Tuesday, September 2, 2008

How to intelligently buy Financial firms

I have attended the past two Berkshire Hathaway annual meeting in Omaha. They are great lessons for anyone interested to learn about investing. The 2008 meeting had a question about investing in financial firms. Warren Buffet's reply was classic.

Warren said that he would invest in financial sector only if he has confidence about the management. He added that in a sector where the earnings are nothing more than guesstimates, management character is the most important attribute.

This is a profound statement that merits closer attention. Many full time analysts have gone through balance sheets of big banks but did not forsee such big write offs. In some cases, the sheer complexity of some of the loan products made it difficult to make meaningful judgement of asset quality. This is further compounded by off balance sheet nature of loans plus relying on financial models that assumed housing price will not decline did not help either. Irrespective of reasons, end result is huge write offs resulting in dilutive capital raisings or firms going bankrupt.

An example of complex product is CDO (Colaterized debt obligation). A CDO is made up of so many different combinations of Mortgage backed security that it is almost impossible to figure out credit quality intelligently. If it is difficult for a full time analyst, think how difficult it is for part time investor!

So what does an average investor do to invest intelligently in financial firms. Here are few things that an investor can do that were derived from Warren's advice.

1. Culture of an organization: This is difficult to evaluate for an outsider. But getting a handle on this is priceless. CEO sets the culture from top. One way to evaluate is by reading up as much about CEO as possible. The annual letters are a good start to verify if the CEO provides a thoughtful evaluation of future or just presents only rosy scenario.

2. CEO must be the chief risk officer: Warren stated that CEO must be the chief risk officer. An organization with CEO who is risk conscious will invariably respond by being risk conscious. Risk metrics in that case are no longer abstract tool output but management task.

3. Keep it simple. Complexity is enemy of a good investor and a good manager. Complex dervatives, CDO's, off balance sheet SIV's and so on are not easy to follow for a reason. They cannot be judged easily. Less complex assets ensures that management as well as the investor will have better handle. My thinking in this line is also to be careful before investing in huge financial entities that are difficult to manage even for a CEO much less for an investor to get an handle. Exceptions always exist like Berkshire Hathaway.

3. Leverage: Financial companies by definition have leverage. But it is best to stay away from those with huge leverage or at least understand what you are doing when you buy a company with huge leverage.

4. Management has skin the game: This does not make the company immune from disasters. But atleast you know that management has incentive to take only those risks that are prudent.

5. Cost conscious CEO/organization: I add this based on reading Warren Buffet's biography as well as his preference for organizations with low over head (including his own). Warren likes entrepreneurs who are very conscious of cost. There is a story of an entrepreneur coming late to a meeting with Warren in order to find unexpired parking meter. This cost conscious nature permeates other aspects of decision making and results in a prudent risk taking. I do not have solid evidence but this attribute seems to be more important than the obivios cost savings it produces. It highlights a culture.

5. Bottom line, Do not buy if you do not have very high confidence on the management. With out that, it is difficult to get a handle on risks. Except CEO, no one else can resist the urge to make huge profits in a division even if they will result in future losses. So CEO is your best margin of safety.

On a personal note, I stayed away from AIG because I did not know enough about management. I read that Chris Davis (Selected fund manager) called for new management to be hired from outside the board. I could sense a lack of satisfaction with management selection. So I stayed away. Short of this, there is no other reason to stay away from bargain priced AIG at that time. It is possibly luck and limited of funds too! But a visit to Berkshire always pays for itself!

Welcome your thoughts....