Thoughts on Warren Buffett and Berkshire Hathaway Stock

This weekend Warren Buffett published his annual report, including his letter to shareholders.  This is always extremely interesting reading, and I plow through them every year.  Despite Berkshire Hathaway's stock being worth a massive $210BB, Buffet has still managed to outperform the market year after year.  Since 2001 even, he has generated 9.7% annual returns on book value, vs the S&P up only 2.5%.  That 7.2% outperformance is remarkable.  If you own index funds or any mutual funds you aren't happy with, I encourage you to swap into BRK/B.  It's trading just under $87 a share, and here is the simple math on why it's still reasonably cheap:

Market Value of Equity:                      $210BB
Less Owned Stocks,Bonds, Cash:       $158BB
Plus Liabilities:                                     $66BB
Value of Owned Businesses:               $118BB
After tax earnings 2011 est:                 $12.5BB  (excluding gains on stocks, interest)
Multiple on owned businesses:                 9.4x

See the Intrinsic Value section in his 10K.

So I should point out that this stock has traded at a sub-market multiple for years.  I suspect concerns for BRK are 1) its size limits its growth potential, and 2) Buffet is 80 years old now and questions of succession are quite valid.  But I still question the market valuing this at 9.4x earnings vs a market at 15x! 

Isn't the worst case that Buffett passes away with no heir, and they break up the business?  Or that new management is inept?  I think if they broke up the businesses, it would yield far higher than where the stock is trading.  And I also think that Buffett is too smart not to find very able managers to run this after he is gone.  Everything I have read about Todd Combs and Ajit Jain and David Sokol are more than positive.

The stock also trades at 1.35x book value, which doesn't seem cheap to some.  However, the 10 year average price-to-book is 1.6x, so its relatively cheaper than its typically traded.  Also, BOOK is merely the cost basis of companies he has bought.  You cannot write UP goodwill for deals like Geico, as he points out in his letter.  While he paid $4.6BB for Geico in 1996, today its generating $14BB in premium, and generated over $1BB in profits last year.  He points out that its likely worth $14BB vs a book value of $4.6BB. 

Same math applies to his $34BB purchase of the rail company Burlington Northern.  While he seemed to have overpaid in 2009 for it, its profits have increased from $1.7BB to now it will likely do $3BB plus in profits in 2011.  That makes his $34BB purchase probably worth $45BB in less than 18 months.  These are just two examples of intrinsic worth being much higher than book.

So you can buy a decent chunk of BRK/B, and I think expect to see reasonable returns.  The stock is actually only up 6% over the past 12 months, vs the S&P 500 up 22% over the past 12 months.  It's going to catch up.

TOP HOLDINGS
If you are curious which stocks Buffet owns within BRK, here are his biggest investments, largest to smallest:
1) Coke, KO
2) Wells Fargo, WFC
3) American Express AXP
4) Procter & Gamble, PG
5) Kraft, KFT
6) Munich RE,
7) Johnson & Johnson, JNJ
9) US Bancorp USB
10) Walmart, WMT

ANOTHER OVERHANGIf you follow BRK and are concerned about the $37BB in very long dated put options he wrote to undisclosed investors, here is the math on them today. 
  Notional:               $37BB
  Estimated Strike:   S&P at 1400
  Time entered into contracts:  2006-2007
  Expiration date (average):    2024
  Net liability on balance sheet:  $4BB (marked to market losses recognized to date)

So he received $4.9BB in premium for very long dated at the money puts on the S&P.  He unwound 8 of the 47 puts in 2010.  I figure 30BB are left, so if the S&P is at 1000 in 2024, down 25% from today, then future liabilities would be about $4BB.  That's a 1.8% hit to the stock. If the market is at least 1400, then he'll have $4BB in gains to realize. Not a concern to me.  My question is, who is dumb enough to buy 15 year S&P puts from Warren Buffett, and pay a big premium for volatility????

 APPLYING BUFFETT METHODOLOGY
I like to delve further and try to understand how Buffet values businesses.  It's very obvious in reading his letters that he appreciates cost controls, good management, and smart capital allocation.  That is, not frittering away free cash flow on overpriced acquisitions or silly expenditures that generate little in the way of returns.  This is perhaps the biggest flaw in management that I see.

But what I want to know is, How does Buffett value stocks?  This he will not tell anybody.  But if you are a bit of a Buffett follower like me, then you read all his annual letters and books written about him. Even once I made the pilgrimage out to Omaha to see the Oracle, as he is named.  In addition to some of the above items, I think he focuses heavily on
  1) high free cash flow (FCF) yields,
  2) solid returns on equity (ROEs),
  3) buying companies you understand, with a moat around them, and
  4) owning good businesses forever.

That's about it.  He says things like, "I know in 20 years people will still be drinking Coke" so he would own KO.  In fact he's owned it since the 1980's.  Management is good, it's not terribly cyclical, you can understand the product Coke sells.  Its obvious.  Not going to see a lot of new challengers to Coke either.  He prefers a management team that is very careful about watching costs.  He himself is a zillionaire who lives in a modest sized house and whose only luxury is his private jet.  When he had his first baby, he emptied a drawer out of his dresser, and had the baby sleep in the empty drawer.  Yes he had money but was too cheap to buy a crib.  I can relate.

So, then what does he look for in terms of VALUING a stock.  That part is trickier, but it's some Graham & Dodd value ideas, particularly, buying stocks that are beaten up and hated.  A Graham & Dodd phrase is "margin of safety" meaning that you should only buy stocks when they are 20% below their intrinsic value, a phrase often used by both G&D investors and Buffett. 

As far as beaten up stocks, he once wrote that a stock that is down 25% is far less risky than one that has risen 25%.  He is clearly not a momentum investor, and neither am I.  To give a quick example, say a growth stock trades at 30x earnings.  The problem is, when that stock eventually MISSES its EPS forecast (and eventually they all do), not only is the EPS lower, but then its P/E ratio goes lower too.  It's a double whammy. 

Say that XYZ growth stock did $1 in EPS, and traded at $30.  That's a 30x P/E ratio.  Then if it did only 0.90 in EPS, and traded to 25x earnings, then it's going to get smoked from $30 a share to $22.50 a share.  That's down 25%. 

Look at FFIV last month.  It fell almost 25% in one day when it missed numbers, and still trades at 25x forward earnings, 50x trailing earnings.  That is a risky stock.  Good luck owning that one.

So, now lets look at some of the financial items that Buffet talks about: ROEs and high FCF yields.  If you use P/E ratios a lot, then you need to understand that P/Es are often manipulated.  Because earnings are manipulated.  Buffett talks about this in his letter, and I focus constantly on cash earnings.  You HAVE to always focus on cash.  I won't get into too much of the accounting here, but one of the first things I do is look at cash Capital Expenditures (Capex), and compare it to Depreciation & Amortization (D&A).  If D&A is much lower than Capex, then you need to figure out why.  Because Capex is the cash, and D&A can be whatever the company wants it to be.

APPLYING BUFFET METHODOLOGY TO CISCO
So, let's look at Cisco, a hated stock that trades poorly today and so far my worst investment this year.  So, first of all, its a beaten up stock.  Good.  Its returns on equity are 17+%.  Good.  Its per share earnings have grown 14% over the past 3 years.  That is through 2008 and our Great Recession.  Not great but not bad.  Revenue, up 14% in that time.

Cash:  It's capex per year is around $1.3BB.  It's D&A is over $2BB however.  That means that its generating a ton of cash relative to its reported EPS.  Specifically trailing 12 month reported EPS is $1.36, but cash EPS is more like $1.50.  Not only that, but CSCO has $4.50 per share in existing cash on the balance sheet.  They could pay the shareholders this cash and nothing would change with the business.  So net the $4.50 against the share price today (18.60), and you get $14.10 per share.  

Take the real cash earnings of $1.50 per share and divides it into the share price net of cash.  So, $1.50 divided by $14.10.  That is a cash yield of 10.6% today.  Not bad.

Now let's look at the stock like Buffet would, that he will own it forever.  Instead of forever though, lets look 6 years down the road to pick a number.  Finally, lets assume EPS never grows at all.  Where are you creating this stock?

<><><><>

years		6
EPS  / yr		$    1.50
Cash/ share		$    9.00
Cash existing		$    4.50
cash per share total		$   13.50
Stock today		$   18.60
creatig stock		$    5.10
EPS in 6 yrs		$    1.50
FCF Yield		29.41%
P/E Ratio		3.4x

3.4x!  So, if CSCO does FLAT earnings for 6 years, in that time you will have generated $13.50 per share in cash on an $18.60 stock.  That means you are only paying about $5 a share for this stock a few years down the road.  For this stock to be flat in 6 years on flat earnings, means that it would have to trade at 3.4x earnings!  Thats a 29% FCF yield.  People really hate this stock.  How can you lose?  There is a zero chance it will trade at 3.4x P/E in 6 years.  It can only be higher than today.  (taken further, in 10 years, the company will have almost $20 per share just in cash, higher than the stock price).

UPSIDE
This shows the power of compounding, even on a flat, mature business.  The key is purchasing it at reasonable valuations.  Likely this company will be a mature business in 6 years too, but let's now assume EPS grows modestly at 3% per year.  That is at least the rate of population growth.  Then in 6 years EPS is $1.79.  If it trades at 12x earnings, a very modest multiple, then it will trade at $35 per share.  That is up 88% in 6 years.  That's my minimum target.

The "free option" is that they grow EPS by 7% per year.  Not that aggressive, historically its been much higher.  And let's use a 15x multiple, which is historically the big cap average.  $2.25 in EPS X 15 is $47 a share including the cash, up 154% in 6 years. 

This is why I buy low P/E stocks that have nice ROEs.  As long as the business can remain stable, you can generate very large risk-adjusted returns.  Markets aren't always saavy.  In Cisco's case, I believe that investors see CSCO doing $1.36 in EPS, and divides the $18.60 by that to get a 14x P/E multiple.  Which isn't seemingly cheap.  But I think the market is ignoring cash on the balance sheet, and too short term focused to see the value here longer term. 

You also have to understand the phenomenom that this stock is being tranferred from growth oriented investors/funds, to value investors.  Personally, I don't get the distinction. Stocks are either OVERVALUED or UNDERVALUED.  Growth mutual funds?  I mean, some growth stocks are cheap, and some are expensive.  But technically its a difficult transition for any equity to make.

I cannot, nor can anyone for that matter, know where CSCO will trade next week or next quarter.  Cisco got blasted this year on weak guidance on their February call.  They beat their bottom line number, but nobody cared.  Sales growth is "only" 6%.  Margins are contracting offsetting sales growth, so EPS growth was flat.  Yet they still generated tons of cash.  Cash will keep flowing into the company.  That is key.

Is Juniper making some headway against Cisco?  Yes, perhaps.  But JNPR trades at 37x earnings.  That's a 2.7% FCF yield.  Who is happy with that?  They have to grow very rapidly to catch up with that multiple.  This is a momentum stock.  When it cracks, it will crack hard.  Cisco dominates the router and switching universe, and internet usage isn't going down.  I can be reasonably assured that in 5-6 years, sales will be higher than today.  This isn't the horse carriage industry.

WHY ENTRY POINT MATTERS
So, why is Cisco flat after 10 years when its EPS more than quadrupled in that time?  Because it traded at 72x forward earnings in 2002.  The stock was at $18.10 as of year end 2001, and it did $0.25 in EPS in 2002.  72x is insane.  Earnings in fact doubled in 2003 to $0.50 a share, but its multiple fell to 26x, so the stock fell by 30% that year!  The gradual degradation in P/E ratios kept the stock flat since 2003. 

I think if we assume limited to no growth in Cisco though over the next 6 years, this stock will perform very well.  Really, it's not a tough bet to make.  Just give it some time. 

Here is the link to Berkshire's annual letter:
http://www.berkshirehathaway.com/2010ar/2010ar.pdf

Why History Points to the Dollar Devaluing, and Gold Going Much Higher

First of all, I frequently write about gold, and right off the bat wanted to dispel the notion that I am a gold bug.  I haven't been sitting in my basement salivating over gold coins for the past 25 years, babbling about the imminent end of the world.  As most of you know, I am a contrarian value investor.  Stocks and Bonds,  distressed stuff.  Not gold.  Buying what others hate.  So its perhaps odd (to me even) that I would be buying gold a couple weeks ago, at it's near historical highs, around $1300 an ounce. 

It's extremely interesting to me also that I rarely get much reaction from people on gold.  The best, smartest investors in the world though love it:  David Einhorn, Marc Faber, John Paulson, Fred Hickey.  I pay attention because these guys are much smarter than even good money managers.  They are the best.  But most people's view is that gold is a quaint relic of economic history, one that wont be repeated.  "The gold standard? Not a chance, it caused the Great Depression."  Perhaps.  Perhaps not.

SOME HISTORY:
The history of gold is that it was the first monetary unit 7000 years ago.  Eventually, governments were created and established gold reserves.  That is, they issued paper money backed by gold. Think, the government owns $100 of gold, and prints $100 worth of paper money.  The money is redeemable for a fixed amount of gold.  So, net net, a government cannot issue more currency without owning more gold.  The government is hamstrung in terms of monetary policy. Not surprisingly, we have a long history of being on a legal or implicit gold standard in the United States.   

First, in 1900 the US passed the Gold Standard Act, and fixed gold prices at $20 per ounce.  You could literally take $20 of paper money, go to a bank and get an ounce of gold.  The US Treasury couldn't issue more printed dollars because they only owned so much gold. 

The problem was, after WWI, Germany owed huge war reparations to England and France.  Its gold reserves were plundered first, but then Germany had no economy left, and no means of repaying their debts.  The debts were so large, in fact, that all they could do was print money (exactly like QE today by the way). They issued what quickly became worthless paper to the British and French, and in the process created hyperinflation in Germany in the 1920's.  They eventually defaulted.

Taking it a step further, the British and French also were having a rough time, and continued to debase their currencies to improve their ability to sell worldwide.  The more you devalue your currency, the cheaper it is for foreigners to buy your goods.  The first Currency War of the century was underway in the late 1920s.

What you should understand generally is, when times are good, GDP grows.  But in times like the late 20's, early 1930's, GDP was suffering everywhere.  To back up for a sec, GDP we know is C + I + G + X.  Consumer Spending, Government Spending, and Investment Spending were all done, and dying back then.  The only thing left was X, or exports.  So currency debasement is the last effort to salvage a very weak economy.  Sound familiar?

So as the Depression was playing out in the US in the early 1930s, our economy got crushed too.  At the same time, we were about the only currency in the world still on the gold standard.  (The British went off the gold standard in 1931).  That meant that a strong dollar was also choking off exports, exports that we desperately needed.  So, to fix this, in 1933, we went off the gold standard.  Not only that, but the US Government went as far as to BAN all ownership of gold.  Your safety deposit box could not be opened at a bank without an IRS auditor present.  And if you had gold in your box, they gave you $20 per ounce for that gold and took it.

What did the government do with all that confiscated gold?  They built Fort Knox, literally, to house it all.  It opened in 1937.  Then they repriced gold at $35 an ounce.  Quite a killing for the government, taking in gold at $20, then upping the value to $35 an oz.  We then created a quasi-gold backed system.  Only 40% of US dollars had to be backed by gold reserve by the Treasury, instead of a full gold standard which requires 100% of gold on deposit.  After WWII, this system created quite a stable currency and the US experienced economic prosperity from 1946 until the late 1960's.

Then, fast forward to 1968.  Again, Currency War broke out.  The Pound broke down in 1967, and the French began to devalue the Franc.  A strong dollar began to be a problem for our exports.  Foreigners were redeeming dollars and demanding gold.  Our reserves were being depleted, and a strong dollar was hurting our exports.  So Nixon reneged on the gold standard in 1971.  Inflation, while running at only 1-2% per year in the late 1960's, then began to take off. 

In 1972 inflation was 3%.  By 1973 it jumped to 6%, then 11% in 1974.  Wow.  If you don't think inflation can move quickly, then just realize that inflation more than doubled prices in that decade.  (the index went from 39, to 82, up 112%).  So for all of those who say oil more than doubled in price, it didn't.  The value of the dollar just fell by more than 50%.  Gold, by the way, jumped from $35 an oz to over $800 an oz.  This was the era of terrible stock and bond performance, as interest rates rose, commodities did well, and precious metals shined for lack of a better word.

HISTORY REPEATING ITSELF
Fast forward again to 2011.  Its almost impossible to miss what is going on worldwide.  Its basically 1970 all over again.  The United States is so heavily indebted, that it's virtually impossible for us to repay our debts.  We are going the easiest route to repayment:  dollar devaluation and inflating our way out of it.  While this goes on, interest rates will go up, stocks and bonds will perform poorly, and commodities will rally.  The economy will grow anemically at best, the new normal.  I wouldn't be surprised to see $150-200 oil in 5-7 years.  In fact I would be surprised if it didn't get to those levels.  Gold can only go higher too.  Treasury Rates at 3.5% have very little room to go down.  Bonds get killed when you have inflation.

CREATING INFLATION IN THE US
So given our fiscal situation, Ben Bernanke and our government have no choice but to create lots of inflation, to pay off our debts with devalued dollars.  But the problem he is having with creating inflation is twofold.  1)  money velocity has slowed down dramatically.  What that means is that the Fed can only control M0, or BANK CAPITAL.  The banks take in capital, and lend them out 10x. So, you put $100 into a bank, and that bank lends out $90.  That $90 gets deposited into another bank, who lends out $80.  And so on.  So that at then end of the day, roughly $1000 in money gets created for every $100 deposited in a bank.  In theory, our $2 trillion of Quantitative Easing could mean $20 Trillion of additional money in the form of M2 (bank accounts plus money market funds).  THAT would be tremendously inflationary. 

For the time being though, banks have tightened lending standards following their recklessness in the bubble times.  And, bank capital requirements are actually going up.  Loans aren't being made, so the money supply isn't going up nearly as much as we would think.  M2, one of the more closely followed measures of the money supply, is only up 6.5% in 2 years in fact. 

The second problem Ben is having with creating inflation has to do with China.  The Chinese Yuan is pegged to the dollar.  So, when a Chinese company sells Widgets to the United States, they get dollars.  They take those dollars, convert them into Yuan at a fixed exchange ratio, and then the Chinese company pays its employees, bills, etc.  With the US printing SO many dollars, that means that Chinese companies are getting tons of dollars, which are being converted into TONS of Yuan.  What you get is a flood of Chinese Yuan, and then inflation there as our money supply grows here.  This is not only true of China, but many emerging market countries with currency pegs to the dollar.  This exported inflation though is keeping inflation at bay in the US.  Our flood of dollars is ending up in China. 

When will money velocity and exported inflation end?  I dont know exactly, but these are mean reverting metrics.  Velocity will return to normalized levels, and banks will lend as they used to.  Foreign governments will raise rates to slow their economies and halt their own inflation.  And after this happens, look out.  Inflation will come home.

As a side note, understand that the government in China is in a HUGE quandary.  Keep the peg to the dollar and keep the masses employed.  Or de-peg and let the Yuan revalue higher.  That would stop inflation, but then lead to much higher unemployment in China.  That would cause major political instability there, something the Communist leaders of China do not want to deal with.  I mean, there are 10mm people every year flooding into Chinese cities from the country looking for work.  What do you tell them???

GOLD IS MONEY
People have pointed out to me that the chart on gold looks like every other bubble.  And yes, it does.  Gold has jumped tremendously in the past 10 years.  But you have to understand that gold is MONEY.  Yes, it is money.  It has been for 7000 years.  Just because the US dropped the gold standard in the last 40 years doesn't mean gold is not currency.  And gold value versus any currency is merely a monetary phenomenon.  Fiat currencies are backed by NOTHING.  The US Dollar has no collateral to back it. Its fancy monopoly money.  If tons of dollars get created out of thin air, then gold, which is fixed in quantity, can only increase in value. 

I have a chart here though that shows the global money supply against the value of gold reserves over 40 years.  Money supply goes up, Gold does too.

THE RATIO OF US GOLD RESERVES TO DOLLARS
What I think is important to figure out is what is the RATIO of dollars to Gold.  If gold is forward looking, then perhaps it's ahead of itself?  That ratio clearly fluctuates greatly over time, and is the key to getting into gold at the right time.  The chart above clearly shows that gold got way ahead of itself in 1980, and was way too cheap in 2000.

So what is the ratio today?  Great question.  For decades the US dollar was 40% backed by gold (until 1971).  Other times 100% (up to 1933).  I don't think we'll ever go back to a fully backed dollar.  We need more monetary flexibility.  But to do the math, right now there is $3 Trillion in US dollars in M0.  We have $350BB worth of gold in Fort Knox (the US owns 8.1k metric tons of gold).  That is a ratio of 11% today.  Our US dollar is essentially 11% backed by gold.  That is pretty low, maybe US citizens have no clue about the risk to our currency.

On the high side, in 1980 at gold's last peak, demand for gold was high and inflation was running at 12% per year.  So much so that we actually had 100% of the value of gold in reserves against dollars in the money supply.  100%!  That is the time to sell gold.  11% today if it just goes to 20%, means that gold could easily double to $2500 an ounce.

I honestly have no idea if gold goes back to a 20%, 40% or 100% gold backed basis.  But as dollars get printed, for one I think even at a constant 11%, gold prices have to go higher to match.  But for two, I think eventually fear of a dollar devaluation will cause this ratio to go sharply higher. It may take years to happen.  But it always has in economies that create inflation and/or default on their debts.  Show me an example of a collapsed currency where gold didn't skyrocket.

DOWNSIDE IN GOLD
From a purely economic perspective, commodities tend to trade at a normalized return on investment compared to their marginal cost basis.  So, if it costs $500 to mine one ounce of gold, would you bother if gold were at $520 an ounce?  Probably not.  I would suggest that a target ROI is around 10-20%, so I figure that $550-600 it becomes worthwhile to mine more gold.  That is my downside.  To think what could make gold fall, I copied a note from David Galland at the Casey Report:

"Setting the stage, I think it’s safe to assume that in order for the gold bull to decisively reverse direction, the following general conditions would have to be precedent in the economy:

1. The financial crisis will have to have ended. Which is to say that…
   1. Unemployment would have to begin falling by significant numbers – with 300,000 jobs or more being added month after month, instead of being lost.
   2. The housing markets will be stabilizing. Foreclosure rates would have to fall to more normal levels (and not because banks are forced to postpone the process for legal reasons, which is the case now), and sales would have to accelerate in the right direction.
   3. Government deficits would have to be sharply curtailed and heading lower.
   4. All quantitative easing will have ended.
   5. GDP will have to be on sound footing and rise based on sustainable, private-sector growth – not based on the activities of government, which loom so large today in the calculation.
2. Real interest rates – the yields you earn over the actual rate of inflation (not the fabricated numbers ginned up by the government) – will have to be solidly positive. Which, of course, is a big problem given the sheer magnitude of the outstanding debt. Rising rates will only beget more debt.
3. The monetary base of the country will have to be contracting, not soaring as it has been in recent years. "

I read this and think: not terribly likely.

UPSIDE
But the upside is that the gold ratio could go to a 30-40% backing of the US dollar.  That would imply $4000 gold.  I know, sounds crazy.  It will take awhile to happen.  But net net, the beauty of owning gold is that, we can simply buy it, then watch the Currency Wars unfold.  Owning gold means I don't have to worry too much about who wins.  Because at the end of the day, gold will win.

The Bubble That Bernanke Is Creating

I often debate with a couple of my smart buddies what we think of this market.  Lately, anyway, the conclusion seems to be that there is very little to like about it.  It's not cheap for one.  Two, the worst and riskiest stocks are the ones rallying the most.  And in some sectors its absolute mania.  Look at many tech names.  Anything with a "cloud" moniker now is ascribed a near triple digit P/E multiples.  CRM trades at 250x trailing earnings, and 96x forward earnings!  And if its a Chinese Internet company, then forget it.  Is it possible that an online company called Dangdang (Ticker DANG) in China is really worth $2BB, when its forecasting net income of 8mm in 2011?  The market thinks so.  (It listed in December on the Nasdaq).

Like most bubbles in the US, it's significantly Fed driven.  Consider that QE1 (quantitative easing) began back in March 2009.  That was the lows of the stock market.  The S&P ran almost straight up until April 2010, coincidentally a month after Quantitative Easing ended.  Not surprisingly summer 2010 was brutal, and by July and August last year, there was much talk of a fallback into another recession.

I myself was giving 50%+ odds of a recession last July.  Then, in late August, Bernanke announced round 2 of quantitative easing, QE2.  Hooray!  The market has shot up 22% since then, helped along by a healthy dose of fiscal stimulus too.  Yes, our taxes will be going DOWN in 2011, our deficits up.  We are fiscally and monetarily full on the gas so to speak.

So, QE2 ends this June 2011.  If we have a repeat of the last mini-Fed-induced cycle, then I suspect that the rally will last until that time.  We could hit full bubble valuations too by then.  While today we are at historical average valuations of 15x, this could certainly go higher.  Don't get me wrong, I am not advocating getting super long the market now.  I personally think fair value is lower.  (Jeremy Grantham suggests fair value is in the mid 900s on the S&P).  But I find that such momentum rallies tend to leave value investors in the dust.  Yes, I completely missed the tech bubble of the late 1990s.  It makes for frustrating investing sometimes, but my contrarian ways have helped me as well.  I will likely end up mostly in cash by the time June rolls around.

So, the question is, will we get QE3 to keep the market going after June?  I mean, if the Fed just prints a million dollars for everyone in this country, won't we all be rich?  Clearly, the answer is no.  The same reason we won't be all rich is the same reason that inflation is going to happen.  Sure, we could all have a million dollars in the bank, but I am pretty sure that gasoline would cost $50,000 a gallon.  (or something crazy, you get my drift).  We have printed $2 Trillion dollars in a year and a half, and the payback is inflation worldwide.

So, inflation worldwide is starting to really cause problems.  When you have a country like Egypt, where food represents 40% of your expenditures, and food prices rise by 24% in ONE YEAR, then you can get riots.  And toppled regimes.  Certainly a lot of unrest is going on.  Kudos to QE2.  India, Thailand, even Great Britain is at 3.7% inflation.  [Sorry about the last blog, typo'd it at 5.7%].

Either way, inflation is happening here already I am convinced.  The best question I have heard in ages was one asked by David Einhorn to former Fed member Larry Meyer last December.  He asked on CNBC:  "Part of the issue with deflation is:  companies improve the quality of their products.  So, Last month the PPI went down because we had a new car year, and we have a better car for the same price.  So they say prices fall [ie CPI falls].  Now why is it that the Federal Government feels we need a policy response to auto company's making better cars and selling them at the same price.  Why do we need to drive up the cost of energy, food and cotton to offset that?" 

I would always recommend listening to billionaire money managers (David Einhorn) as opposed to journalists (or market pundits) making $50k a year when looking for stock or market advice.  His point is that the Fed is creating a bubble in commodities.  Larry's response was so weak, it illustrated that he didn't even understand the issue.  "You are worried about another bubble in housing?"  Einhorn interjected that he is worried about a bubble in oil and corn.  Even worse, CPI is reported excluding "volatile" food and energy prices.  Amazing.  Someday I'll tackle that one.

So, in addition to this, Fred Hickey puts out a great newsletter every month.  And this month he convinced me to buy more GLD.  I paid around 132.40 today.  He points out that gold has fallen 7% from its peak last fall, and as Fred says, "Gold is up simply because the imbeciles at the Fed are dramatically debasing the US dollar through their negative real interest rates and their monstrous money-printing campaign (quantitative easing).  If money was stable, gold would be too."   It seems that the corollary to this would be:  as soon as the Fed stops easing, then I should sell gold.  However, the Fed simply can never stop printing money.  It's the only thing financing our federal deficits.  I have spoken at length on this issue in prior blogs I believe.

The Chinese have stopped altogether buying Treasuries (going on 2 years now).  They and India are importing tremendous volumes of gold with their currency reserves.  And, the contrarion factor in gold is, futures traders built up their largest SHORT position in gold just this January.  The largest in fact since January 2005.  And as noted in his newsletter, gold shot up 75% in 2005.

I also bought some puts on Micron Technology.  $9 strike, July-dated put options @ $0.40.  The stock is trading at $11.40 today.  The reason is simple.  This company is the airline of the tech industry.  It's lost money the past 3 years, that is until they turned the corner in 2010.  The stock has spiked recently, and for $0.40 an option, I can cheaply buy insurance on a historically volatile stock.  DRAM prices will fall 50% this year, and EPS looks like this the past 4 quarters:  $0.39, $0.92, 0.32, then they only did $0.15 in the November 2010 quarter.   Overcapacity, huge fixed costs, pure commodity play.  Never ever own this stock unless its like 3-4 a share, and a very cheap option worth going long.  And, finally its up 40% in 5 weeks.  Sell.

Portfolio Breakdown, Again

Ok, a short note on the portfolio, and thoughts about the market.  I'll be brief. If you had acted on everything suggested in the blog, then your portfolio would look something like 55% stocks, 45% bonds.  The "small trades" or "little positions" I called $5,000 in size, and the full positions I called $10,000 in size to make up numbers.  All names I priced as of the date of the blog, and on average that seems to be about year end 2010, so a good comparison to the market's returns year to date.  (these are closing prices last night).

					Current
Name	Price	Position	Shares	Purchase Pr	Value	Gain (Loss)
Bond Book
PLBDX	10.47	Long	933	$      10.50	9,772	(32)	-0.3%
PUBDX	11.17	Long	933	$      11.05	10,425	110	1.1%
FXA	101.62	Long	50	$      99.19	5,081	122	2.4%
Short Treasury TBF	46.5	Short	250	$      42.22	11,625	1,070	10.1%
CSJ	104.2	Long	100	$    103.84	10,420	36	0.4%
						1,306	0.0%
Equity Book
WGRNX	14.16	Long	733	$      13.80	10,384	264	2.6%
UTF	17.33	Long	600	$      16.21	10,398	672	6.9%
NFLX	217.63	Short Sell	(30)	$    178.50	(6,529)	(1,174)	21.9%
CSCO	21.99	Long	483	$      20.21	10,629	858	8.8%
NEM	58.27	Long	175	$      60.59	10,197	(406)	-3.8%
TD AMERITRADE	20.69	Long	533	$      18.40	11,035	1,221	12.4%
AAPL	355.2	Long	30	$    341.00	10,656	426	4.2%
TEVA	52.02	Long	100	$      53.75	5,202	(173)	-3.2%
HPQ	48.14	Long	223	$      43.90	10,751	947	9.7%
SPY	132.57	Short Sell	(78)	$    125.50	(10,385)	(554)	-5.6%
					109,661	2,082	0.0%
						3,388
		Bonds			47,323	43.2%
		Stocks			62,338	56.8%
		Portfolio Size			109,661
		Return			3.1%
		S&P Return YTD			5.4%
		Bond Index YTD (AGG)			-1.4%
		Portfolio Index			2.5%

Looks like the S&P is up 5.4%.  This portfolio's equity book is up only 3.3%, with Netflix detracting 100 bps from performance.  The Bond book is up 2.76% including interest, vs the Lehman Government/Corp bond index down 1.4% (ticker AGG).  That is good, TBF is helping a lot.  The 10 year has moved from 2.5% to 3.7% in a very short time.  Muni's also continue to lose money in 2011, hopefully you have been out of them as I have.  (too bad you cant short them).

Equity-wise gold also was a drag with Newmont Mining weakening with gold prices in Janaury.  I think its highly likely that NEM will kill numbers when they report this month though.  Q4 estimates are $1.10 a share, unchanged essentially from the $1.09 they did in Q3 last year.  However, gold prices jumped in Q4.  It looks like gold rallied 10% from Q3 to Q4, and yet no analysts changed their estimates.  They also produce copper, which was $3.67 in Q3 vs $4.50 today.

Net net the total portfolio is up 3.1% vs the index weighted basket up 2.5%.  That is ok, and given the conservative blue chip nature of the portfolio, not bad actually.  The average hedge fund was up 0.8% in January.

While I suspected the market would be up 10% this year, we have already seen up 5.4% in less than 6 weeks.  We have had 56 straight trading days above the 30 day moving average, a record.  I am paring back a couple names that have been winners for me, perhaps not here, but generally I am selling 30% of 2 stocks that are up 30%+ for me today: CI and AMTD.  Both I have owned since last summer and have done well.  I think adding some PLBDX makes sense given the dollars strength lately, and the fact that foreign goverment balance sheets are still solid.

As far as Netflix, I am taking it off.  Pretty much everything went wrong with the trade:  management is continuing to depreciate all their Epix costs on a heavily back end loaded basis.  That is, while real cash EPS was $2.42 last year, they reported $2.96 in GAAP EPS.  Also, there was a huge short squeeze in the stock as 30% of the float is short as of month end.  Revenue was up more than expected, and the market generally has been on a tear.  While a stock trading at 91x earnings is insane, I am stop-lossing this one.  I will revisit this after the Starz deal is renegotiated this August.

With so much inflation creep happening worldwide, I think it looks like many central banks are combating this by raising rates.  China just raised rates yesterday for the second time in month. Inflation is running 5% there.  UK inflation is at 5.7%.  Commodity prices do impact prices, albeit indirectly.  With our deficit problem continuing, the Fed really has no choice but to create another asset bubble here.  Other countries are tightening monetary policy, but the US is remaining loose and keeping rates low mostly because it has too.

Why does this matter?  Generally the stock market is most correlated to monetary policy.  GDP is influenced mostly by debt increases of households and businesses and our government.  So, I think US stocks are the place to hunker down.  Its no coincidence that Chinese rates are going up, and its market is down 1.25% this year to date.  (I used the FXI as a proxy).  I am a little surprised that the US dollar has been rallying, but I think the credit problems we pose are ultimately our death knell relative to other currencies.  Best place to hide in an inflationary world are commodities and equities and foreign currencies.  My exposure to these has worked well mostly over the past year, but not so much in January.

Speaking of commodities, I haven't been able to get comfortable buying oil yet.  With so much unrest in Egypt, the risk premium seems too high.  I will probably wait until things die down, then revisit.  Good luck.

PS I tried to expand the width of the blogs, and somehow got some goofy airplanes as a background.  Anyone know how to get some cool stock charts back there???