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The Importance of Due Diligence
Posted by: Josh Zachariah (IP Logged)
Date: October 14, 2012 09:04PM
Let’s take two examples to convey the point: Wells Fargo (WFC) and Bank of America (BAC). Both were outstanding banks that were well capitalized in 2008. Both were considered to have navigated the financial crisis quite well and to avoid the loose lending practices made by many of their failed competitors. But by 2009 we saw exactly what differentiated the two.
Wells Fargo acquired Wachovia shortly after Lehman failed in the fall of 2008. Wells was in no rush to buy Wachovia. The company poured over its financials and it initially concluded it couldn’t buy the bank without time for further examination. Citi promptly stepped in and made an offer with government assistance. A week or so passed and after conducting further research, Wells made a 180-degree turn and decided it could pay more than Citi, without government assistance. Fast forward to 2012 and Wells is making its largest profits in history.
Now consider Bank of America. The bank had a checkered history of acquisitions. It was very much obsessed with growing — maybe at the expense of growing shareholder value. Bank of America bought Countrywide in early 2008 and Merrill Lynch in the fall; both were bought before the onset of the financial crisis and both very much in a hurry. There was no, “We need some time to examine its books and think this through,” as in the case of Wells Fargo, and today we see the consequences of their actions.
It’s not to say that Bank of America couldn’t have still bought either Countrywide or Merrill Lynch and performed well. As Warren Buffett said, "Had Bank of America waited, it could’ve had Merrill for nothing the next day." In that case Bank of America would be making record profits too instead of writing down the value of its overpaid acquisition and accompanying loan portfolio.
Now let's examine the investor of subprime mortgages in the mid 2000s. This type of investor bought a product but never bothered to look under the hood. Of course it would be a little more complicated combing through the voluminous paperwork, but that’s the nature of investing (Bill Ackman knows, he devoured 140,000 pages related to bond insurer MBIA). Had subprime investors actually discovered the quality of the borrower they were financing, perhaps they would have declined forking over their money. And if these investors never financed subprime borrowers, then our world would be completely different. There would be no run up (and run down) in house prices and ensuing financial collapse. It was subprime investors volunteering their capital with complete abandon that enabled unqualified homeowners to own a home without having the financial resources to service the debt.
The investment today that seems to invite much more excitement than meaningful arguments is gold and other precious metals. The common argument for gold is that governments are debasing the currencies, which will cause gold to perform well. But what is the price of gold other than what's driven by consumers and investors? There is no guarantee that gold will hedge against inflation. In fact, the correlation between the two is quite poor. Series I Savings Bonds are correlated with inflation and have a positive yield unlike TIPS bonds. Gold investors seem to be driven by the notion that they will receive inflation plus some real rate of return. How realistic is that? If the real price of food has declined over time then why should gold increase over time? Even Coca-Cola (on Coke) has had limited price increases and has trailed inflation over the years!
When the housing market took off years ago, there were many arguments for investing in it, but few grounded in economics. You didn’t hear about price-to-rent ratios (unless you were reading The Economist which was bearish housing); you didn’t hear about the supply of homes versus household formations, the most fundamental supply-and-demand relationship in housing. Instead, real estate investors proclaimed real estate superior to other investments, asserting that house prices never decline. The latter statement was always false. The former was false then but is true now in some U.S. cities. The determining factor is price, and real estate investors avoided that concept — as gold investors are doing today. Gold investors must ask themselves, "Is gold priced attractively or is it attractive at any price?"
Not nearly enough of the critical factors affecting gold are discussed today, namely the supply of currency versus the supply of gold. Yes, we know the Fed is growing its balance sheet and the dollar’s value should decline, but the dollar has already depreciated substantially relative to gold. Exactly what exchange rate of dollars do gold investors expect? It’s not as simple as the Fed printing money and dishing it out. The Fed is printing money to buy assets that it will presumably sell later, but will it get par value for these assets or less? The likely scenario is less, but exactly how much less? This is what gold investors need to be obsessed with.
Another disconcerting factor I see is that gold investors don’t seem to be fazed by the declining demand for gold as jewelry or consumption purposes (the article wrongly notes that China is a consumer of gold, but they are in fact an investor, holding it in physical form). India has been one of the largest consumers of gold for jewelry, but as the price has risen demand has declined. Increasingly, gold is being recycled in the country to purchase new gold as the price has become prohibitive. As the price of gold increases faster than income, consumers will increasingly be priced out of the market, but paradoxically investors may then covet gold even more. You could replace “gold” with “housing” and that statement may be more apparent with some people.
Even my cursory examination of gold is not nearly enough, but I’ve yet to read a compelling argument for buying gold at a given price. David Einhorn offered a rebuke to Warren Buffett in preferring gold to cash, but he did a poor job in praising gold and instead spent his words cutting down fiat currency. I don’t even think Buffett would disagree about a depreciating dollar, but Einhorn avoided explaining why gold would be preferable to cash-flow-generating assets, which is what Buffett was championing to begin with. Nevertheless, both Einhorn and Buffett are two investors that do not skimp on due diligence. It is that due diligence that will show up in the returns for their investors and what any investor will need to be successful.
Re The Importance of Due Diligence
Posted by: vgm (IP Logged)
Date: October 15, 2012 04:49PM
Making decisions in the white heat of the crash cannot be seen as representative in my opinion. Time simply did not permit real DD. And I think your interesting piece actually supports that.
1. You mention that Wells at first turned away from Wachovia after some DD, but then rushed back with an offer once they saw Citi moving on Wachovia. The conclusion is that they were motivated by losing out, as much or more than by their DD.
2. Buffett's comment that if BAC had waited another day they could've had Merrill for nothing is also not DD, but rather an observation that the markets were crashing - maybe it's more of a macro call.
I'd add a comment which Jamie Dimon made a year or two back, about JPM acquiring Bear. They paid an exceptionally low price for Bear which he rationalized by saying it was the difference between buying a house, and buying a house on fire - in other words you don't really know what you're actually buying, so you cover yourself as much as possible. He has also commented that there simply was not enough time for true DD.
However, to me a few real cases of DD around the crash are Bruce Berkowitz's purchases of financials - banks and AIG in particular. He carried out his own assessments, drew his own conclusions and committed at a time when no-one wanted to touch them. This was post-crash, of course, but his DD is now serving him very well indeed.
Re The Importance of Due Diligence
Posted by: Josh Zachariah (IP Logged)
Date: October 15, 2012 09:44PM
Thanks for the critique, in response:
1. I don’t know that Wachovia necessarily rushed back. I’m sure they knew there were other bidders for Wachovia just as Jamie Dimon wrongly believed there were other bidders for Washington Mutual. Initially it was believed that Wells made the about face because of a change in the tax code that happened days before and positively affected acquisitions of banks with large losses. But Richard Kovacevich (wells CEO at the time) refuted that this was the motivating factor. Kovacevich offers a narrative of the acquisition in his interview with the FCIC - http://fcic.law.stanford.edu/interviews/view/50
2. That point is true, it feeds into a separate value of investing – patience.
That’s a good point on Dimon, thanks for your comments.