Crossroads

At the intersection of technology, finance and the Pacific Rim.

Wednesday, August 23, 2006

We all wonder what it takes to have a global view of investing. And as noted in earlier posts, there are as many routes to success as there are successful people. The interview I have copied below is not from a particularly "famous" investor, except perhaps to those who invest in his funds. I found the interview with Barrons to be noteworthy in several respects: a) note the world view, the ability to place his investment environment within the context of global economic and political events of today; and b) his view of the close ties of Bill Gates and Warren Buuffet and the resultant expected investment outcome. Two qualities of an astute investor come out from the interview: the ability to anticipate events and the ability to see their ripple effects (sometimes 2-3 cause/effects away in a chain reaction). Questions from Barrons are in italics.

Big on Bill and Warren
Interview with David Richards, Private Investor
By SANDRA WARD

EVERYTHING AND NOTHING HAS CHANGED in the two years since we last spoke with David Richards, a private investor and former money manager at two of the most venerable and silent investment outfits around -- Capital Research & Management and PrimeCap. His gold and energy picks have performed brilliantly, and the consumer he's been so worried about just now appears to be cracking. Still, the long-awaited financial disaster he's expected has yet to occur, despite 17 interest-rate hikes, and the dollar has held up better than he imagined, too. Just wait, though. Looking past the blue sky and sun-sparkled sea surrounding his saltwater farm in Maine, Richards is braced for calamity. How Microsoft and Berkshire Hathaway fit into the picture, we'll let him explain.

Barron's: Let's get your take on the Federal Reserve's latest move. Were you surprised it took a break and seems to be fighting a slowdown in the economy?

Richards: No.

Do you consider it the right move?

No. [Federal Reserve Chairman Ben] Bernanke is in the mode of wishful thinking. He is betting the economy slows down as a result of the increase in interest rates he has already brought into play and the decline in the housing market, which is continuing to weaken. That's occurring. But inflation is getting back into the system. There's been an illusion that it wasn't happening because people have concentrated on the core CPI [consumer-price index], which excluded all the areas that have seen big price increases. Those price increases are now having a broader impact on many products and that is going to continue to be the case.


The inflation that was out there had been understated, and now it's being recognized for what it is. So Bernanke is faced with rising inflation and he will have to raise rates again.
Central banks around the world have been raising rates.

Did that make it more surprising the U.S. took a time out?

The European Central Bank, the Bank of England and the Koreans hiked rates recently. It is a global inflation play and central banks are raising rates, some more aggressively than others. To me, this is like 1979, when there was rising inflation and the Fed was behind the curve and inflation got out of control -- and, eventually, as Paul Volcker did then, it will be necessary to raise rates dramatically to curb inflation. We are quite a long way from that.
For now, look for rising inflation and a continued uptick in short rates, which will create a financial crisis of some kind. Then, Bernanke will cut rates because, of course, the housing market will be in the crapper. That will not lead to lower long-term rates but, in fact, to higher rates because confidence in the dollar will go down. So it's a really bad situation.

How do you prepare for such a worst-case scenario?

In the short run, try to have companies that have some possibility of protection against inflation. You should also avoid companies that are leveraged or whose customers need to borrow money to buy products because their cost of credit is going to go up.

Categories to shun include retailers, finance companies, credit-card companies and banks. Those are the areas I have shorts on. On the long side would be oil and gold. I have also recently bought a big chunk of Microsoft [MSFT] and an average position in Berkshire Hathaway [BRK-A].

Why?

There are two big events that happened with respect to Microsoft and Berkshire. What is intriguing to me is the combination of Warren Buffett and Bill Gates. People pay money to have lunch with these guys, and they have lunch with each other every day. So you have two of the smartest guys in the world, two of the richest guys in the world, and they are buddies and they teach each other different things. With Berkshire, there has been succession risk due to the fact that Warren is 75, and Charlie Munger is 82.
Buffett's deal with the Gates Foundation reduces that risk. It reduces the risk because Gates is on the Berkshire board and he has invested $350 million or $400 million in its stock, which to him is chump change, but it is not insignificant. In the next 20 years, the Berkshire stock owned by Mr. Buffett is going to be transferred to the Gates Foundation. So Gates has a tremendous interest in seeing to it that Berkshire is run well after the demise of either Buffett or Munger or both. In the meantime, Buffett is teaching Gates about finance. And the evidence of that is that two or three years ago, Microsoft got out of the business of using options to incentivize its employees.

That had been a pet peeve of Buffett's.

Yes, because it basically transferred money to the employees or the managers at the expense of the shareholders. All mature technology companies are going to have to get into that mode eventually, and Microsoft is already there.
One of the things I always like to look at with an investment is whether the owner is on the premises. With Berkshire, clearly that's true, and with Microsoft, that's true. People forget about Microsoft CEO Steve Ballmer, but he has about $10 billion of Microsoft stock and a significant financial interest. More important, he is smart and he is tough and he is proud.
When he upped spending on research and development, the market took it as a negative and drove the stock down four or five points. The market made a mistake. Microsoft, as an investment for the long term, depends on continuous innovation. They have to assure their customers they will be innovative and that no one else is going to come into any field that is relevant to the first-class operation of the products they are selling. And, to do that, they have to spend a helluva lot of money. That it is a pre-emptive strategy.

Isn't that the problem, though? The spending hasn't resulted in much.

Not really. You can't say they haven't been successful. Revenues are still going up. The profits are still there. Google (GOOG) has taken share in search, but Google is a long way from taking serious share from anything else that Microsoft does. The only competitive player out there is Apple [AAPL], which is also a very intriguing company. I have a tiny position there. It is a very innovative company. It has a competing operating system and it is clearly in an innovative mode.

Why own Berkshire?

Both Microsoft and Berkshire have important things I want to have in this environment. They have cash. They have products they can raise prices on, particularly the insurance side of Berkshire. The stocks trade at around 15 times earnings, which is not very expensive. The other reason I own these two is because I reduced some of my position in oil and gold a few months ago by about 15% to 20% and decided to diversify. But I'm still heavily invested in oil and gold, and if the Fed is forced to ease after this potential financial debacle I foresee, those investments will provide protection.

Do bonds interest you?

When bonds were yielding 10% and 12% years ago, somebody referred to them as certificates of confiscation. At about 5% today, there is no real return in bonds and they might as well be certificates of confiscation. People like Bill Gross are bullish on bonds because they think the Fed will cut rates because housing is so weak. That's a possibility. If the Fed cuts rates, bond prices will go down because of the loss of international confidence in the dollar. I don't have a position in bonds. The dollar surprised everyone last year by showing more strength than expected.
The risk comes as inflation continues. After the Fed pauses, maybe the next time it meets as well, they realize they've got to raise rates again because of inflation. Then we'll begin to get some real pressure in the mortgage market and the asset-backed bond market.
The asset-backed bond-derivative business has been based on statistical analysis of historical data over the past five to 10 years, which was basically a period in which interest rates went down and housing prices went up. The risk analysis is irrelevant to what the period ahead is likely to be, which will be a period -- at best -- in which the housing market stays flat in some areas and goes down quite a bit in some others, and interest rates go up instead of down.
So you are going to have a much different degree of tension in the system, and there is a risk the analysis on the various tranches of these assets is basically wrong. It is going to turn out to be too optimistic.

Risk is not being paid for the way it should be at a time when everyone is under tremendous pressure to seek higher yields. The big municipal and state pension funds are underfunded, and can't make the 8% to 9% return assumptions in a 5% world. They're subject to the snake- oil salesmen coming out of Wall Street, and that's why there is a flood of money going into hedge funds and private-equity funds and derivative securities, under the assumption they will save them from raising taxes to fund the pensions at a time when people are desperate.
The idea that you can take a trader from Goldman Sachs or Morgan Stanley and give him $5 billion to run a hedge fund or put several billion dollars into a private-equity fund and have it give you a higher-than-normal return -- after 2% fees and 20% of the gains, in an environment where interest rates are going to go up -- is totally nuts. The record of these guys is based on an environment in which interest rates were going down. The fees are too high, and the environment is much different than it was and it is not going to work.

Talk about the consumer. It seems we are seeing a pullback. What's your view?

The consumer is under a lot of pressure. People have used their houses like an ATM [automated teller machine] and have increased their debt from second mortgages and home-equity loans and used that to buy all sorts of consumer goods or to renovate and improve their houses. There could be a sudden sharp drop in consumer spending, and that seems to be developing. I want to be in companies that have very strong balance sheets that don't have to borrow money and where the products, like gasoline and the Windows operating system, are bought by people who don't borrow money in order to buy them.

How high does oil go?

I don't know. You could see rising investment and you should get some economizing because of the high price. On the other hand, there is evidence that some of these big fields are rolling over in Mexico, Kuwait, and now there is the North Slope problem.
Another problem with major oil-producing countries is they've got so much cash that they have little incentive to encourage exploration and production. This is true of Russia, Venezuela and even Saudi Arabia. They look at their portfolios and decide maybe they should have oil in the ground, instead of cash in the bank. And when you get outside these big OPEC producers, you have a problem finding enough oil to make a lot of difference in global production.

Oil is so important that we haven't seen much of any reduction in usage in this country, even though gasoline prices have gone up to more than $3. If you think about how the average car uses around 1,000 gallons a year, you are spending a $1,000 or more extra for the gasoline, relative to the financing of the $20,000 or $30,000 vehicle, and insurance on top of that and just for the convenience factor of driving to the shopping center. The whole American distribution system is based on going to Wal-Mart and Lowe's and Home Depot and Target. The last leg of the distribution system is the SUV driven by American housewives.
The adjustment process will happen, but the investment is so great, there's huge inertia. Plus, the price of oil in real terms is still lower than it was in 1979 or '80. In relative terms, it was $90 or $100 a barrel back then and, at that time, oil was a bigger percentage of gross domestic product, and living standards were less and so the sensitivity was greater.
Also, there have been huge changes in efficiencies since the oil crisis in the 1970s. And the incentives for finding oil were greater then than they are now. That is, the risks of investing in oil exploration were less. Now you worry about finding oil in Russia and Nigeria. You worry about whether you can go into Venezuela. Companies in Bolivia got a surprise when the new government came in and raised taxes on finding gas. The companies still make money, but instead of making a huge profit, they are making a smaller profit.

How does the geopolitical scene affect your scenario?

U.S. foreign policy is out of line with the economic situation the country is in, and it has been for the last few years. We are living on borrowed money, and we are living on imported oil.
We are living in a world today where people are increasingly angry at us, including our creditors and our oil suppliers. We don't give them any incentive to behave differently. President Hu Jintao of China comes to the United States, and he is not accorded the trappings of a full state visit. Talk about insulting your creditor! The administration goes to St. Petersburg and [Vice President Dick] Cheney makes a speech that basically insults the hell out of the Russians. He tells them how to run their country. This sort of bullying unilateralism is just nuts. The whole Arab world is angry at us because we sit on our hands and do nothing to prevent the Israeli destruction of Lebanon. Why should they buy dollars? Why should they buy U.S. assets?
Our behavior has been stupid and insulting and arrogant and, financially, these guys could say screw it. Russia, for example, has $250 billion of reserves. This was a country that was bankrupt several years ago. Their finance people have concluded that they shouldn't hold so many dollars and need to diversify into euros and gold.

The Chinese are making noises about revaluing again because they have inflation problems. Wages and salaries in China are going up at a very rapid rate: The minimum wage in the south rose 17% recently. More seriously, the shortage of skilled workers, managers, accountants and financial people is extraordinary, and they have to bid for local workers. That means the cost of producing stuff in China will be rising. The cost to American consumers of exports coming out of China is definitely going to go up. There has been a huge margin squeeze there, and prices are now going to be pushed up.

And Wal-Mart has agreed to unionize its Chinese stores.

Yes. The big benefit the big-box retailers saw from sourcing in the Far East and shutting down sourcing in the U.S. is basically over, because there is very little left to shift and, secondly, the price of goods coming out of China is going up. That's another factor in the inflation equation.
Overall, what's changed in your investment thinking in the two years since we last spoke?
My views haven't changed too much. What has changed is the discount of the things I was concerned about. Oil and gold have gone up a lot, and the stocks have gone up a lot so there are more risks in those areas than there were back then. But I don't want to hold cash because the dollar is going to go down. I don't want to hold bonds. I don't want to hold any consumer stocks and financial stocks. I would rather have gold and oil in the ground.
If you buy ExxonMobil [XOM] or Royal Dutch [RDS-A] or Chevron [CVX], they've got oil deposits in the ground.

What about foreign stocks?

I still have some Russian stocks, but it is not a big position, only about 3.5%, because it's unclear what will happen in the 2008 elections.
What's your overall portfolio look like?
My long positions exceed my short positions by 30%. Oil represents about 50% of the long portfolio and gold 30%. Microsoft is at 11% and Berkshire Hathaway is 4%. I have 3½% in Russia.

I've got 48 different short positions, mostly financial-service companies, retailers and consumer-discretionary companies, including 10 home builders and Harley Davidson [HOG]; Lowe's [LOW]; Home Depot [HD]; Best Buy [BBY]; and Coach [COH]. SPDRs [exchange-traded funds that represent sectors of the S&P 500] make up 15% of the total short position.

Thanks, David.

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