Debate on financial innovation

Read this awesome commentary by Jeremy Grantham at http://www.gmo.com/websitecontent/JGLetter_ALL_4Q09.pdf

" “Beware the Financial Industrial Complex”

It is not often one gets the opportunity to debate a Nobel

Prize winner, but Richard Bookstaber and I went to Wall

Street to debate Myron Scholes and Robert Reynolds

(Putnam’s CEO) on a very topical topic: “Financial

Innovation Boosts Economic Growth.” There are no

prizes for guessing which side opposed the proposition.

Richard Bookstaber, by the way, is an experienced quant

who, despite that, wrote an excellent book, A Demon of

Our Own Design: Markets, Hedge Funds, and the Perils

of Financial Innovation – a title so superb you might think

it unnecessary to read the book, but do."

Mind blowing presentation below. People pays $1500 for the summit.

We get to watch if for free :)

The Letter that I've been waiting for

As usual, the annual letter by Warren Buffett to Berkshire Hathaway shareholder is an awesome read. This letter is particularly good as an Berkshire Hathaway introduction as its target readers are the tens of thousand of new shareholders that got their shares through the acquisition of Burlington Northern.

The letters are available here: http://www.berkshirehathaway.com/letters/letters.html

I love the part of where Buffett advised that for every deal, another investment banker should be employed whose fee will be paid contingent on the deal NOT going through. Haha. Another great section is the part of the letter where he discussed the issue with stock for stock acquisition. To me, this is another instance of Buffett publicly chiding the Kraft-Cadbury deal. I need to learn how to criticize without offending people...

On a personal note, I'm glad that i went to the shareholder's meeting last year, as this year on, Buffett will no longer meet the international shareholders individually. However, the school that i went on exchange in, Richard Ivey School of Business, sent their students in the Value Investing course led by Prof George Athanassakos, to meet Buffett in a closed door session last week!!! How I wish I was there.

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Reading through Zkai's recent post on real estate makes me realize that this is one asset class that I am totally unfamiliar with. I have no clear idea of what are the economic drivers, and the intricacies of making a purchase (e.g. contract details). However, I believe that real estate as an asset class allow you to measure value in the same metrics that you'd measure an investment in the stock of a company.

We should be able to value the said property's prospective rental yield, potential for growth in the rental, accounting for a relevant financing charges and other maintenance cost; and compare the yield to the actual cash outlay that is required.

However, a property like 'land', will not allow us to subject the asset to the same calculation. This is because like other asset such as gold and silver, there is no inherent cashflow in undeveloped land. Thus its profitability will be fully dependent on the sale price, which is determined by supply and demand.

In my view, buying an asset with no underlying cashflow is much risker than buying an asset with cashflow. So unless prospective return is way higher than other alternative (rental properties, equities) this would be a highly speculative venture.

The following quotes are relevant to our above discussion. It is quoted from John Maynard Keynes, The General Theory of Employment, Interest and Money, Chapter 12. The State of Long-Term Expectation. Available here.


...If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous.

(...)

There are, moreover, certain important factors which somewhat mitigate in practice the effects of our ignorance of the future. Owing to the operation of compound interest combined with the likelihood of obsolescence with the passage of time,there are many individual investments of which the prospective yield is legitimately dominated by the returns of the comparatively near future. In the case of the most important class of very long-term investments, namely buildings, the risk can be frequently transferred from the investor to the occupier, or at least shared between them, by means of long-term contracts, the risk being outweighed in the mind of the occupier by the advantages of continuity and security of tenure.