The arguments for why one should sell the cat, pawn the mother-in-law and use the proceeds to buy gold are well known: The Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.   However, here are some arguments why one should think twice before jumping in bed with gold bugs. 

1. For investors (not speculators) it is very hard to own gold because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry — it costs you money to hold it.  It is only worth what people perceive it to be worth right now.

2. The gold ETF SPDR Gold Shares (GLD) is the sixth largest holder of physical gold in the world.  If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to? 

3.   In the past, gold had a monopoly on the inflation and fear trade. Not anymore.  Now you have competition from Treasury Inflation Protected Securities (TIPS), currency ETFs, short US treasury ETFs, etc.  (If you want to know more, I make this case in my book)

4.  If, because of points two or three above, gold fails to perform as expected, the perception that gold is worth something may start disappearing. 

5. Over the last 200 years, gold was really not a good investment. It may have a day in the sun, but it may not.  And the cost of being wrong is fairly high.

The best way to deal with the risks of dollar devaluation and high inflation — with a much lower cost to being wrong — is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability.  Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar. 

There is a wild card in the price of gold, though: China. If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket. (John Burbank made this case at the Value Investor Congress in Pasadena in May).

In fact, most of the gold ever mined is around today. It is exhibited in museums, worn as jewelry and buried deep in the vaults of the central banks. Peter Bernstein, in The Power of Gold, wrote:

“Despite the complex obsession it created, gold is wonderfully simple in essence. Its chemical symbol AU derives from aurora, which means “shining dawn,” but despite the glamorous suggestion of AU, gold is chemically inert. That explains why the radiance is forever. In Cairo, you’ll find a tooth bridge made of gold for an Egyptian 4,500 years ago; its condition is good enough to go into your mouth today. . . . Stubborn resistance to oxidation, unusual density, and ready malleability-these simple natural attributes explain all there is to the romance of gold.”

Despite its unique properties, gold has not been a good investment. Over the past 200 years, its returns have barely kept up with inflation. Its value has a low correlation with stocks (prices of gold and stocks move independently of each other most of the time), which is a big positive from the portfolio construction perspective; diversifying with gold can reduce a portfolio’s fluctuations(volatility). But the diversification benefit comes at a large cost: Once added to the portfolio, gold substantially reduces that portfolio’s risk-adjusted returns. Its dismal returns negate any benefit the portfolio receives from reduced volatility.

One thing about gold, however - it is real! You can hold it and touch it and see its shine. This tangibility makes it seem impervious to the whims of politics, nature and time, as opposed to paper assets such as stocks and bonds. Gold’s physical attributes attract investors during times of economic uncertainty, and so it serves a purpose in the markets and society - it is a stabilizing influence. It feels safe.

Doomsday currency

The thinking of the so-called gold bug (a believer in gold’s supremacy, a gold aficionado) often takes on a variation of this form: While in the bunker (or any other variance of the “world-falling-apart” scenario), you cannot pay for food with paper money or a stock or bond certificate. You may do so with real tangible assets, such as gold. If this scenario played out (God forbid), it is conceivable that gold could become the de facto currency. In that event, you need to have real gold in a safe or buried in your backyard. The wise gold bug would have managed portfolio risk by also investing in a good arsenal of guns, as the demise of government bonds would likely lead to the end of the rule of law as well. Gold held by your broker or through ownership of gold stocks or exchange-traded funds will not come to the rescue; these bytes and bits are not superior to default-free bytes and bits, for example, U.S. Treasuries. Canned food may actually be a better store of value in this “world coming to an end” scenario.

The ever-increasing complexity and globalization of the financial system, rapid spread of international trade and the availability of risk-free investment instruments that were not available to investors in previous economic crises may have changed investor behavior during economic doomsday times. Financial instruments such as Federal Deposit Insurance Corp.-insured checking and savings accounts, U.S. Treasury bills and Treasury inflation-protected securities may challenge gold’s status as the safest haven in times of inflationary crisis.

Treasury inflation-protected securities may turn out to be the key challenger to gold’s store-of-value supremacy status in the future. Aside from being issued by the U.S. Treasury and therefore backed by the full faith of the U.S. government, they also protect investors from inflation - one of gold’s most-valued qualities. TIPS’ principal is tied to the CPI: The principal value increases with inflation and falls with deflation. When the security matures, the original or adjusted principal is repaid, whichever is greater.

Though TIPS appear to have superior financial properties to gold, they still lack one of gold’s main attractions - tangibility. After all, they are still just bytes and bits on a brokerage firm’s or bank’s mainframe, or pieces of flammable paper stored in a safe.

Holding gold has costs

Any cash flow-generating asset, like a stock or a bond, can be valued on the future cash flows that it is expected to generate. Predicting gold prices is extremely difficult because gold is not a cash-generating asset. In fact, it is important to note that gold actually has a negative yield. Gold is a cash-consuming asset; its safekeeping and transportation cost money. TIPS, as well as any bonds and dividend-paying stocks, have a positive yield; they pay investors for holding them.

Gold is also considered a good currency hedge, especially for the U.S. investors who are concerned about the declining dollar. Again, our financial ingenuity is stealing gold’s long-held exclusivity on that trade, providing options that were not available a few decades ago. To protect themselves against the declining dollar, U.S. investors can use currency futures and options, foreign-currency-denominated mutual funds and certificates of deposit; they can buy foreign stocks on foreign exchanges or through American depositary receipts; and, of course there is a most recent development - currency exchange-traded funds.

In both the long run and the short run, gold prices are driven by fear of the world coming to an end and investors’ expectations of future inflation. Although gold has some industrial applications - in jewelry, dentistry, computers, jet engines, electronics, as a superconductor, etc. - linking its intrinsic value directly to its price is difficult. Perception of its ability to store and preserve real value, especially in an inflationary environment, is the key driver of gold’s price.

As long as investors perceive gold to be a refuge in times of uncertainty, gold will act as such. It is important to note that gold’s monopoly as an instrument of choice at the time of fear and uncertainty has been undermined by other very capable and often superior financial instruments.

Vitaliy Katsenelson, CFA, is a portfolio manager at Investment Management Associates Inc. in Denver. The above selection is an excerpt from his book, “Active Value Investing: Making Money in Range-Bound Markets,” published this fall by John Wiley & Sons.

Sun and Shadow by Naum Katsenelson

Our emotions are our biggest enemy, at least when it comes to investing.  We should all know this. If you don’t, stop making your own investment decisions right now.

Our emotions lead us to do the opposite of what we should be doing. They lead us to buy high and sell low. They make us excited when we should be scared, and scared when we should be excited. They make us slaves to the stock market; they let the market become our master.

The market is there to serve us, and not the other way around.  It is okay to have emotions; we’re human, after all. But what we really need is an investment process. This is system of rules that we follow that keeps emotion in check.

Now, I hate republishing old articles.  But a few, the ones that focus on the process,  I’ll recycle (and improve upon) for a long, long time. I wrote the following article, in 2007. I included it in my book. I’ve shared it with readers in the past. And I even wrote the flip side of it in October 2008, addressing the impact of a cyclical bear market on out psyche by cyclical bear market.

I’m not offering it now to provide a hidden message that I think the current (cyclical) bull market is over. I don’t know that.  I just want to remind you (and me) that a rising market has an impact on our psyche, our analysis and our decisions, and we need to be aware of it.

You are not as smart as you think you are;
psychotherapy for (cyclical) bull markets

Lately I’ve been getting this powerful feeling that everything I touch turns to gold. Every time I buy a stock, it goes up. Did I finally figure out the stock market game? Did I find a secret way to follow Will Rogers’ advice: Buy stocks that go up, and if they don’t go up, don’t buy them.

No, I didn’t get much smarter, and my stock-picking skills haven’t improved that much over the past year. I was simply a willing participant in the latest (cyclical) bull market. A bull market makes you feel smarter than you are the same way a bear market makes you feel dumber than you are.

Feeling smart makes you do the opposite of what you should be doing. The euphoria of the golden touch is a dangerous thing because it can make us careless. We forget about risk since we haven’t seen it in a while and focus only on the rewards. You have to actively make yourself aware of the four-letter word R-I-S-K!

How do you do that? My favorite way is to remind myself how dumb I am. I pull out an annual return report of a company on which I lost a boatload of money and masochistically try to read it from cover to cover, reliving my errors.

We all have these stocks, the ones we lost a lot of money in because we were overconfident. We tend to forget about them during a bull market. But I suggest you remember them now, so you’ll have fewer of those names to remember in the future. Risk is still there; it is just hiding under the joyful sentiment of the bull market.

Believe me, it will show its ugly face. It is just a matter of time.

Discipline counts

In a bull market, it is easy to forget about selling discipline and then turn into a “buy and forget to sell” investor. Every time you sell a stock, you look dumb because it usually goes up afterward.

I recently sold several stocks, shamelessly, paying absolutely no attention to the fact that after I sold, they went higher. I don’t feel smart about that decision. However, when I bought those stocks, I set valuation targets. When they approached the targets, I quickly reviewed their fundamentals. They had not changed much.  The decision was obvious — sell.

Cyclical bull markets teach us not to sell, while cyclical bear markets teach us not to buy.  If you let the market tell you what to do,  you have no process.

But the bell doesn’t ring when bull or bear markets are over.

You cannot worry about marking the “top” in every sell. My objective is not to buy at the “bottom” and sell at the “top.” My objective is to buy a great company when it is cheap and to sell it when it is fairly valued! I suggest you do the same.

The city revolves around its port, and its academic institutions are geared toward producing a workforce for the fishing and merchant marine industries. It was always assumed that I’d attend either the Marine College or the Marine Academy. Both were semi-military schools where the students (cadets) had to reside in dormitories, wear navy uniforms, follow strict military-like rules, and take orders from navy officers (and ask no questions).

Russia has a draft army. It is not concerned about recruiting and thus treats its soldiers very poorly (an understatement). The pay is only high enough for soldiers to afford the postage to write home asking for money. Russian youth look at serving in the Russian army as akin to a two-year prison sentence (at least when I was there). The army avoidance in the late 1980s was not about fear of death, as the war in Afghanistan was over, but came from the dread of losing years of one’s youth and the dismay of humiliation, as the older soldiers commonly abused the younger ones. My very sane friend entered a psychiatric institution and faked mental disease just to avoid serving in the army.

My father and both of my older brothers graduated from the Murmansk Marine Academy. My father, a PhD, also taught electrical engineering at the academy for 27 years. Neither my brothers nor I had any dreams about being seamen. Quite to the contrary, my oldest brother could have been a philosopher (now he is a technology engineer); my other brother wanted to be anything but an electrical engineer (he is now a successful real estate broker in Denver). Our choices were limited: either attend one of these two semi-military schools or join the Red Army.

By the time I was finishing eighth grade, the law had changed: Cadets from the Marine Academy lost their draft exemption, but college cadets were spared. I enrolled in the Marine College and dreaded every moment I spent there, but the alternative was even worse.

Aunt in Siberia

My father has two younger sisters; one lived all her life in Moscow, while the other moved with her family from Moscow to Siberia in 1979. For a long time I wondered why my aunt and my cousins in Siberia never visited or called us. It seemed so uncharacteristic of our family, who were always very close. In the summer of 1988 my father finally told me that my aunt did not really move to Siberia — she immigrated to the United States of America. My immediate reaction was resentment toward her. The first words out of my mouth were “traitor” and “spy.”

It sounds a bit silly now, but you have to understand I was a child of the Cold War. A couple of times a month my class walked to the movie theater (this was before VCRs) and watched propaganda documentaries about decaying capitalistic America, infested with the homeless, where black people are lynched, the poor are exploited by the rich, and people are poisoned by hamburgers (later, of course, I learned that the part about hamburgers was not a complete lie).

Russian movies showed Americans as evildoers, usually spies whose single goal in life was to destroy Mother Russia — the whole country was brainwashed. When I was nine years old, I attended a pioneer camp and went on a field trip. A foreign tourist, mesmerized by my smile and internal beauty (okay, that is just a wild guess), gave me bubble gum. My camp teacher, in horror, took it away, yelling that I was lucky to be alive as it was probably poisoned.

My father was not at all surprised to hear the words “traitor” and “spy” come out of my mouth. He calmly explained that despite being well educated, his sister’s family had lived in poverty because they had faced the invisible anti-Semitic wall that is so often encountered by Jewish people in Russia.

He also explained that he hid the truth about my aunt’s whereabouts from us because the consequences of the truth leaking out to local authorities would have been dire. My mother and he could have lost their jobs, and my brothers and I would never be permitted to leave the borders of the country, which for (future) seamen would have been devastating. In fact, his sister who stayed behind was demoted due to my aunt’s departure for the United States; she was deemed guilty of betrayal by association.

Shame of Being Jewish

Though my parents always tried to shield us from anti-Semitism, I was often made aware that there was something wrong about me being Jewish. Even as a little child I often encountered a second-class-citizen attitude toward me.

Nationality was a mandatory line in Soviet passports and was a required disclosure on every application. When I was seven, my parents, hoping that I had a hidden music talent (I didn’t), signed me up for singing lessons. While filling out a standard application, the teacher asked me the usual questions: parents’ names, address, phone — and then nationality. I vividly remember being filled with shame, while staring at the ground, when I said, “Jewish.”

Russia was not South Africa under apartheid regime; there was no formal discrimination and segregation towards Jews. Though Stalin was going to send all Jews to the Far East, fortunately his timely death interrupted that endeavor. I’d be lying if said that we constantly felt anti-Semitism in Russia; we did not. It had sporadically touched parts of lives; some people were impacted more than others.

We were impacted even less by discrimination than most. Murmansk was a city of immigrants, a melting pot that came to life for the most part in the 1960s and 1970s. My father moved to Murmansk in 1952 from Moscow. Despite tutoring other kids in math, he failed the math admission exam in Moscow University. Of course, the real reason for failure was his “wrong” nationality; he actually aced the exam. Murmansk Marine Academy at the time could not afford to be choosy — Murmansk was in the middle of nowhere and accepted anybody who showed up.

I always thought of being Jewish as a nationality. Until my late teens I never related being Jewish as a religious identity. My parents and grandparents were not religious. The premise behind all organized religions was “debunked” by teachers at school in Soviet Russia from first grade forward. I don’t think “the God doesn’t exist, it is all a mass delusion” lecture was on the curriculum, but it sounded consistently the same from all teachers. My father says my teachers were just a product of their environment; he is probably right.

Come to think of it, I did not know a single religious person of any religion. My parents had a lot of Jewish friends which for the most part were either teachers, scientists or doctors, and none of them were religious. In reality, the Soviets just substituted one religion for another. They wanted to have a monopoly on the real estate in one’s brain that controlled one’s life goals and ambitions, and they did not want to share it with other religions.

Coming to America

After the glasnost reform (transparency, openness) of 1985, the decades of brainwashing were slowly supplanted by the truth. In the late 1980s few people could afford VCRs, but little VCR movie theaters were popping up in basements of an apartment buildings everywhere, comprised of several TV sets hooked up to a VCR. Unlike state-owned theaters, they were not censored and had the freedom to choose their repertoire. Picture and sound quality were terrible, as VHS tapes were copied dozens of times before they made it into a VCR. Movies were dubbed by one monotone voice that translated all characters. But none of that mattered; we were hungry for variety, and American cinema was it. After watching hundreds of these flicks, it became painfully obvious that America and capitalism were not so rotten after all, and despite what my camp teacher told me, Americans did not really have any intention of poisoning little kids.

Just a few years earlier it would have sounded absurd, but after my “Siberian” aunt’s invitation in 1990, we decided to immigrate to the United States. My father saw no future for us in Russia. On December 4, 1991, we landed in New York City. Our new and in many ways harder (at least at first) life started, and we never regretted leaving Russia.

Our coming-to-America experience lacks the color and drama one would expect. Pan Am oversold its coach class, we got a free upgrade, and we flew first class from Moscow to New York. In 1991 the road to new immigrants was already paved by the hundreds of thousands that came before us a few years earlier. So with the help of my aunt and Jewish Family Service (a terrific organization that helped tens of thousands of Jewish families successfully integrate), we were able to get on our feet relatively quickly.

I discovered that my English was worthless. It was good enough to buy a pack of cigarettes but beyond that, I could barely understand anything. Americans spoke in full sentences, not in separate words. But lack of language did not stop me from visiting every neighborhood fast food establishment in search for a job. I never got the fast food job, but I did get a job at a health club folding towels and cleaning locker rooms.

TV was a great educational tool. In fact, the show Married with Children is responsible for a good portion of my day-to-day vocabulary and Al Bundy for awhile was my role model (not too long though).

When we first arrived, we were not residents of Colorado and could not afford paying out of state college tuition rates. So I found myself going to high school to learn English. This was quite a shock considering I left Russia three months before my college graduation.

The rest of my American life was fairly straightforward. I was very fortunate to discover what I wanted to do (more accurately what I love to do) — investing. While enjoying the benefits of being single and living with my parents, I worked full time and put undergraduate and graduate degrees in finance under my belt. I got married. My wife and I have, thank God, wonderful kids. I figured the best way to learn is to teach, so I started teaching an investment class at the University of Colorado and write regularly for financial newspapers and websites.

We had a lot of great experiences in Russia - mainly from family and friends. But at the same time it was also full of injustice, powerlessness, discrimination, lack of choice, and Russian-like poverty. In America, our past was a great motivator and none of the problems we encountered felt insurmountable. We feel very blessed to be here.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from Active Value Investing. Copyright (c) 2007 by Vitaliy Katsenelson

It does, and the current run-up in stocks is very positive for the economy. Here’s are three reasons why:

1. Banks can loan

Financial stocks have doubled from their lows.  This is great news for banks — they were able to capitalize on higher stock prices and issued $85 billion of new common equity in one month.  Some of the newly issued equity will go to pay back TARP money from the government; some will allow banks to boost their balance sheets so they can swallow more losses that are coming their way from mortgages, credit cards, commercial real estate, etc.; and whatever is left will go to originate new loans.

Since banks use leverage, equity funds will allow banks to generate new loans in the multiple of 15-20 times of issued equity.  Of course, banks have to be willing to lend and consumers/corporations will need to be willing to borrow, but that is a different story.

2. CEOs have reason to hope

We think of corporate management as rational, numbers-driven individuals, and some of them may be all that. But they are still just well-paid, well-dressed and well-spoken members of that species that we call humans.  As such, they are susceptible to the pressures and influences of their external environment. 

The stock market has great influence on their decisions.  The recent stock market rise  made them question how much downsizing they really want to do. In other words, in the absence of the stock market’s positive influence, management possibly would have been laying off more people that they’ll be actually laying off.

Of course, some corporate managers simply realized the impact that the stock market has on decisions of other managers and adjusted their behavior accordingly. 

3. Have job, will spend

Finally, consider the employed consumer – the driving force of the economy, the one who still has a job, the 92% of workforce.  They see the Dow climbing, hear the media going hysterical over the green shoots and hear fewer people discussing the end of the financial world. Suddenly Dr. Death (my nickname for economist Nouriel Roubini, whose more common Dr. Doom nickname was misappropriated from Marc Faber) is not as popular as he was two months ago.
These employed consumers are feeling better about their future and may actually start spending money. (Those who are unemployed are unlikely to change their behavior, as the job market is very tough.)   I don’t think we should expect a repeat of the 2000-2007 spending spree, but maybe they’ll start putting butter on the popcorn when they watch DVDs at home,

George Soros has a name for what I described above; he calls it reflexivity. To me it just sounds like a self-fulfilling prophecy – stocks go up because the economy is expected to do better, the economy does better because stocks went up.  Of course, everything I said works the other direction, too.   

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

MSFT did something very uncharacteristic. It did not push back the release of Windows 7, which will be released on Oct. 22.

Bing is excellent. I played with it for a couple of days, and it’s an “un-Microsoft-like” search engine. It is very good. Type for instance “flight from NYC to Denver“, and it will tell you that fares are predicted to rise in the next 30 days. Click on the green arrow and it will tell you everything you want to know about fares.

MSFT demonstrated Project Natal this week at the E3 tech expo. If the technology demonstrated is real, and it looks like it is because MSFT has released an SDK (Software Developer’s Kit), programmers can now start developing games and applications for Natal. Natal puts Wii’s wireless controller to shame. In fact I think it will change the gaming industry forever, and I’d be very worried if I owned Nintendo (NTDOY) stock. Natal is:

“A motion sensing device that allows you to control video games and Xbox 360 menus with your body instead of a peripheral controller. Natal gives you voice and full-body motion control over your on-screen avatar using an RGB camera, depth sensor, multi-array microphone, and custom processor running proprietary software,” writes PC World.

Finally, in a previous post I wrote that “it is believed by many that creativity retired with Bill Gates.” In response, I received a lot of e-mails saying that Microsoft never had any creativity because it never had an original product. It just took products created by someone else, improved them and marketed the hell out of them.

It is very true that even the original DOS — the one that MSFT sold to IBM (IBM) — was created by someone else. But copying requires creativity, too; otherwise, why would anybody buy your product instead of competition.

Think about WordPerfect, for example. It was a dominant product at the time. Microsoft created Word, basically a replica of WordPerfect — but a much superior replica.

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

The Rain in Rome by Naum Katsenelson

When I think of Microsoft stock, images of Susan Boyle in “Britain’s Got Talent” come to mind.  The Scottish woman appeared — middle aged, awkwardly dressed, unsure of herself, unattractive by conventional (stereotypical) standards — and expectations of her singing were in line with her appearance.  As long as she did not fall off the stage, the audience would have concluded that her performance was a success. 

If Susan Boyle was a stock, I’d call her a deep value stock with very low expectations, and thus a great margin of safety, selling at a discount to its fair value. 

Then she opened her mouth, and to everyone’s shock, this duckling had a beautiful swan of a voice.  She became an overnight sensation. The video of her performance was YouTubed more than President Obama’s inauguration. 

Then here comes Microsoft (MSFT). The company’s name doesn’t have the luster it once had.  It’s seen as middle-aged, overweight and slow, and it is believed by many that creativity retired with Bill Gates.

 The sentiment is so horrible that there is almost universal expectation that it will not come up with another good product, ever.  Kodak and Polaroid are now used to describe Microsoft’s “bright” future, and Apple and Google are the ones that will retire it there. 

But the ugly duckling is about to sing, and it will be a Susan Boyle-like performance.

Vista’s flop will lead to Windows success
Microsoft is releasing Windows 7 sometime in late 2009 or early 2010 [after I wrote the article Microsoft announced release date - October 22, 2009]. It’s last operating system, Vista was a flop.  Consumers did not care for the product and corporations did not upgrade. 

Of course failure is a relative term when it comes to Microsoft. At its release, Vista sales were double that of XP, the previous version. Vista still commands almost 24% of market share, second only to XP’s 60% plus.  

Windows 7 is not just another new release. It is really Windows Vista 2.0, or Vista-fixed, if you like.  Microsoft took Vista’s kernel – the core of the operating system — fixed it, made it faster, improved the interface and added new features, Voila, you’ve got a new multibillion dollar product.

Many corporations did not upgrade to Vista: they stayed with XP. This is now eight years old, a dinosaur in software years.  Microsoft will eventually discontinue support and updates for XP.  Unless all hackers “pinky swear” (my 8-year-old son’s favorite phrase) that they’ll not try to figure out a way to hack into the 400 million computers that run XP worldwide, a computer running could be left exposed to new security attacks. 

Corporations will not likely take hacker’s “pinky swears”, they’ll have no choice but to upgrade to Windows 7.  Also, this time they won’t have to do the usual thing and wait for Service Pack 2 — the inevitable set of bug fixes to the original product.  Vista’s Service Pack 2 is already out, and in many ways Windows 7 is Service Pack 3.  Expectations created by Vista for Windows 7 are incredibly low for Microsoft, but 7’s success is likely to be very high. 

Other reasons to go Bing
There’s more:  Aside from Windows 7, there is plenty of promise in other products that are not built into Microsoft’s stock.  Bing, a new, improved search engine, is just out and the presentation I’ve seen of it is very impressive [played with it for couple of days now, looks good].  Office 2010 will bring a subscription-based office onto the Web which may fix a longstanding consumer piracy issue.  (I personally don’t know a single person who actually bought a copy of Office for home use. Maybe I need new friends, but people just don’t want to pay $300-400 for something that we consider our birthright. )

 With Office Live, Microsoft will charge an annual fee, and you’ll get a Web product that has the same look and feel of the Office you are used to using at work. 

This ugly duckling is not hanging by a thread. Microsoft still has Windows, server products and Office, holds a leading position in gaming, generates billions of dollars of free cash flow, has $23 billion of cash and its debt will likely be trading at lower yields than Treasury’s very soon.

But the best part, there is nothing positive priced into this stock, which trades at about 10 times free cash flow.  It is incredibly cheap.  Buying it now is like a talent agent signing Susan Boyle as a client the day before she went on stage.

P.S.  Though I’ve written this article last week, before Susan Boyle lost on Britain’s Got Talent, her loss did not make the point of the article any less valid. J  In fact, I spent several hours this week watching Britain’s Got Talent on YouTube with my wife and kids.  What an incredible show.  Susan Boyle did not win, but did not lose either, she’ll will likely become a big star – she has a wonderful voice.  I’d buy her CD and go to her concert in a heartbeat. 

Position in MSFT

• Slide 17 - new slide on Japanese secular bear market
• Slide 18,19,20,21 - updated valuation data for recent stock market rise, added a new 10 year trailing P/E chart, and new reported and operating earnings expectations
• Slide 20 - brand new discussion on the role interest rates play in stock market cycles
• Slide 24 – new slide, are we still in range-bound market?

The May 2003 rally turned into a cyclical bull because the economy started to recover, but more importantly earnings growth started to outpace GDP growth (margins expanded). Today’s rally is predicated on the fact that the US is not going out of business – which is great news, but not good enough for this to turn into a sustained cyclical bull. 

Investors soon will realize that the growth prospects going forward are not 2003-2007-like. We are going through the consumer deleveraging that will depress the economic growth rate for quite awhile. I am not betting on much margin expansion for the corporate sector as a whole. Though cost cutting helps, sales growth is not there to exert economies of scale. Also, investors are still looking at past earnings as a guide for stocks’ earnings power. The cold shower of reality is that the past has passed and should force them to revalue their stocks.

Secular bull is out of the question as overall stocks are still too expensive, depending on what ‘E’ you use in the P/E. S&P 500 is around a P/E of 15-22 which is not cheap.

This is a stock picker’s market – owning stocks is not good enough, you need to own the right stocks – the ones that meet Quality, Value and Growth criteria (opens PDF). Though love of stocks is in the air, again, don’t fall in love with stocks. We are in the environment where being a buy and sell investor is paramount. It is important to sell the stock when it reaches its fair value level. Remember the ‘cyclical bull market giveth, the cyclical bear market taketh away’.

If you overpaid for a stock - in most cases that is because earnings power was overestimated or the margin of safety required was not high enough, or both. Don’t let anchoring drive your decision. ‘Anchoring’ is something that we all actively need to overcome (myself included), It is very natural but the very wrong thing to do. When we lose money on a stock we “anchor” (our sell price being based on what we paid for the stock), we feel the need to at least break even on our purchase as losses cause us pain. Thus we don’t want to sell the stock at any price below our purchase even if our research leads us to believe that the company is not worth the purchase price anymore. Forget what you paid for your stocks and revalue them again.

The Golden Sea by Naum Katsenelson

Be careful about investing your hard-earned dollars in the latest Chinese five-year economic miracle.  One should not confuse China’s latest economic growth — retail sales up 14.8 percent, industrial production up 7.3 percent and car production ahead 18 percent — with sustainable growth.

Now that the US consumer is de-leveraging and the global appetite for goods is declining, Chinese exports dropped 22.6 percent in April.

But this raises a question: How can China, a mainly export economy, continue to thrive when its exports are falling?  The answer is that today’s China is a story of two competing economies: the real economy, producing goods and services for mostly external consumption, which is declining at a tremendous rate and the government-spending stimulated economy, which is currently expanding on steroids.

The latter one is clearly winning, for now. Here is why:

• The Chinese central bank has a significant advantage over ours. The Fed can print a lot of money — and it has — but there’s almost nothing it can do to speed our spending. The Fed cannot force corporations and consumers to spend. Since China isn’t a democracy, it doesn’t suffer the problems of the democracy.
• China’s communist government owns a large part of the money-creation and money-spending apparatus: Money supply therefore shot up 25.5 percent in March. Since it controls the banks, it forced them to lend.
• Finally, China can force government-owned corporate entities to borrow and spend. And the government itself can spend quickly — which is important when trying to build infrastructure. If the Chinese government decides to build a highway, it simply draws a straight line on the map. Any obstacle — like a hospital or a school — becomes a casualty of the greater good.

The Chinese government goes to great lengths to stimulate its economy because it doesn’t have the kind of social safety net one sees in the developed world, so it needs to keep its economy going at any cost.
Millions of people have migrated to its cities, and now they’re hungry and unemployed. People without food or work tend to riot; to keep that from happening, the government is more than willing to artificially stimulate the economy, in the hopes of buying time until the global system re-stabilizes.

This type of growth is simply not sustainable, as it comes from borrowing. Its quality is low — hundreds of billion-dollar decisions made on the fly don’t inspire a lot of confidence in their efficiency. It will result in a huge pile of bad debt — forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple — there is no miracle in Chinese miracle growth, and China will pay a price — the only question is when and how much.

The Western Wall by Naum Katsenelson

As a follow up to a recent article, I had a very interesting conversation with a reader.  He argued that there is something very important and intangible that economists cannot measure.

The will of people.

That public will becomes even stronger when a country’s past is ridden with political and economic misery.  Think of Germany and Japan after World War II; their economies were in shambles. Human capital and ingenuity played much larger roles in their recovery than what we traditionally think of as capital.

In other words, economic models at the time would have predicted that those economies would not recover as quickly or as well as they did, as the models would not have accounted for the key human factor — the raw (and very selfish) drive to succeed.

The reader was making the argument that because of their poverty-stricken past, the Chinese people’s ingenuity will put their economy on a tremendous growth trajectory – just as the drive of the Germans and Japanese did for their countries after WWII.

It takes more than misery

I thought it was a very interesting observation, though I never really made the argument that China is going to fail and go back to a poorer era.  My argument is that all good things need time to rest, which is why economies are cyclical, with periods of expansion followed by recessions.  Chinese growth was very high for a very long time; now, the economy needs a good rest. But it’s not getting that because its government is afraid of civil unrest and thus is spending money at a very fast pace. 

Misery alone is not enough to fuel an economy.  Japan and Germany recovered and blossomed because they were capitalistic societies; their success is a triumph of capitalism.  China is toying with communism, socialism and capitalism, all at the same time. Unfortunately, at the time of crisis if a choice is given, government will chose the path of lower resistance — communism and socialism.  (Just think of what the U.S. government is doing today.)

The correct choice is the harder, more painful (at least in the short run) course of creative destruction: capitalism.   

Russia’s wrong turn

Russia is a good example. Russia in the early 1990s was a lot like Japan/Germany after WWII. It had a very educated population living with plenty of misery.  For a while, Russia was going the right direction, but the crisis of the late 1990s shifted the country back from democracy and capitalism toward a more command-and-control economy. 

This conversation made me realize that China’s success in the future will depend on the market system it chooses.  Capitalism lets human ingenuity prosper; communism will just cause it to crash.

In investing, it’s important to think unconventionally, to consider not just the obvious risks but the ones that are hiding around the corner.

For many investors, it seems a foregone conclusion that China will consume more stuff (energy, materials, industrial goods) in the future. So many argue that one should put money into the stuff China is going to need.

But this investment thesis will only play out if China continues to move into capitalism and current crises don’t push it down the road of the least resistance, to the tighter controls of communism.  So let me issue this warning: If you’re following the “buy what China needs” investment, theory, keep a close eye on political developments there over the next couple of years.

Sun and Shadow by Naum Katsenelson

I never write about politics.  First of all, it bores me.  Second, its guaranteed to upset about 53% of my readers, which normally I would not mind, but since I won’t be able to change their mind why bother.  Third, and most importantly, my writing is a byproduct of my investment process – I am an investor who thinks through writing, not a writer who invests.  The following article is not meant to be a political one, though I am sure it has turned out as such, but was written to defend free markets.   

 By shafting bondholders and undermining the bankruptcy system, the Obama administration may change the way investors view risk. 

On May 1, the United States took a drastic step toward becoming Russia.  Not Russia at its best, not the motherland of Dostoevsky, Tolstoy, Rachmaninoff… 

 Instead, Russia at its worst, the one that in 1917 took from the bourgeois and gave to the working class; the one that signed contracts with western oil companies in the 1990s when oil prices were low and then — in 2007 when oil prices skyrocketed – blatantly and unilaterally “renegotiated” those contracts.      

Wielding the public’s empathy as a weapon, President Obama took Chrysler from its rightful owners: secured loan holders (a.k.a. TARP-tainted banks, the “evil” hedge funds, faceless pension funds).  And he gave it to struggling, very sympathetic, $40-an-hour earning (including benefits, this is not a typo), blue collar workers — Chrysler’s employees and the United Auto Workers union.  Chrysler, simply, was stolen from its rightful owners. 

Fixed-income investors spend an enormous amount of time studying bond covenants, which spell out how assets are disbursed in the event of a bankruptcy.  Secured senior lenders have dibs on the secured assets; unsecured, junior bondholders and loan-holders follow (as a part of leveraged buyout Chrysler had no unsecured outstanding bonds or loans); unions and employees are next in line; and equity investors get whatever is left, which in this case would be almost nothing. 

The White House fish-fry

For two hundred years our country has had a well functioning bankruptcy-court system that was designed to make sure that division of assets is equitable. Now that system is threatened.

The banks, the ones that received billions of Federal funds, were forced to give up their legal ownership first.  Were they told they would fail the recent stress tests (which they recently passed) if they didn’t give up their rights? Or maybe their CEOs were told they’ll be fired if they did not go along? These days you don’t have to be a conspiracy theorist to make these accusations. After all, then-Treasury Secretary Hank Paulson and Federal Reserve Chairman Benjamin Bernanke used the latter tactic to get Ken Lewis, CEO of Bank of America, to lie to his board and shareholders about the purchase of imploding Merrill Lynch.  We may never know what happened, but I’ll promise you this — banks did not walk away from billions of dollars of the desperately needed money, not at their own will. 

After the big fish were fried, President Obama went after smaller loan-holders — he called these hedge funds and pension funds “speculators” — who put up a fight.  Those institutions were not tainted by TARP money, thus the president had to use populist rhetoric, saying that they “endanger Chrysler’s future by refusing to sacrifice like everyone else.”  He turned public opinion against the loan-holders, whose only fault was that they financed the dysfunctional automotive sector for too long and maintained fiduciary duty to their investors by attempting to collect what was legally due. 

President Obama is popular and hedge funds are not. Thus as the financial and political costs became too high, these smaller fish jumped into frying pan with the banks.  The fact that these pension funds and hedge funds invest money for regular folks like you and me is ignored. Average Joes aren’t paying close enough attention to catch that little detail; and unlike the UAW, they did not bankroll Mr. Obama’s campaign. 

Losing the empathy contest

The consequences of what took place May 1 are not immediately apparent, but there are consequences.  Forget about right or wrong, forget about politics: If any other President had done what Mr. Obama did you would have been reading the same thoughts from me.  The rule of law, the bedrock of our system was chipped last week. Instead of company ownership being redistributed based on the provider’s place in the capital structure — as the law requires — the asset redistribution took place based on a very subjective criterion, empathy. Banks, hedge funds and pension plans don’t win empathy contests these days, especially when competing with down-and-out workers.

 President Obama’s actions will have a twofold impact:

•  First — and this is certain — they impaired auto companies’ ability to borrow from the fixed income market for at least a generation, and that’s regardless of whether they have secured collateral. A fixed-income investor, when pricing a security, makes certain assumptions of recovery based on the collateral and its place in the capital structure in the event of bankruptcy.   The better the collateral and the closer it is to the front of the capital structure, the less money they stand to lose, and thus the lower the interest rate they expect to receive.  In the case of Chrysler, loan holders expected to recover around 70-80 cents on the dollar if the letter of law was followed. After the company was given away to UAW, however, that number dropped to 29 cents. Would you buy an auto company’s bonds in your retirement account if you knew that this industry often flirts with death, the rule of law is suspended and empathetic workers take your money if/when things go wrong?  

• The second impact is more significant to the US economy, but will depend on future government actions.  If the empathetic distribution of wealth stops with the auto industry, investors may look at it as a one-off deal, specific to the dysfunctional auto industry.  But if Mr. Obama repeats this even once outside of the auto industry — and he’ll have plenty of chances as we are in a prolonged recession — the political risk of the US will increase.  Lenders, be it bond or loan holders, will lower recovery assumptions for even very secured assets, and the risk premium and thus borrowing costs will rise for all companies.Empathy is an honorable emotion, we feel bad for people losing jobs, but changing the rules, in this case the law, in the middle of the game in most developed countries would be considered criminal, shortsighted and not good for the system.  If you don’t trust the rules, you cannot play the game.  I hope our president stops while he is behind.

 Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

Israel Old Ruins by Naum Katsenelson

There is a tremendous misconception that leveraged (double, triple, long or short) ETFs are to be used as long-term investments.  On the surface they make a lot of sense.  You want to hedge your stock portfolio, for instance, you buy a double short ETF of the market SDS (double short of S&P 500) or QID (double short of Nasdaq 100) and for each 1% decline of the market you make 2%.  It does sound like a great deal.  Leveraged ETFs have been sold as panacea to this market volatility, but panacea they are not.   If used as investment (not trading) vehicles they may cause a lot of harm to your portfolio even if you were “right” on their use.  They should not be used as a long term investment, but only for short-term trading (i.e. days not months).  

Daily compounding (recalculation) will cause their returns to deviate substantially from the underlying index.  The math is too complex and too boring (here is an article by Morningstar that explains this well), but instead let me demonstrate by this very real example (click here to see the chart ).  Let suppose that six months ago you had a great insight that financial stocks will decline.  You figured to get bigger bang for the buck you’ll buy a double short of Dow Jones Financial Index (a simple plain vanilla long ETF for this index goes by symbol IYF).  The index and thus IYF declined almost 20% in six months thus you’d expect your double short (SKF) would be up about 40%.  However, if you look at the chart below you’ll see that it declined almost 60% instead, as much as double long ETF (UYG) of the same underlying index. 

Note that over the short term (days) these ETFs seem to work.  This is one of those investments where you have to make sure that you nail the timing perfectly, otherwise you are screwed.

P.S. I am off to Omaha for the Berkshire’s annual meeting. As I mentioned before, several friends and I are meeting up for a very informal cheap talk and water at the Double Tree hotel from 1:30 to 4pm on Friday (May 1st).  If you are in the area you are welcome to join us.  After I return home from Omaha on Sunday, I’ll spend 12 hours with my family and  then jump on the plane to Pasadena where I’ll attend the Value Investing Congress (VIC).  It is a terrific, must-attend event and a great source of investment ideas.  In fact one of the stocks that was presented last  year we are buying today – it takes a long time to process information I guess.  I presented to VIC last year (here is a link to that presentation).  Things did change in a year – a lot. I’ll be back on Wednesday. 

My religious Jewish wife wants me to wear a surgical mask while I travel due to the non kosher (swine) flu.  I am not sure if her trouble with the flu has to do with the fact that it is non kosher or because it kills people or both (she swears it’s the deadly part).  I figure I’ll wear a bandana and a cowboy hat instead of a surgical mask, so people will think I am a Jewish/Russian cowboy, not just a sissy who is scared of a deadly flu.     

I know it is not the name of the final product, and I am probably reading too much into it. But “Pink” doesn’t inspire employees to create a product that will challenge a market leader.

Three Colors of Life by Naum Katsenelson

Mr. President is facing the first econ lesson of his presidency. According to a New York Times article Mr. President is trying to figure out what to do with shortage of doctors. He said “we are not producing enough primary care physicians”.

Education is expensive, consumes a lot of time and the payoff is not worth the trouble. This is a very early wake up call on socializing medical care in the US.

The econ lesson? When you lower the price you get less of it. This is a good preview of what will happen to little chemical compounds we call legal drugs that save millions of lives every day if you start instituting price controls to “protect” people from “evil” pharmaceutical companies.

After the Rain by Naum Katsenelson

One more bubble, please.

After the bubbles in technology, housing, and commodities, we saw the mother of all bubbles: the one in global liquidity. The world economy seemed to require bubbles for its continued functioning.

I get the distinct feeling that investors’ prayers are now being answered: There’s a new bubble now - or an old one is being re-inflated, depending on your perspective even as I type this. I’d like to call it the Troubled China Revival Program (TCRP).

Why start reserving bubble-naming rights? Well, I recently received an email from a friend that had the following subject line: “China … Record Loan Addition, Record Money Supply, Record Auto Sales, Record Imports of Copper, Iron Ore, and Coal, Strong Property Sales.”

I checked every figure (the hyperlinks above are mine), and every single one checked out. I couldn’t quite believe what I was reading. I had thought China was in a spiraling-down recession. But even the decline in electricity consumption — a true gauge of economic growth — decelerated from 3.7% in January and February to a mere 0.7% in March.

So is China really the first nation to rebound? Is this the first sign of a rebounding global economy?

I’m sorry to say that the answer to both questions is no.

China’s fortunes over the past decade remind me of Lucent Technologies in the 1990s. Lucent (now Alcatel-Lucent (ALU)) was selling equipment to dot-coms. At first, its growth was natural, the result of selling telecom equipment to traditional, cash-generating companies. Thereafter, it was only semi-natural: Dot-coms were able to buy Lucent’s equipment only by raising money through private equity and equity markets, since their business models didn’t  factor in the necessity of cash-flow generation.

Funds to buy Lucent’s equipment therefore quickly dried up, and the company’s growth should have decelerated or declined. Instead, Lucent offered its own financing to dot-coms by borrowing and lending money on the cheap to finance the purchase of its own equipment. This worked well enough - until the time came to pay back the loans.

The US, of course, isn’t a dot-com. But a great portion of our growth came from borrowing Chinese money to buy Chinese goods - which means that Chinese growth was dependent on that very same borrowing.

Now the US (and the rest of the world) is retrenching, corporations are slashing their spending, consumers are having moments of sickening recognition - and the consumption of Chinese goods is on the decline. This is where my dot-com analogy breaks down. Unlike Lucent, China has nuclear weapons. It can print money at will, and can simply order its banks to lend; this is a communist-command economy, after all. Lucent is now a $2 stock - but China won’t go down that easily.

Let me explain: The Chinese central bank has a significant advantage over ours. Mr. Bernanke and company may print a lot of money (and they did), but there’s almost nothing they can do to speed the velocity of money: They simply cannot force banks to lend without nationalizing them (and only the GSEs have been nationalized). They also cannot force corporations and consumers to spend. Since China isn’t a democracy, it doesn’t suffer the problems of one.

China’s communist government owns a large part of the money-creation and money-spending apparatus: Money supply therefore shot up 25.5% in March. Since it controls the banks, it can force them to lend (which it has also done.)

Finally, they can force government-owned corporate entities to borrow and spend. And the government itself can spend quickly - which is important when trying to build infrastructure. This isn’t some slow, touchy-feely democracy: If the Chinese government decides to build a highway, it simply draws a straight line on the map. Any obstacle – like a hospital, a school, or a politburo member’s house — can become a casualty of the greater good. (Okay - maybe not the politburo member’s house).

Though China can’t control consumer spending, the consumer is a comparatively small part of its economy: Currency control diminishes the consumer’s buying power. All of this makes TARP 1 and 2 look like child’s play. If China wants to stimulate the economy, it does so - and fast.

That’s why we’re seeing such robust economic numbers.

China doesn’t have the kind of social safety net one sees in the developed world, so it needs to keep its economy going at any cost. Millions of people have migrated to its cities, and now they’re hungry and unemployed. People without food or work tend to riot; to keep that from happening, the government is more than willing to artificially stimulate the economy, in the hopes of buying time until the global system restabilizes.

It’s literally forcing banks to lend - which will create a huge pile of horrible loans on top of the ones they’ve originated over the last decade (though of course we can’t see them). Don’t confuse fast growth with sustainable growth. As I’ve discussed in the past, China is suffering from Late Stage Growth Obesity. A not-inconsequential part of the tremendous growth it’s seen over the last 10 years came from lending to the US. Additionally, the quality of late-period growth was, in all likelihood, very poor, and the country now suffers from real overcapacity.

As a US taxpayer, I’m delighted to see the Chinese economy coming back to life. A new bubble in China means the US government will have to spend fewer taxpayer dollars on the bailout (or will at least borrow less money from the Chinese). Furthermore, the Chinese are an extraordinary potential market for American goods.

Identifying bubbles is a lot easier that timing their collapse. But as we’ve recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer inflated prices persist, the harder they fall when financial gravity brings them back to earth.

Another casualty of what’s taking place in China are US interest rates. China is the largest holder of US Treasuries. China sold us goods; instead of driving the US dollar down and the renminbi up – as would be the natural order of things –  China parked its money in the US dollar via Treasuries. This artificially propped up the dollar vis-a-vis the renminbi.

Now China needs to stimulate its economy. It’s facing a very delicate situation indeed - which is a nice way of saying that China’s screwed. China needs the money internally to finance its continued growth. However, if it were to sell dollar-denominated treasuries, several bad things would happen. Two come immediately to mind: 

1. Its currency would skyrocket - not good for China, because it would lose its (relatively) competitive low-cost producer edge.

2. US interest rates would go up dramatically - not good for the US (its biggest customer), and therefore, not good for China.

This is why China is desperately trying to figure out how to withdraw its funds from the US dollar without driving the dollar down. Good luck with that.

And the US government isn’t helping: It’s printing money and/or issuing Treasuries at a fast clip, and needs somebody to keep buying them. If China reduces or halts its buying, we may be looking at high interest rates, with or without inflation.

The latter scenario worries me most.

Preparations included a visit to my doctor where I paid $285 for three vaccinations against hepatitis, tetanus and typhoid. My wife packed me antibacterial wipes and gave me clear instructions: “Wipe your hands every time you touch anything.”  

Images of dirt roads, AIDS, food-deprived kids, militants with AK-47s, and general lawlessness were circulating in my head, and on some very subconscious level I was saying final goodbyes to my wife and kids. I was going to South Africa. 

Ignorance is bliss. With hindsight, my expectations were so low that the presence of semi-paved roads would have elicited a positive surprise. The South Africa I found was not dominated by shades of brown, the color of sand and poverty that were imprinted in my head about Africa. The South Africa I found was bright green, blue and white. If it was not for the cars driven on the “wrong” (left) side of the street, a gift from the U.K., you’d confuse it with Southern California (Santa Barbara comes to mind especially).

The roads are in far better shape than in most cities in first world countries. Neatly manicured grass and palm trees and endless vineyards are responsible for the rich green colors. White is the color of waves bathing the coasts and the color of European-style buildings that are in perfect shape. Blue, the color of two oceans (Indian and Atlantic) surrounds the Cape, meeting at the Cape Point, and of course is the color of the bright blue sky.

 This is the view that you’ll get of Cape Town and the Cape if you only stay on the major roads and only visit the tourist areas. Until the early 1990s you’d see this side of the country only if you were white. If you were black, colored or Indian this paradise was off limits. The slums, poverty, humiliation, and treatment as a second class citizen were your domain. Whites controlled the country.

 Until the early 1990s, South Africa was governed under apartheid. Instituted in 1948, apartheid was a version of modern day slavery. Though individual black people were not per se owned by white folks, white people as a class dominated non-whites. People’s treatment and their rights were based solely on race. They were divided into four categories. Whites, about 15% of the country, had all the rights and ran and owned the country. Blacks, 80% of the population, involuntarily segregated to live in ghettos, also called townships, had no right to vote, were kept for the most part uneducated or were provided only vocational education, and were treated as sub humans. Blacks were not free to roam around the country; they needed a special travel document that allowed them to travel between ghettos and their place of work. Colored (mainly Indians) accounted for the remaining 5% of the population.

Even more disturbing was that people’s rights varied based on skin color–the more white blood you had in you the more rights you had. Black people had no rights at all, colored and Indian had slightly more rights. The definition of colored in South Africa is someone of mixed race between white and black. There was even a special commission in South Africa that determined a person’s official color (race). In one year, thousands of people would change their color in their official documents through that commission. None went from black to white or white to black, most of the changes were (”upgrades”) from black to colored or colored to white.

 In the early 1990s the country was ready to explode; modern day slaves got fed up with apartheid. They started demonstrations which spilled into violent confrontations with the government. They demanded equal rights and the release of their leader, Nelson Mandela, who at the time had been in prison since the 1960s. The government resisted at first, blood was spilled, but out of fear of a nationwide uprising Nelson Mandela was released. Negotiations between him and F. W. de Klerk, South Africa’s newly elected president, began as result. Apartheid was dismantled, equal rights for all races were established and black people voted for the first time in the 1994 elections. Nelson Mandela was elected president.

 Then amazing transformations began in South Africa.

 Nelson Mandela’s actions after he became president are fascinating to me. This is a person wrongly imprisoned for 27 years by white people, who now had effective control of the country, as his party controlled over 65% of the votes. He did not seek revenge. He did the unthinkable–he united the country. It would have been easy for him to go after his oppressors and try to socialize wealth. After all, a small minority of the population controlled all the wealth of the country. What is easier than taking wealth from the rich oppressors who had gotten rich on the backs of slaves, and distributing this wealth to the poor? Though it would have been the easier decision, it would have been the worst decision for the country and for all races. This type of thinking sent Zimbabwe (South Africa’s northern neighbor) back to the proverbial Stone Age. White people would have fled the country and the new owners of businesses and land) would not have known what to do with it, lacking the skills and experience to manage it.

 Mandela and de Klerk received Nobel peace prizes for their roles in the transition. Mandela united a country that was deeply divided, prevented bloodshed in a time of great risk for civil revolt, and put South Africa on the right course to strengthening democracy and capitalism.

 With that historical backdrop, let’s get back to the trip. At first I was touched by the beauty of South Africa, especially the pulchritude of Cape Town; at least the parts visible to a tourist. But as I learned more about the country, I was deeply touched by its transformation from modern day slavery to a capitalistic democracy where everyone enjoys equal rights. Now, people of all races are an equal part of the country that used to be controlled by a relatively small minority.

 South Africa has the most robust economy on the continent, which is kind of like being the best baseball player on a minor league team. After all, the majority of its neighbors are embattled in civil war or suffering from the last one. A peaceful transition from one of the worst civil rights abusers on the continent to a model for other nations, spiked with a healthy dose of capitalism and democracy, has given this country a chance to be a formidable competitor in a more serious league.

 Don’t assume that South Africa doesn’t have problems; it has plenty. Official unemployment is running at 25% or so, and the unofficial number is a lot higher, closer to 40%. The country still has to make up for the hole in education created by apartheid, but the situation is improving dramatically for blacks. People with means, still predominantly white, have access to better private education, but government sponsored programs have made huge leaps since the 1990s.

 While in Johannesburg, I visited the infamous slum of SOWETO, which stands for South Western Township. It is probably the most well known township, as guided tours go there twice a day, and it was the residence for the most famous person on the continent, Nelson Mandela. His house has been turned into a museum.

SOWETO, just like other ghettos created by apartheid, is still around but the contrast in its transformation is very observable. The shacks and matchbox houses (the size of a two car garage) are gradually being torn down and replaced by government built housing. That did not impress me much, as this new housing reminded me of socialist Soviet Union government built houses. You could call them “architectural terrorism.” They were probably designed by Stalin’s or Khruschev’s favorite architect. They were identical ugly ducklings and made all cities look blandly the same.

 What amazed me about SOWETO were the beautiful, privately owned houses that are being erected in the township. The contrast of shacks, government built houses and beautiful new little mansions located side by side is quite a view. Though a lot of non-whites still live in townships, they do it by choice and can buy or build a house in any neighborhood, including previously white-only areas.

Crime is high in South Africa, as poverty is still much, much higher than in developed world countries. I was told not to walk on empty streets at night even in safe neighborhoods. But as long as the country remains on the road of democratic capitalism, the poverty will decline and the crime rate will follow. Most of the houses in semi-wealthy (non-township) neighborhoods have fences topped by electric wire. While crime is an issue, I did not see a single electric fence in SOWETO. Of course, there is little to steal from the shacks of poor people, but the electric fences were even missing around the wealthy houses. I was told that if you try to rob folks in SOWETO they don’t call the police, they just shoot you.

 Politically, South Africa is only slightly more dysfunctional than the rest of the world, even the good old U.S. of A. All corruption charges against Jacob Zuma, a leader of the majority party and likely to become the next president, were withdrawn by a high court (before the case went to trial), and he was acquitted of rape charges in 2006. Most people in South Africa believe that he was guilty, but they’ll never find out, as the case never went to trial. This sounds horrible, but then our senator from Alaska was almost reelected in November after he was convicted of bribery, and then all the charges were dropped in April by the U.S. Attorney General.

 Today, South Africa is still battling with discrimination, but a different one–reverse discrimination. Its version of affirmative action is called black economic empowerment (BEE). Blacks, colored and Indian candidates must be given preferential treatment when hiring decisions are made. As my white South African friend put it, this is a small price to pay for a bloodless revolution that has taken place in the last two decades. I agree that neither BEE, nor affirmative action, is good for the economy or the race they try to promote. I had a very pleasant two-hour conversation on the plane from Cape Town to Johannesburg with a very bright (I mean smart here) black woman who is online marketing manager for LG. She resented BEE because it created a perception that she was hired not based on merit but on color.

 BEE is not good for South Africa, though it was a sacrifice needed to appease population that has been oppressed for a long time. It is by far not the worst that could have happened, but it does produce a “brain drain,” as well-educated, skilled workers are leaving the country.

 I’ll be watching them with great interest to see if South Africans still vote in this election along racial lines. The African National Congress, the party of Nelson Mandela, has been ruling the country since 1994. Absolute power corrupts absolutely and thus many perceive this party as being corrupt. Though ANC and its current leader Zuma are expected to win, this year ANC has a new challenger, the Congress of the People (COPE), a party that was started by ex-ANC members who are respected by non-whites. The emergence of COPE provides a hope (I know it rhymes) that presents a formidable opposition force that might prompt ANC to clean up its act.

South Africa’s success in the future will be determined by several factors:

• The country’s ability to remain a capitalist, free market economy. It has a long history of this, along with a Roman-Dutch-English legal system and property laws. 
• Maintaining democracy and equal rights. This is the country’s biggest test. If it maintains equal rights for all races, in this case especially for minority whites, it will stop the “brain drain” and people who left may actually return. 
• Educational achievement. Apartheid has kept 85% of the country intentionally uneducated. Education will solve a lot of the problems in South Africa. Unfortunately, it is a slow process that requires substantial upfront investment and a long-term payoff period.

The history of the continent doesn’t bode well for South Africa’s future. It is full of starts and failures, riddled with examples of what not to do. So far, South Africa has defied the continent’s history. Hope is the word that describes South Africa and its transformation from what appeared like a hopeless situation in 1990s to by far the most progressive political and economic force in Africa. It gives me the feeling that almost anything is possible.  

Click here to see pictures from this trip (opens PDF).

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo. He teaches a graduate investment class at the University of Colorado at Denver and is the author of Active Value Investing: Making Money in Range-Bound Markets (Wiley 2007).

I am sure this will be a very popular with voters, but it is horrible for banks, the economy, and the population whom Mr. Obama is trying to “defend.” When you lower the price of something you’ll have less of it. But maybe all this won’t matter in the short-run as consumers are deleveraging and paying off their debts.

The lesson is: if you screw up, screw up big, drive your bond prices into the ground and voila your profitability increases.  Seriously, that is what happened to Citi last quarter.

Blossoming Lilac by Naum Katsenelson

After muting CNBC for years, I turned it on by accident yesterday and learned something very interesting. The gold ETF (GLD) is the 6th largest holder of gold in the world - the whole world, even ahead of China.  When investors buy GLD they have to go out and buy gold driving up the prices. This raises a little question - who will be buying this gold from GLD when investors will decide to sell it?

Gold is one of those weird assets where nobody knows what it is really worth. You cannot run discounted cash flow analysis to value it - it has no cash flows. It is an asset where perception and reality are deeply intertwined.

Investors buying the gold ETF (GLD) are influencing the price of gold which is fair for the most part as otherwise they’d be buying the real thing. Though of course the ease of buying GLD creates a slightly higher artificial demand, but still it is fair game.  The violent sell off in GLD will drive the prices of gold down dramatically unless a real buyer steps in (like another government sick of owning the US debt for instance) and the gold price could get cut in half overnight. Suddenly perception of not being a store of value will create a reality of gold not being a store of value. The gold game will be over.

This made me think that I should either update the book (write a second edition) or write a series of articles to address the following two questions: Are we still in the range-bound market I described in the book? How should investors change/readjust strategy investing in this environment?

In the mean time I wanted to ask you this: what would you like to see in the second edition of my book. Tell me what you think. Don’t hold anything back. If you think I should shut up and stop writing, tell me this too.

CEOs, who despite the appearances, are as human as everyone else may decide to postpone or at least reduce the speed of job cuts as they start taking cues from the stock market.

Thus this stock market rally (if not followed by a sharp decline) may actually help the economy, at least in the short run.

I’ll be attending Berkshire Hathaway’s annual meeting at the beginning of May.  After attending it last year, I had serious doubts about returning.  The Q&A session, which is really the reason to attend and consumes three quarters of the meeting, was not very fruitful.  Questions asked by attendees were “dumb” - Charlie Munger’s words, not mine.  The majority of questions had nothing to do with Berkshire and addressed important investment topics like Buffett’s “relationship with Jesus” (no kidding) and tips on how to look for a job.  Buffett is great, brilliant, we love him but he is not God.  I was surprised last year’s questions did not ask him for advice of how he would do brain surgery.  I’ll stop here….   However, Buffett, being a smart fellow and all, changed the format of Q&A this year.  This year questions will be submitted ahead of time to three reporters and thus will go through the process of un-natural selection, which in this case is a good thing.   

The BRK annual meeting turned into a value investing social gathering.  It does provide a great opportunity to meet, debate, learn from, and, this year, sympathize with other value investors.  I’ll have a couple of free hours on Friday.  You are invited to join me and couple of friends for cheap talk (we are value investors after all) and drinks (mostly water with no ice - value investors cannot afford anything else in this market).  We’ll be at the Double Tree hotel bar area on Friday, May 1st, from 1:30 to 4pm.  Nothing formal, just like-minded folks getting together for a chat.

In addition I’ll attend the following events:

·    I’ll stop by Dairy Queen on Friday night to sign books.  But more importantly I am looking forward to meeting other authors who will be there.  I am especially looking forward to meeting Jeff Matthews in person (we exchanged emails over last five years, but never met).  Jeff wrote a must read book on Berkshire and Buffett.  It was not another biography, but the most insightful, and very critical (fair and balanced) analysis of Buffett and Berkshire I’ve ever read.  I recommend this book strongly to everyone. 

The authors of two other books that I believed were excellent will be at the signing.  Robert Cialdini’s Yes! I’ve read many books on behavioral finance, this one is top notch.  Pat Dorsey’s The Little Book that Builds Wealth is a must read as well, he took well known concepts from Michael Porter’s competitive strategy and added a lot of value and great examples of how to apply them to company analysis. 

·    Yellow BRK’s Group, here is more information, Friday 4pm

·    Graham and Dodd Investing reception, here is more information on Saturday 4-6:30pm.

·    Tom Gayner’s of Markel Sunday brunch presentation (804-747-0136 for more info)
 

Here is more information about DQ event:
OMAHA–Start your “Woodstock of Capitalism” experience with an exercise in good taste: Enjoy a free ice cream cone at the West Dodge Dairy Queen, 404 N. 114th St. (at Dodge) from 8:30 pm until 10 pm on Friday, May 1.

The reception, now in its 11th year, will also give you a chance to visit with a Warren Buffett CEO and several authors:
·    Glen Arnold, The Financial Times Guide to Value Investing, (FT Press)
·    Bill Buffett, Foods You Will Enjoy - The Story of Buffett’s Store
·    Randy Cepuch, A Weekend With Warren Buffett (Perseus)
·    Bill Child, How to Build a Business Warren Buffett Would Buy: The R. C. Willey Story (Shadow Mountain)
·    Robert Cialdini, Influence (Collins); Yes! 50 Scientifically Proven Ways To Be Persuasive (Free Press)
·    Patrick Dorsey, The Little Book That Builds Wealth (Wiley)
·    Vitaliy Katsenelson, Active Value Investing (Wiley)
·    Janet Lowe, Warren Buffett Speaks, Damn Right: Behind the Scenes With Berkshire Hathaway Billionaire Charlie Munger, Google Speaks (Wiley)
·    Jeff Matthews, Pilgrimage to Warren Buffett’s Omaha (McGraw-Hill) 
·    Robert P. Miles, 101 Reasons to Own the World’s Greatest Investment; Warren Buffett CEO; and Warren Buffett Wealth (Wiley)
·    Janet Tavakoli, Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street
·    Timothy Vick, How To Pick Stocks Like Warren Buffett (McGraw-Hill)

No reservations are necessary, but you’ll need to show your annual meeting credentials for an ice cream cone, compliments of John Wiley and Sons Publishers. Other DQ products will be available for purchase. This event is also sponsored by The Reader, The University of Nebraska at Omaha College of Business Administration and the Omaha Airport Hudson Booksellers. Hope to see you there. More info and directions