, send mixed messages, and fear the future."

That’s the whole book right there. Sorry to spoil it for you.

But what I haven’t spoiled for you is the fun of seeing how Keough takes these trite little dictums and develops them through anecdotes. He makes passing reference to many of the most familiar business failures; Xerox, Ford, and IBM are all taken to task.

However, Keough’s best stories are his Coke stories. Even his best IBM story is really a Coke story:

"After the opening of the meeting, Akers made a speech on the supremacy of the customer in the IBM world, and in order to highlight how important this new paradigm was, he said that as the centerpiece of this meeting I was to be the speaker at the first session."

Before letting Keough (then President of The Coca-Cola Company) speak, Akers told the audience: “I want you all to get the flavor of some of the in-depth discussions we have been carrying out here at headquarters to explore ways we can better serve our customers and reaffirm our dedication to those customers.”

"He then showed a video of senior executives including him with their coats off and sleeves rolled up in some clearly serious meetings on customers and customer service. There were charts and graphs and a professional facilitator who kept reminding everyone of the importance of the new paradigm…I watched this video along with everyone else. Of course I couldn’t help but notice that on the conference table in front of every executive taking part in the customer-oriented discussion was a can of Pepsi-Cola."

Keough heaps one anecdote on top of another. I won’t ruin it for you by cherry picking the best bits and reprinting them here. Like a comedy, this book is best approached without having already been exposed to all the good material.

“The Ten Commandments for Business Failure” is a lightening fast read. I read it twice yesterday. The first half of the book flies by.

It loses some momentum near the end, where Keough, who majored in philosophy, gets a bit too philosophical for a bit too long. Even here, what he does he does well, but I’m not sure it needed doing – at least not in the same book that cuts quickly to the heart of so many bone-headed business mistakes. Keough’s slight meandering near the end of the book is far from a fatal flaw; it is, for instance, nothing like the two-book format of Alan Greenspan’s “The Age of Turbulence” which subtracted from one good book by adding another.

There is one other flaw: the chapter on bureaucracy is too long. While I’d love the book to be twice as long if we got twice as many of Keough’s well-told tales, the chapter on bureaucracy and Keough’s brief foray into Malthusian thought (and other equally dismal topics) are either longer than they need to be or altogether unnecessary.

These small missteps are but a pebble on the scales when compared to Keough’s honest assessment of just about everything in business:

"Now annual reports of most companies are page after page of full color, featuring people of all races, creeds, and cultures plus a double-page spread of a pristine forest in Maine that was not cut down to produce the report. Somewhere in all this green beauty you’ll find the numbers."

I wish Keough were embellishing the truth to make a point. Sad to say, I once read an annual report where the financial data literally appeared among those trees – the great upward trend of earnings causing each year's EPS to rise like a redwood – higher and higher – ‘til it scraped the azure sky.

Yes, there are a few hairline fractures on Keough’s little gem, but a gem it remains.

I have no doubt Don Keough’s “The Ten Commandments for Business Failure” will go down as one of the best business books of 2008. I also have no reservation recommending it.

Verdict: BUY

*****
(5 out of 5)

Related Reading

WSJ Interviews Keough

Atlanta Journal-Constitution Interviews Keough

Attention Investment Bloggers:

I’m hosting this week’s Festival of Stocks (on Monday).

Please send me your best post of the last week.

Thank you.

The introduction to Security Analysis is a treasure trove of Grahamian thought. It is impossible to fully plumb the depths of this Grahamian gold mine in a single post. Therefore, I have separated my comments into two posts. This post explores the opening paragraph of the introduction with special attention to Graham’s style.

We should begin with the most general point made in Graham’s introduction: It is impossible to completely separate analysis and action, theory and practice. Therefore, while the title of Graham’s book is Security Analysis, the scope is necessarily wider:

Although, strictly speaking, security analysis may be carried on without reference to any definite program or standards of investment, such specialization of functions would be quite unrealistic. Critical examination of balance sheets and income accounts, comparisons of related or similar issues, studies of the terms and protective covenants behind bonds and preferred stocks – these typical activities of the securities analyst are invariably carried on with some practical idea of purchase or sale in mind, and they must be viewed against a broader background of investment principles, or perhaps of speculative principles.

This is vintage Graham. In many ways, it is a sort of cold open into the book and the mind of the man who wrote it. He begins with a logical and overly literal opening sentence; to Graham, “strictly speaking” means speaking strictly – nothing more or less. He adds a word we wouldn’t think necessary – “definite” – but in Graham’s mind it is a necessary and meaningful modifier. Finally, he interjects his personality with the word “quite”, which we will see repeated again and again throughout Security Analysis (Graham was born in Britain).

Next, we have a catalogue. The activities Graham lists are all activities he’ll cover in Security Analysis. If you wonder what Graham means by security analysis, look no further than these lines. He lists three main activities: “critical examination” of corporate financial statements, “comparisons of related or similar issues”, and finally “studies of the terms” of senior securities.

This is an especially excellent introduction for the modern reader, because we learn just how different Graham and his book are from what we might expect – and we learn our lesson well within the first few sentences.

What is the most unusual feature of this paragraph? Can you find the words almost no other writer would have included?

I’ll give you a hint. In Graham’s list of activities undertaken by the security analyst, there are two words that stick out like a sore thumb – a seemingly redundant sore thumb – can you find them?

Here they are:

“Critical examination of balance sheets and income accounts, comparisons of related or similar issues, studies of the terms…”

These two words tell you more about Graham and Security Analysis than anything else in that opening paragraph.

Why?

Because they are peculiar. What tells most is often what is said least. The appearance of these extra words in this sentence is something almost no one but Graham would ever insist upon.

Graham thinks these words are necessary; otherwise, he wouldn’t have included them. Related and similar are not synonyms. Similar means “alike”; related means “connected”. Connections do not necessitate similarities or vice versa.

For instance, there can be no doubt that airlines and railroads are related (as transports). But are they similar? In some ways yes; but, other industries that are not closely related are at least as similar to one or the other when we drill down into the micro-economics of each.

Graham knows this.

He loves comparisons. Comparing two or more different stocks or bonds was always one of his favorite activities; he did it over and over again in class after class. He used comparisons in his teaching and in his writing. Sometimes these comparisons used similar issues, sometimes related issues, and sometimes random issues (as in the Intelligent Investor).

Choosing random issues (e.g., by taking stocks that are listed together in alphabetical order) allows the security analyst the greatest opportunity to see each stock in the sharpest relief. Looking only at related issues can be very useful (and is a common practice, especially when putting a valuation on a stock or a company); however, such comparisons can cause tunnel vision.

One phrase in this introduction will come back to haunt many readers – as it foreshadows what will quickly become their least favorite part of Security Analysis – “studies of the terms and protective covenants behind bonds and preferred stocks”.

Oh how some of you will come to hate that phrase!

There are a lot of reasons for Graham’s focus on senior securities. Some are peculiar to the time he was writing; most are not. Graham’s own personal history made him a sucker for a good, long exploration of every aspect of senior securities.

Here is a passage from Graham’s memoirs, describing his activities when he first arrived on Wall Street:

Even in my spare time I took the job of self-education very seriously. I got myself a small looseleaf notebook, and on each page I wrote the salient data about a given bond issue in convenient form to be memorized. After all these years I can still remember the appearance of that black notebook and some of the entries in it. The first was: “Atchison, Topeka, & Santa Fe, General 4s, due 1995: 150 mil.” There must have been a hundred different issues entered; I memorized their size, interest rate, maturity date, and order of lien. Why I wanted to memorize facts that could be readily obtained from manuals or my notebook I am at a loss to explain…After making what I thought was wonderful progress with these studies, I found all the different issues hopelessly mixed up in my mind, and I gave up the exercise as a bad job. But I was surprised to realize some months later that the figures had somehow straightened themselves out. I had becoming something of a walking Railroad Bond Manual.

Some would prefer to skip everything Graham wrote about senior securities. You can read Security Analysis without reading Graham’s views of bonds and preferred stocks and still get something out of it. But, I wouldn’t recommend it. In a later commentary, I’ll defend the value of the parts of Security Analysis that deal with bonds and preferred stocks. For now, just know that they are there – and that you may not like them as much as those parts of the book that deal exclusively with common stocks.

Tough.

Graham wrote about both for a reason. Luckily, much of what he says about senior securities will help us better understand his thinking on common stocks. But, for now, just brace yourself for reading (and reading and reading) about bonds.

Those of you with book in hand – or more likely, hands – know that Security Analysis is quite literally heavy reading.

There’s no getting around it: Security Analysis is one big book. It’s long. Too long for some modern readers – or at least long enough to give modern readers an excuse for eschewing Graham.

There are two kinds of long. There’s little-thing long and big-thing long.

The best illustration of the difference between little-thing long and big-thing long is Alfred Hitchcock’s The Man Who Knew Too Much (1956). This Jimmy Stewart movie features a climax many have seen even if they haven’t seen the movie (hint: it involves cymbals). This climactic sequence is little-thing long. It is a long, long sequence. It seems to get longer as you watch it. Every little thing is noted and adds to the suspense. Unfortunately, this climax is not near the end of the movie. In fact, it isn’t even the last climax of the movie. There’s another climax: a perfectly good one involving a song, a kidnapped child, and a gun. These two climactic sequences make The Man Who Knew Too Much big-thing long as well as little-thing long. The movie has a lot of big building blocks strung together – several different exotic locales, two climaxes, etc. Being big-thing long is very different from being little-thing long. A little-thing long movie is exhilarating and exhausting for the audience; a big-thing long movie can be either satisfying or sleep inducing depending on how it’s handled.

Security Analysis is big-thing long. It has lots of parts and chapters, sections and subsections. It covers a huge amount of material. It touches on a lot of different ideas and explores a lot of different arguments. But, when it does, it doesn’t do so in extraordinary depth. Graham doesn’t circle round a subject; he cuts right to the heart. Therefore, he can pick up and dispose of a subject or argument within a relatively short time. If you miss a paragraph of Graham, you may have missed a lot. There are nuggets in there – great scenes, real gems – but they aren’t especially long and Graham doesn’t make a big fuss about each and every one of them.

No where is this more obvious than in the introduction. In my next post, I’ll try to discuss some of the subjects Graham takes up in more detail. For now, just note how many different topics he picks up, scrutinizes, and then disposes of in a single introduction. Then, open up any other investment book and read that book’s introduction. Even if the number of words are equal, the number of ideas is likely to be less. Most investment writers circle more and cut less.

Finally, there’s the matter of Graham’s subversive style. In Security Analysis, the author is ubiquitous but not conspicuous. In one of my podcasts, I compared Graham to Tacitus. If that strikes you as a totally insane comparison, consider the close of Graham’s first paragraph:

“…they must be viewed against a broader background of investment principles, or perhaps of speculative principles.”

This kind of sentence is more common in Graham (and Tacitus) than in most writing. It maintains an objective tone, while injecting the author’s personality – or more accurately – his personal judgment. Using “or perhaps” and placing it after a complete thought that includes the word “must” suggests not so much uncertainty as deceit. In this case, Graham is honestly saying security analysis may be used either for investment or speculation.

However, he’s also saying – without really having to say it – that we often speculate and call it investment. We practice self-deceit. The way he’s constructed his sentence allows us to read either objective uncertainty (i.e., could be “a”, could be “b”, who knows?) or subjective subversion (we say it’s “a”, but you and I both know it’s often “b”).

Graham – like Tacitus – tends to subvert his own sentences.

His presentation of the facts and his willingness to explore all the facts – and all the possible explanations – is exceedingly honest and objective. However, he concomitantly conveys his own views to the reader, regardless of the objective textbook format in which he operates.

You get a real sense of Graham without his ever taking off the textbook writer’s mask, just as you get a real sense of Tacitus without his ever taking off the historian’s mask. In both cases, you feel you’re reading a very disinterested account written by a very interested party.

It’s an unusual experience.

I hope you enjoy it.

There are two recent pieces on morality and credit worth reading. One is written by David Brooks; the other by Jim Grant.

Brook's piece is good; Grant’s is better. Brooks takes the matter as far as he can. He sees the importance of the everyday examples that constitute a culture; but fails to see the overwhelming importance of incentives – incentives that have been both perverse and pervasive throughout the third millennium.

(The borrower) and the lenders were not only shaped by deteriorating norms, they helped degrade them. Despite all the subterranean social influences, there still is that final stage of decision-making when individual choice matters. Each time an avid lender struck a deal with an avid borrower, it reinforced a new definition of acceptable behavior for neighbors, family and friends. In a community, behavior sets off ripples. Every decision is a public contribution or a destructive act.

Great.

Unfortunately, he goes on to write:

Meanwhile, social institutions are trying to re-right the norms. The government is sending some messages. The Treasury and the Fed are trying to stabilize the system while still ensuring that those who made mistakes feel the pain.

Brooks is out of his depths here.

Ultimately, the pain will come in the form of inflation. It has to. Either the Fed will realize it has assumed weaknesses that are mostly illusory – or the Fed will cure those weaknesses the only way it can. Either the Fed’s balance sheet will turn out to be solid, or the Fed will have to counterfeit that solidity.

Unlike Brooks, Grant resorts to numbers:

In June 2007, Treasury securities constituted 92% of the Fed’s earning assets. Nowadays, they amount to just 54%. In their place are, among other things, loans to the nation’s banks and brokerage firms, the very institutions whose share prices have been in a tail spin. Such lending has risen from no part of the Fed’s assets on the eve of the crisis to 22% today. Once upon a time, economists taught that a currency draws its strength from the balance sheet of the central bank that issues it. I expect that this doctrine, which went out with the gold standard, will have its day again.

John Bethel of Controlled Greed recalls a past phrase from Grant – “the democratization of credit and the socialization of risk”. There is no clearer example of this phenomenon than the weakening of a public balance sheet to strengthen private balance sheets.

The first part of that phrase is as important as the second. When do you hear someone told they shouldn’t buy that house or take out that student loan? Is anyone ever told they can’t afford to own a house, or attend a four-year school?

No. These are the new unalienable rights. Unfortunately, they still have to be paid for out of pocket. No amount of money is too much to spend on your education or your abode...

But if that’s true, what difference does the price make? If you’re going to buy the best – the absolute best you can (because you’re worth it) – then what difference does the price make?

None.

All that matters is whether you can afford it – and since you’ll be borrowing the money, whether or not you can afford it will depend (almost) entirely upon whether or not a lender thinks you can afford it – and whether or not a lender thinks you can afford it will depend (almost) entirely on how cheap he can get the money and how valuable he thinks your asset is – and since your house is a marketable asset all that really matters to your lender is how much he thinks other people are willing to pay for your house - and all that really matters to those other people is how much their lender thinks they can borrow at the current rate - and so far this millennium, that rate has been low, low, low.

And no one’s trying to take the addict to rehab.

In the third millennium, coming clean about your oil addiction is suddenly in vogue; but, cutting off a credit-whore remains a thankless job.

We talk a lot about loans and very little about balance sheets – especially personal balance sheets. An individual has one great earning asset: her labor. It’s a terrific asset. It can support a lot of debt. But, we mustn’t forget it can only support a finite amount of debt.

The housing bubble inflated by overburdening a more tangible asset. The ugliest truth of the mortgage mess – the truth everyone prefers to sidestep – is the bottom line: you can’t saddle an asset with more debt than it can bear. If a leveraged buyout can bankrupt a corporate cash cow (and it can) – why should we be surprised to find that loading a house up with debt can crush it?

Because it had never happened before – or, if it had – we hadn't measured it.

As is our custom, we didn’t let logic get in the way of the data.

Thankfully, we’ve now been proven empirically wrong, so this shouldn’t happen again.

We’ll come up with something new next time.

Brooks is right about one thing. In the end, it does come down to personal responsibility – and no where was there less personal responsibility than inside the housing bubble.

No distinction was made between price and value. Everyone trusted the market (and, of course, everyone was the market).

A house was worth what it could be sold for; a loan was worth what it could be sold for.

It was one big Keynesian beauty contest.

You didn’t have to appraise a liquid asset; everyone else did it for you.

No one needed to know what anything was worth.

And now no one does.

Greed has been unfairly singled out as our nation's greatest vice. Greed may be a sin, but it isn’t deadly.

Being greedy, lazy, and stupid all at once – now that can kill you.

We drank a little too deeply of this newfangled liquidity. We did some things we aren't too proud of. And slowly, slowly, we’re beginning to remember just what those things were.

In his 2002 letter to shareholders, Warren Buffett wrote that despite several years of falling prices, he wasn’t finding many stocks to buy; evidence, he said, of just how crazy “The Great Bubble” valuations had been. He went on to make a prediction:

“Unfortunately, the hangover may prove to be proportional to the binge”.

Now that our liquid courage has left us, that kind of thinking is all you hear.

Visit Controlled Greed

Jeff, author of Circle of Competence, is a young and learning investor not yet out of college. He derives his investing framework from Superinvestors ranging from Ben Graham and John Maynard Keynes to Joel Greenblatt and Eddie Lampert. Jeff believes the most effective approach to investing is that of a business owner and entrepreneur looking for misunderstood businesses selling very cheaply with little risk of capital impairment.

Visit Circle of Competence

1. Are you a value investor?

No doubt. There’s no other approach I’ve ever been comfortable with. The thing is, value investing, as we tend to think of it, is not the only path to investing success. I’ve read about plenty of individuals who have been successful trading, making macro calls, and reading tea leaves for all I know. Value investing, business investing, is the one I hit it off with, so I’m with it for better or worse.

2. What is value investing?

Value investing is this really simple approach that’s not so easy to practice. In my eyes, value investing is a mentality that assets have some value independent of their selling price. They might be the same, they might not be, but if you can find the ones selling for some large amount less than they’re worth, there’s an opportunity to make a ton of money down the road. Buffett, Graham, Klarman, I mean these guys have proved this thesis true over and over with their successes. It takes some hubris, a confidence that you’re right and everyone else is wrong, and the courage to basically not let your humanity interfere with rationality. That’s the toughest part of value investing.

3. What is your approach to investing?

I’m basically just looking to own a small handful of companies that I know pretty well, selling for way less than they are worth. I want to find 5-10 companies where I can be extremely confident that I know what the heck is going on. It’s the only approach to investing that makes sense to me. I approach investing like I was a control investor, a buy-out specialist, or an entrepreneur. To find these opportunities, I’m search for companies that are being subject to some devil: neglect, myopia, or misunderstanding. If I can find a solid business with a solid balance sheet, run by competent management, being subject to one of those devils, and it’s something that I understand, I’m probably researching or buying it. That means spinoffs, small caps, distressed businesses, companies with multiple divisions; all of these are fair game. I want to find situations where the risk I’m being asked to take is out of whack with the potential upside. I’m okay with an investment that doesn’t make me any money. I’m not okay with losing money.

4. How do you evaluate a stock?

I don’t really evaluate stocks. I (try to) evaluate businesses. As I said before, I’m thinking like a control investor. What is the company worth now, and what is it going to be worth 3 or 4 years out? I’m willing to hold something for 5 or 10 years, absolutely, but only if there is a compensatory reward, and little downside. If the business passes my first two filters, I’m reading everything I can on the business. I’m evaluating the strength of the business, the strength of their balance sheet, their performance versus competitors, the words coming from the mouth of management, the price of the shares, everything. I’m either going to value the company based on the salable assets it has today, or the present value of its future cash flows. Something selling for a 20% sustainable free cash flow yield is as cheap as something selling for half of liquidation value. I just want to know all I can know about this business from an outside perspective, given the limited resources at my disposal. It’s necessary if you’re going to have 80% of your portfolio in 5 holdings, or even 4 holdings.

5. Why do you buy a stock?

I’ve figured out that I don’t have the time or intelligence to evaluate every security, so I’m only buying the companies I’ve taken the time to understand. Did Sam Walton care that Bill Gates got rich building Microsoft? I doubt it, because he was too busy getting rich building Wal-Mart. When I’ve strayed from this mentality, I’ve bought into the wrong companies, trust me. I don’t want to see a small price disconnect, either. I’m looking for a price that’s way off considering the value and economics of the business. GARP is a good term, except not the way it’s traditionally used. I like Growth at a Ridiculous Price. My early experiences losing money helped me develop that sort of thinking. Lastly, though I’m thinking like a 100% owner, I don’t have the money to actually do it, so I have to have faith that management won’t kill my company and cause me to lose money. In some cases, management is a key part of the thesis. At minimum, I’m just betting that they’ll maintain the value that is already there. I’m running a very concentrated portfolio, so I can’t afford to be wrong very often. One big mistake could do some serious damage, so I keep that in mind before I buy anything.

6. Why do you sell a stock?

I’ll sell something for a couple of reasons. Number one, I was wrong. Either I didn’t understand the business well enough, or my analysis was off. Unless there is a compelling new reason to hold on, say the business is now selling for less than net cash or something, I’ll sell. Number 2, the business becomes overvalued. I don’t want to risk permanent capital loss at the point. Lastly, if I have a much better opportunity to invest in, I’ll sell. However, the burden of proof is on the new idea, as Eddie Lampert has said.

7. What investment decision are you most proud of?

I’m proud of my decision to hold off on buying Delta Financial last year. I’d already gotten killed on another, similar, company, and I started analyzing DFC in a similar way. I’m looking at this company, saying to myself “OK, here’s a better than average mortgage originator, they’ve done a great job securitizing…” I mean I almost rationalized buying this company after losing my shirt on American Home Mortgage. Somehow, I was able to catch myself and not invest. I knew that it was outside of my circle of competence, even though it looked cheap and somewhat understandable at the time. I’m a huge fan of Mohnish Pabrai, but he made an admitted mistake and I was able to say no ahead of time. A rare good decision for me.

8. What investment decision do you most regret?

Since I’ve made lots of mistakes, I’ll give you two. First, I bought American Home Mortgage, as I just mentioned, and it went Chapter 11 a week or two later. I was trying to catch the falling knife, and I did shallow, shoddy, analysis. Bad times. Second, I bought 6 month calls on Discover after its spinoff from Morgan Stanley. Lost it all. Those two were awful investments, but I learned a good deal from each of them. One was that I needed to overhaul the quality of my research. The other was a pretty firm rule: no short term options.

9. Why do you blog?

I began blogging for two reasons. One, I am an avid reader of financial blogs myself, and I couldn’t help it. Two, I desired the opportunity to get my words down on paper and in the view of public scrutiny. It would allow me to improve my analysis and my framework, because if I’m wrong or sloppy, someone will hopefully notice and call me on it. Plus, I have to keep writing to keep readers reading. That means I have to spend time researching stocks, reading good articles, and really thinking about what I’m reading so I can write about it on the blog. There’s some obvious positives in there for someone looking to improve as an investor.

10. What's your best post?

Even though, by far, I focus most of my attention on the business I discussed
above, I very occasionally do little arbitrage situations, I mean like 3 of them ever. I think my best post was one called Jaclyn: Arbitrage for the Little Guys. I like it because I got to go, point by point, through the relevant materials in their filings, with direct information and my own analysis to back it up. The arbitrage worked out perfectly, and my analysis was on point. If only all of my investments, and public analyses, went so well. Also, my readers seemed to really enjoy it, got a lot of positive feedback.

11. What's your worst post?

I try to put my best foot forward every time I post, so this is a tough question. I’d give it to Of Toads and Princes: The Yahoo! Deal Falls Apart. Not necessarily because it was a bad post, it was fine, but that type of post is not what my blog is really for. I kind of just grabbed a news headline that stuck me and ran with my own criticism. Search technology is not in my circle of competence, so I shouldn’t be commenting on it in the blog. It’s called the Circle of Competence. For all I know, that transaction has the potential to create a search leader out of Microsoft. I won’t be commenting on it in the future, needless to say. I should be sticking to analyzing the handful of companies I understand, writing about mental models and intelligent investing, and commenting on Superinvestors. The Yahoo! post broke that mold.

12. What financial publications do you read?

I enjoy the WSJ every day, Barron’s every week, Fortune, Forbes, SmartMoney. I also read Bloomberg and the Financial Times online, often. I just recently ordered the Economist and I’ll be reading that weekly as well, replacing Forbes and SmartMoney. I’m switching off of Forbes and SmartMoney to get away from reading the same opinions over and over. Forbes is a great magazine, no doubt, but given a limited resource (my time), I think I’m better off reading a broader and better written publication like The Economist. After reading Fortune, Barron’s, the WSJ, the New York Times, you start getting sucked into groupthink, which can be dangerous. The Economist will help broaden my thinking and push it in other directions. For instance, if you stick to those publications, all you’ll currently read about is housing, energy, the election, the falling market. I’d like to stay abreast of all that, but I need more perspective. Buffett has an uncanny ability to filter noise from signal. I’m not nearly as good at doing so, and thus I need to filter out some of that noise out before it even gets to me. Information overload is a real thing if it’s not usable information.

13. What investing blogs do you read?

Besides newspaper run blogs, like DealBook, I read a ton of value investing blogs. In addition to yours, some of my favorites are NoiseFreeInvesting, Valueplays, Controlled Greed, Cheap Stocks, and Reflections on Value Investing, which I also contribute to. My blogroll has the entire list. I find good ideas and enjoyable reading in these blogs. I’m a fan of Going Private as of recent. She is a great writer.

14. What's the best investment book you've read?

If you’re talking about investing how-to’s, it’s The Intelligent Investor. I derive the base of my thinking from that book, no doubt. The Dhando Investor is close as a modern treatise. If we’re talking everything investing related, then it’s easily Buffett: The Making of an American Capitalist. I’ve read that about 6 or 7 times probably, in two years. It goes without saying that Alice Schroeder’s book this fall is going to cause me a few sleepless nights. Regarding The Dhando Investor, that book hit some nerve in my brain. I must’ve read that one 6 or 7 times as well. Buffett and Graham talk a lot about business-like investing, that mantra we’ve all heard. But, it wasn’t until I read Pabrai that I began thinking of investing like an entrepreneur thinks about running a business, which is at the core of my framework now. If Graham is the Old Testament and Buffett is the New Testament, Pabrai is like CCD or Sunday School for me, clarifying some already established concepts. Low risk of capital impairment, uncertain future outcomes; that framework hit me like a ton of bricks. It just made a lot of sense.

15. What's the last investment book you've read?

I just finished reading a book called Extreme Value Hedging by Ron Orol. It’s about the tactics and strategies of activist hedge funds in this day and age, and where they came from. It’s a very detailed book that takes this subject from many different angles. Some of it I already knew, but I learned a ton, from activist strategies to required disclosures.

An interesting thing about EVH is that it connects value investors genetically to activist investors. To me, that makes a whole bunch of sense. If you owned a private business, wouldn’t you try to protect it if the managers were screwing up? I believe that activism is necessary at times. You own the business, after all, and one of the privileges of ownership is (partial) control. Even the 1950’s Buffett and Graham would go in and shake things up when they weren’t happy. So while I would never wish to run an “activist fund,” I think it’s wise to speak up when your managers are misbehaving with your capital. Good book.

16. When did you start investing?

I didn’t start investing, really, until a bit over a year ago. I’d been learning about it, reading about it, dreaming about it, for a couple of years. Last year I decided that even though I’d probably lose some money, which I did, it was worth to it to start experiencing investing rather than reading about it. Incidentally, I began investing right near the top of the market. That was a nice, quick proof that market timing isn’t a good approach for me. I’m getting better, slowly.

17. How have you improved as an investor?

The major thing was recognizing my fallibility and inexperience. It’s easy to read up on things and think you’re a real smart guy who’ll do 30% a year for the next 30 years. Then you get in there and lose a whole bunch of money and say, what happened to the smart guy I thought I was? I’ve progressed in learning where my circle of competence lies, how I can expand it, and being patient until that happens. Concentrated value investing involves some serious price swings for your portfolio. I’ve seen some huge volatility in what I own. From that, I’ve learned that I won’t be able to hang in there and buy more unless I’m really comfortable with my holdings. Writing publicly about them helps more than I anticipated, another reason I enjoy blogging.

18. How do you need to improve as an investor?

More of the same I spoke about above. I still need to work on patience and understanding. They are interrelated in more ways than most people realize. Without understanding, you’ll have serious trouble being patient. If I founded and owned some private business, I sure wouldn’t let some idiot tell me what it was worth every day. I really need to take that mantra and apply it 100% to investing in public securities. I can gain understanding through reading about companies and talking to knowledgeable people. I can only gain patience through introspection. It helps to have read Munger, Zweig, and all these guys who point out our psychological flaws. I’d also love to learn more about bankruptcy and real estate investing some day, as I believe that, periodically, there will opportunities in both areas to make a ton of money.

19. Where are the bargains in today's market?

At first, I was thinking to myself “If you don’t have much capital, there are bargains everywhere.” To heck with that. Even if you do have five or six billion, there are bargains everywhere. Financial stocks, restaurants, retailers, healthcare… pick a sector you think you can understand and get working. There are companies being left for dead that won’t die. Sears is a $50B retailer selling for less than $10B. The market is saying, “This isn’t gonna work, Eddie.” Well, it might, and we don’t have to pay up to see it through; in fact we’re probably being paid to see it through. I’m finding stuff like that everywhere. That’s very true with financial stocks, as well, except that 99% of them are outstanding my realm of understanding. This is not the time to be clutching gold and treasury bonds, sucking your thumb until it’s all better. Just know that the recovery won’t be immediate, and you won’t know when it’s going to happen. At some point, though, people will return to the retail stores and restaurants, return to the credit markets, and need some serious help staying healthy as they get older. I’d structure my portfolio knowing these things will eventually happen.

20. What's the most interesting company we haven't heard of?

Primus Guaranty (PRS). They sell CDS on corporate single names and tranches. Basically, 95% of their revenue is just receiving quarterly premiums for insuring default on investment-grade corporate bonds and tranches. The GAAP numbers look awful due to marks, but the business is as good as ever. The company will never have to post collateral for falling CDS values, and they hold 98% of the contracts to maturity. The stock has cratered from over 12 to under 3, for no rational economic reason. It’s simply fear and misunderstanding. They’ve been thrown out with MBIA and Ambac, but unlike the bond insurers, they don’t owe people all kinds of money, and none of their counterparties can demand collateral. There’s no exposure to structured finance insurance. The only situation where Primus is murdered is if investment grade corporate bonds start defaulting at unbelievable rates. Meanwhile, the stock sells about 2x economic earnings and less than a third of solid book value. I know, here I am talking about all the mistakes I’ve made owning financial companies and now I’m recommending one. But I understand Primus the way I didn’t understand a bunch of those other companies I lost my marbles trying to make money on. Primus is a very simple company, one I’m comfortable owning. In any case, I’ll either have a big smile or lots of mud on my face in a couple years.

Visit Circle of Competence

Note: My continuing weekly commentary on Benjamin Graham’s Security Analysis is being bumped for this roundtable; the commentary will appear here tomorrow morning. Sorry for the inconvenience.

This is a new format for Gannon On Investing – a pseudo-roundtable, where the same questions were posed to different bloggers simultaneously (via email). In this first post, we have answers from the authors of four of my favorite blogs: Fat Pitch Financials (GEORGE), Cheap Stocks (JON), Bill Rempel (BILL), and Controlled Greed (JOHN).

Performance

How have you fared so far in '08?

George: It’s been a rough year for my portfolios so far. My Fat Pitch Financials Portfolio, which tracks my longer term value investment picks, is down 15.9% year to date (as of July 11th). My Special Situations Real Money Portfolio is down 6.7% year to date.

Jon: It's been very challenging, especially the past month. Even some of the illiquid names I hold have started to come under pressure.

Bill: YTD as of 7/18 close, -1.67%.

John: My portfolio is down 12% through June 30th of this year.

What's been your greatest success this year?

Bill: I'm not viewing the individual trade results as being composed of individual successes or failures. I view the process as one of methodology applied consistently, with individual trade results being somewhat randomly distributed over time, around an average result for that system. That holds true for relative value traders, GARP traders, cigar-butt traders, special situation traders, and other types of system traders. Sticking to a chosen system is the "success." Currently I trade one of the four systems I track; in time, with a larger account, I'll probably trade two simultaneously.

George: In my Fat Pitch Financials Portfolio, my position in Western Union (WU) seems to be holding up the best so far.

My greatest success this year in my Special Situations Real Money Portfolio was my investment in JACLYN INC (JLN) that I bought for $7.65 on April 4, 2008 and I was cashed out (since this company went private) for $10.21 per share on May 22nd.

John: ArmorGroup International, which traded in London, got taken over by a UK company called G4S for a gain this year of 147%. You’ll remember I talked about ArmorGroup in the “20 Questions” interview we did previously. I originally bought the company in September 2006. My gain from start to finish was 61.3%, or more than 36% on an annualized basis.

Jon: The launch of the Cheap Stocks 21 Net/Net Index, the first index that tracks a basket of companies trading below net current asset value has had some very interesting results. Since inception (2/12/08), it’s up more than 9%, while the closest benchmark, The Russell Microcap Index is down 10%. Pico Holdings has also made a very nice recovery

What's been your greatest failure this year?

John: General Motors (GM), down 51.8% through June 30.

George: I recently made a big mistake not selling a stock immediately when its tender offer terms were modified and lowered. That stock, Sunstone Hotel (SHO) has plummeted since. I consider this my greatest failure since it was do to poor judgment. I believe this behavior is called anchoring.

Jon: Premier Exhibitions (PRXI), and 4 Kids Entertainment (KDE) have been big disappointments. I still hold both, and will likely continue to buy Premier.

Market

On the U.S. stock market, are you a bull, a bear, or a chicken?

Bill: On the U.S. market, my Timing system for the SPY has been 25% stocks, 25% bonds, and 50% cash since pretty much the beginning of the year. Looking outside the system, at indicators not included in it, I still think that the general level set by the January (and now the July) lows will be a multi-year bottom.

Jon: Believe it or not, I am still a bull. I believe oil, not housing, not the financial crisis is the single biggest risk factor in the market

George: I’m starting to get bullish on the U.S. stock market. For the past few months, I’ve been a chicken, lol. The market has been pretty scary this year. The bursting of the housing bubble, depreciating dollar and increasing oil prices is a tough combination.

John: Oh, I’m bullish longer term. Shorter term, things are lousy and could even get worse. But I don’t invest for the short term

Are stocks cheap, expensive, or fairly valued?

Bill: How you look at "stocks" depends on how you aggregate the index, how you weight the components, etc. If the question is, "how is the S&P 500 valued?", I dunno. I haven't done the math on it, and don't really care. Certainly some individual stocks are fairly valued, some are cheap, and some are dear, by methods that I would consider using.

John: I don’t look from a top-down perspective. But bottom-up, there are lots of cheap stocks. If a buyer is willing to wait and suffer lower prices between now and when things recover down the road, he or she could see significant gains.

George: Stocks are starting to look cheap.

Jon: Cheap, at least where I am looking--the smallest of the small

Where is the market headed? What should investors do?

George: I don’t know where the market is headed, but with the failure of IndyMac last week and the turmoil that is coming Monday due to auctions for Fannie Mae and Freddie Mac bonds, I doubt the we will see any significant market gains next week.

Now is the time to find cash. Look under those couch cushions, shake the piggy bank, and save as much as you can. Plow that cash into value opportunities.

Jon: Investors should stay on course, and use some of their dry powder to pick up some bargains. I believe that we are at or near the point of there being blood in the street,

John: For a value guy with a long-term view, I think you buy inexpensive stocks if you’re willing to hold for several years, suffer any price declines, and not worry about the market.

Bill: I think individual traders should find a system (or systems) that work(s) over the long haul, and apply it (them) relentlessly. Even if they use the system as a screen for discretionary trades, provided the system itself is robust, they'll do OK over time. Don't worry about the day-to-day market moves, because in the long run, they're irrelevant.

Oil

Why are oil prices where they are?

John: We’re hitting an area outside my circle of competence. I suspect it’s a combination of greater demand, refinery capacity not having kept pace over the past couple of decades or longer, and a “terror” premium added to oil prices. My hunch is that all the crying we hear about speculators is bull.

Jon: The declining dollar, hot spots in the Middle East, and speculation. We are in a vicious cycle, and each of these factors feeds the other. I believe Iran has no intention of attacking Israel, but is rather trying to disrupt our economy, with success, I might add.

George: Demand for oil continues to grow worldwide. Production may have peaked. The risk of supply disruptions is perceived to be high. Most importantly, buyers continue to be willing to pay the current high prices.

If you are interested in learning more about why the price of oil is established, I recommend studying Hotelling's rule.

Bill: Oil prices are where they are (or were where they were) because of speculation. That's the answer for all prices, SPECULATION. All market participants speculate, even those that are end-users or producers of commodities, even those not using leverage, even those buying "value" stocks with the intention of holding them for years.

Where are oil prices headed?

George: I think in the short term oil prices may continue to climb a bit higher to $150 per barrel. However, society is starting to make changes to confront higher oil prices. People are buying more efficient vehicles and driving less. Companies are investing more in energy efficiency and alternative fuel sources. I believe that next year we will see lower prices than we have today. Of course, this is really all just speculation, but it is what I think may be the most likely outcome.

Jon: Ultimately lower, perhaps the $60-$80 range. That presumes a stronger dollar, decreasing tensions in the hotspots, and that offshore drilling, and reduced consumer demand all become a reality. A tall order, I know.

Bill: The sarcastic answer is "they will fluctuate." I think we saw a blow-off top in oil prices just now. Long-term, I think the cycle of gasoline prices is topped as well, and GM's boneheaded too little, too late moves probably marked the top as well as any capitulation ever could.

John: My guess is lower this fall. I think there’s been a “bubble” effect with prices lately. But if America and/or Israel attack Iran, or another event happens in the Middle East, who knows?

What do oil prices mean to investors? Should they care? And what should they do today?

Bill: What should traders do about oil? The same thing they should do about the market, find and apply a methodology and stop "reacting."

John: I believe investors like me should invest in undervalued companies. Spread your bets and let the chips fall where they may. Basing investments on oil prices strikes me as too much “top-down” investing. Of course, if gas suddenly shot up it could have a bad impact on a whole host of industries. But we’d adapt over time. I have relatives in England. They tell me they’re paying right around the equivalent of US$10 a gallon (a lot of that is taxes). They don’t like it, but life is going on over there.

George: As an investor, it is hard to completely dismiss oil prices. I think most investors should consider the macro impact of oil prices and also how it impacts their individual holdings.

As for what investors should do today, I think they should think about what value opportunities may exist in excellent companies that may have been overly discounted due to current oil prices.

Jon: Oil is the single biggest factor weighing on the markets, they should care, but need to be able to weather the storm. It is very difficult to do so psychologically, though

Economy

How bad is the economy?

Jon: Housing is bottoming, there are some positive signs there, unemployment is benign ( but may worsen), the credit crisis was improving, but Fannie and Freddie situation is of concern. I believe it's not as bad as the pundits suggest. What frightens me most is one big shock to the system, i.e. oil supply shock, terrorist attack, etc, that really shuts things down, and frightens consumers worse than they already are. That aside, its not as bad as some think.

Bill: The economy is never as bad or good as you think it is. Certainly the rate of "real GDP" (which ISN'T "the economy") change isn't going to be as low as the consensus projection (read: it ain't gonna be negative).

John: We’re definitely in the midst of an economic downturn. Whether it meets the textbook definition of a recession I’ll leave to others to decide, but things aren’t great, that’s for sure.

George: All I know is that the health of the economy is not good. Thing could end up a lot worse next week if the IndyMac takeover and the handling of Fannie Mae and Freddie Mac crisis is not handled properly.

How bad will it get?

Bill: I doubt we'll see an overall "recession" (as called by the NBER) this year.

Jon: Fundamentals will improve, but elections are scary. I fear an Obama Presidency from an economic standpoint. His policies, if enacted will damage the free markets, and flow of capital. He makes George McGovern look like Ronald Reagan.

George: I hope not much worse, but if more major financial institutions fail that could get real ugly (see my previous answer). Inflation is also one of my biggest concerns right now.

John: I have no idea. When I read a smart guy like Francis Chou telling his investors that even the CEOs of these big financial firms have no idea if the bad stuff is on their own balance sheets, I pay attention. Then I recently read Ted Forstman, another smart fellow, saying in The Wall Street Journal the credit crisis is bad and that we’re only in the second inning of this mess. So it could get much worse. I’m hoping the second half of this year will tell us a lot, so that prospects for 2009 will look brighter. But what do I know? We might be muddling along another year or more after that.

Where does today's economic environment fit in a historical context?

George: To some degree today’s economic environment is fairly unique. However, there appears to be some similarities to the 70s fuel crises era.

Bill: In historical context, this current "downturn" is milquetoast.

John: If it stays like it is, it certainly won’t rank among the worst downturns in American history, broadly speaking. In 1973-1974 and 1980-1982 things were worse with unemployment much higher. But if housing prices keep going down, and then the crisis moves on to credit cards, auto loans, etc., as some forecast -- it could be a doozy.

Jon: Reminiscent in some ways, of the early 70's, although not as bad

What does the macro economy mean to investors? Should they care? What should they do today?

Jon: They should care, but not to the point that it forces them to make a mistake. There are values out there. If they have dry powder, they should deploy some of it at current levels. They should be concerned about inflation, and hedge it (exposure to TIPS, Metals, perhaps REITS, even HY bonds). They should be well diversified across and within asset classes

George: Investors should try to have some understanding of the current macro environment. However, the focus should still be at the specific company level when analyzing various investment opportunities.

John: John Templeton died recently. Think of all the stuff that happened from the time John Templeton started the Templeton Growth Fund in 1954, to when he gave up daily management in 1987. Cold wars, hot wars, assassinations, scandals, Bull markets and Bear markets, you name it. Sure, the macro economy is important and I care about it. But the investor in me doesn’t let macro stuff get in the way. It’s mostly just noise.

Bill: Unless their system is based on macro projections, individual traders shouldn't care. I think it's unwise to base trading decisions on macro data, because it involves overlaying another set of assumptions and calculations, which gives just one more source for error. Certainly "value" based traders should IGNORE the macro data, or if they pay attention, run CONTRARY to the macro data, because the premise of "value" is that the market OVER-reacts to data. Follow the methodology.

Opportunity

Do you see any opportunities in financials? Housing? Real Estate?

George: I think it is still to early to invest in financials. It is hard to say any investment in this sector provides a margin of safety as the financial crisis continues to spread.

Jon: Definitely in real estate. I'd look at depressed companies that own land, and are not highly leveraged. Financials are still too scary for my blood.

Bill: I don't usually look at individual stocks by sectors or industry group. I'm sure there are some fine opp