Buffett & Aesop

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“The oracle was Aesop and his enduring, though somewhat incomlete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now posess that should be offered for it.”

Warren Buffett

Berkshire Hathway, Annual Letter to Shareholders, 2001

Munger on the Proper Discount Rate

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Questioner: When you try to arrive at the valuation number using the discount rate…

Munger: Your opportunity cost is so great. Considering everything else, you should forget about it. Most people don’t pay enough attention to opportunity cost. Bridge players know about opportunity cost. Poker players know about opportunity cost. American faculty members and other important people, they hardly know their ass from a plate of hot squash.

We don’t use numeric formulas that way. We take into account a whole lot of factors. It’s a multifactor thing. There are tradeoffs between factors. It’s just like a bridge hand. You have to think of a lot of different things at once.

charlie-mungerThere’s never going to be a formula that will make you rich just by going through some little process. If that were true, every mathematical nerd that gets A’s in algebra would be rich.

Charlie Munger

Thanks to Farnam Street
(C) 2016 FARNAM STREET MEDIA INC.

Imperial Bedrooms

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Elvis Costello is one of the most gifted lyricists of our time. His prolific run of albums between 1977 and 1983 rank among the most memorable song collections in music history.Attractions

With the passing of one of Costello’s many collaborators, Allen Toussaint on November 10, I thought it was worth tossing in my two cents on Costello’s masterful memoir Unfaithful Music & Disappearing Ink.

Here are ten points on the book. Much more in depth reviews are available elsewhere.

  1. Buy the audiobook. It is narrated by Mr. Declan McManus himself. He alternates between his Liverpudlian lilt and west London twang as the story requires. He is animated and brings the fantastic prose to life.
  2. The book is at its best when Costello discusses the inspirations for his songs. The studio crafting of Imperial Bedroom is particularly mesmerizing.
  3. The book is not totally chronological. This adds a unique series of tangled webs throughout the book that is far more colorful than a straight passage through time.
  4. McManus’ father Ross is an ever-present character. His long career as a performer in the Joe Loss Band exposed young Declan to the rigors of show-business and the glories of performance. The grind-it-out schedule and his frequent absence are sources of pain for both father and son alike.
  5. Like me, Costello needed an editor. I will admit that I didn’t finish the book which clocks in at over 600 pages. His relationships with Paul McCartney, Bob Dylan, Burt Bacharach, George Jones, among others, are interesting but these chronicles eventually become tedious. Costello’s encyclopedic knowledge of music is, however, incredible.09BOOK1-master180
  6. Britain in the Thatcher era is on full display. The miner’s strikes, the hopelessness of youth, the sense that one can’t rise above a working class level are palpable. If anything, Costello downplays his own rise from country western pubs to American tours and record deals. He worked hard.
  7. The Attractions get short shrift. The relationship is strained between the quartet, but we never really get to the core issues. Steve Nieve, Bruce Thomas and Pete Thomas are genius musicians and they deserved far more attention.Nieve
  8. Costello gets off a little easy when he talks about his failed relationships. His allusions to affairs and bad behavior are not explicit enough for a true memoir.
  9. His explanation of his most controversial moment: alleged racist comments made in a Columbus, Ohio bar during 1979 about black music luminaries such as Ray Charles gets an impassioned defense, but it feels like he performs an escape act rather than uncovering a full character analysis. In Costello’s defense, this topic has been Beaten to the Punch like a King Horse over decades. Its been so debated and discussed that it really is last Year’s Model. There is no question that Costello more than made up for his possible transgression: The influence of R&B is significant throughout his catalog.
  10. Did we really need all that Brodsky Quartet information? Snooze.09BOOKCOSTELLOJP3-articleLarge

Anyone who appreciates Costello at his peak, knows that his true gift to the music world was (is?) the ability to wrap up biting sarcasm and satire in the sweet and sugary beauty of a pop hook (just listen to Get Happy and you’ll find 20 songs that hit on all Five Gears – not in reverse). Unfaithful Music delivers the background for these awesome songs. The Beatles loom larger than expected (and why wouldn’t they?). The bitterness of politics (Radio Radio, Oliver’s Army) and misguided relationships (The Long Honeymoon, Man Out of Time) are laid bare in these pages.

Pension Fund Fantasy: Omaha’s 8% Return Projection

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Omaha is not unique among municipalities across the country – deals cut with workers many years ago have left pension funds well short of money needed for retirement benefits. The shortage has cost Omaha it’s top municipal bond rating and has driven Chicago – the nation’s most egregious offender – to the brink of bankruptcy.

It’s time for the City of Omaha to level with unions and citizens and admit that it’s 8% return projection for the future is a mathematical impossibility.

Today’s World-Herald:

The city expects a return of about 8 percent each year. In 2014, the fire and police pension fund returned 4.9 percent and the civilian fund 5.5 percent, according to annual performance appraisal reports for the funds.

pensionsgraphic

Let’s start out with how the pension fund managers performed over the past two years, because frankly, its hard to fathom. If you try to “back in” to the portfolio allocation, some weird numbers emerge:

First of all, let’s assume that the City of Omaha is smart enough to follow John Bogle’s advice and put its money in low-cost funds that track the indexes. If the City is paying anything more than 1% to have someone manage the portfolio, it is an outlandish fee and further detracts from the struggling performance. That’s an argument for another day. Let’s stick with the passive formula assumption for now…

In order to have generated a 16.2% return in 2013, the fund would have allocated roughly 33.7% of its money in bonds. Let’s say they went with the biggest option and chose the PIMCO total return bond fund. It was a bad year for Bill Gross and prompted his departure to Janus as the fund returned -1.92%. But don’t fret Omahans, the remaining 66.3% of the portfolio invested in the S&P 500 index would have returned 26.39% in 2013. Thus, for the year, the fund still generated an outstanding 16.2% return in 2013.

But if you apply the same asset allocation assumption to 2014’s numbers, the performance breaks down. PIMCO’s broad based bond fund bounced back and delivered a 4.69% return. Meanwhile, the S&P 500 continued its bull run and advanced by 12.39%. Based on the same allocation weighting at 34/66, the pension fund should have easily turned in a gain of 9.8%, not 5.5%. The only way this 5.5% performance could have occurred is if the managers shifted almost 90% to bonds or made the even-worse decision of holding straight cash in a large portion of the portfolio. The pension manager should be called on the carpet.

The questionable 2014 results notwithstanding, reaching an 8% return assumption will be a virtual impossibility going forward:

First, you have the problem of rolling bond maturities. Assuming the pension fund bought some 30 year treasuries back when rates were north of 10% means that as those bonds reach maturity, those funds have no place to go but lowly 2-4% yields.

Second, if bonds are 34% of the portfolio and a PIMCO-esque fund runs at a typical 100 basis points over treasuries, 3.5% is a good year. What would the 66% of the stocck portfolio have to generate to reach an overall return of 8%?

10.35%

Nobel Laureate Robert Shiller has tracked stock market data from 1871 to the present and has shown an average return of about 8.2%.

Aswath Damoradan at NYU has a data series leading back to the late 1800’s showing that stocks have returned approximately 5.74% over the treasury bond. Based on these data points, one will do well to expect a stock return of more than 8% going forward with a Ten Year Treasury yield of 2.15%.

Using the same portfolio weighting noted above, the Omaha’s pension fund expected return should be adjusted to 7% (if not 6.5%!). Denial and compound interest don’t mix well.

If Omaha is looking for a dose of reality, it should look to California where unfunded liabilities are at 50%.  Calpers, the largest pension fund in the US, reduced it’s target rate to 7.5% in 2012. Its own actuary argued for 7.25%. 

WeWork: Venture Capitalists Take Real Estate to Ludicrous Heights

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Do you like the idea of hanging out with people in a laid-back environment where you have free WiFi, beer, and ping pong? Hell yes. Do you want to work in this environment? Hallelujah.

WeWork sounds like a cool co-working concept where users pay fees for differing levels of access and services. But when I saw that venture capitalists have valued the company at $5 billion, I needed a beer of my own to wash down this slice of fantasy.

Source: Bloomberg

Here’s the founder quoted in Bloomberg’s article:

Adam Neumann, WeWork’s Israeli-born co-founder, has called the company a “physical social network,” and it makes every effort to lubricate connections. “We gave 90,000 glasses of beer last month,” he said in a recent onstage interview at TechCrunch Disrupt NY 2015, “which is a number we’re proud of.” 

I get the general concept, and it is appealing: there’s probably enough people in New York, LA, Chicago and San Francisco who would rather pay a la carte for office space. There’s a cool factor as well. These aren’t beige-carpeted Regus office centers with a Bunn coffee maker in the corner. Non-dairy creamer is probably disdained at WeWork.

But a $5 billion valuation is preposterous.

There are many flaws in the venture capitalists’ assumptions:

First, they make the old Pets.com argument that X is a multi-billion dollar market, and if we can just capture Y, we’ve got a home run. In this case, they estimate the size of the office market as being $15 trillion, so their whole value is based on the idea that they can capture just a thimble-full of the market. Unfortunately, capturing a market of users does not necessarily translate into profits.

The doubts pile up quickly:

A. Sorry, there’s just not that many freelancers. I know we’ve all seen the hype around start ups, but most new tech businesses generate zero cash flow for many months or years and are purely boot strap operations that can’t stomach a posh rent in a highrise office space. There’s a reason why a lot of Silicon Valley success stories got started in garages.
B. So where do most small companies and freelancers work?Their homes. Why pay double rent?
C. Open floor plans suck if you need to complete tasks that require focused concentration. I’ve tried it. It’s hell.
D. There are already competitors (and will be more)…including building owners themselves.
E. There’s a little place called Starbucks that has free WiFi. I’ve heard they have some locations around.
F. WeWork has no assets and relies entirely on leased space. Leases are a contractual obligation akin to debt. They may not get capitalized on a balance sheet, but they should be. The company will immediately be an over-leveraged behemoth with tremendous fixed costs.
G. Ping pong and beer are amenities, they’re also distractions for the others who actually need to work. Go to a bar.
H. They will need to hire a staff to maintain the spaces.

Here’s my biggest gripe: The article references Uber as a comparable. The logic goes something like this: workers share spaces and more efficiently utilize a common area by making use of what would otherwise be spare capacity. But is WeWork really like Uber? In the case of Uber, individual drivers carry all the risk and Uber only acts as a technology infrastructure for sharing transportation. If there is no one to pick up, its the driver who doesn’t make any money. In this model, WeWork carries all the risk.

If I was going to create an “Office Uber” I can see a better market where companies with existing leased office space (an advertising firm or insurance company) post available cubes and conference rooms for rent when they are empty. You probably have offices that only run at 50-75% capacity on a daily basis (ie, Don Draper heads to California for a few weeks), so there’s a lot of spare space that can be posted. I’m sure someone has already thought of this concept.

On the positive side for WeWork, there’s probably a health club model here – sign up tons of people at $40 per month and know that they only show up a fraction of the time of what they thought.

But $5 billion is a bridge too far.

Kilroy Property Trust is one of the biggest office landlords in San Francisco (if not in the the entire US) and their market cap is $6 billion. Ping Pong and beer are probably not included in Kilroy’s market capitalization, however, so there’s tons of upside.

The Discipline to Say NO

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You want to follow the herd. It’s natural. Do you remember the 1999 internet bubble? I got so frustrated hearing about my neighbors investing in Level 3 Communications, I thought I was the dumbest person on the block. I bought some Level 3. I made a little money, but I was too chicken to ride it out. I’m glad I didn’t.

Yes, some people escaped that bubble with fortunes intact, but most were swept away. The same can be said of house flippers and land developers in Las Vegas during the middle of the 2000’s. I remember feeling so envious of all these people making quick bucks left and right. What did I do? I went to Baltimore. I flipped a house and lost my ass. Thankfully I got out before the meltdown and I didn’t lose my entire net worth.

So, now, I look at my industry: apartments. Everybody loves apartments as an investment right now. The yield, the safety, the myth that people can’t afford houses anymore. I remember fretting about Omaha surpassing $1.00 per square foot rents in the late 2000’s. We’ve blown through that number.

Downtown is hot. Midtown is hot. But someone is going to be the last one in and they’re going to be late to the party. They will overpay for land, underestimate costs, and underestimate the depth of the market at an affluent level of rent.

It’s frustrating. You know people are making a lot of money right now. But you also have a sick feeling in your gut that everything is being propped up with artificially low interest rates. I went to a conference and heard they are paying 4.82% cap rates in Dallas.

Are we there? Is this Japan with a perpetual zero interest rate policy?

Everybody repeats the same cliche that real estate is about location, location, location. Here’s what they don’t say: real estate is also about price. You can have the best corner in the world, but if you pay too much for it you will dig yourself a hole that will take a generation to extricate yourself from.

We have to take risks as developers. You can’t make money without taking a risk. But you can’t follow the herd. Sheep get slaughtered as the saying goes. Lemmings head blindly over the cliff.

Farnam Street blog has an outstanding transcript of a television interview in India featuring Warren Buffett and Ajit Jain. Everyone needs to read it and watch the interview. It is pure gold.

Ajit: The discipline to say no, if you have that and you’re not willing to let people steamroll you into saying yes. If you have that discipline, that’s more than 50 percent of the battle.

Warren: Don’t do anything in life where, if somebody asks you the reason why you are doing it, the answer is “Everybody else is doing it.” I mean, if you cancel that as a rationale for doing an activity in life, you’ll live a better life whether it’s in the stock market or any place else.

I’ve seen more dumb things, and sometimes even illegal things, justified (rationalized) on the basis of “Everybody else is doing it.” You don’t need to do what everybody else is doing. It’s maddening, during the Internet craze when the bubble was going on.

You have to forget about all those things. You have to do what works, what you understand, and if you don’t understand it and somebody else is doing it, don’t get envious or anything of the sort. Just go on and wait until you find something you understand.”