Clayton Homes Approach

James Clayton built a Tennessee-based manufactured housing company that was subsequently purchased by Berkshire Hathaway (BRK). Clayton Homes was remarkable because of its ability to expand marketshare and improve profitability regardless of the economy's condition. Today's environment has been no exception.

Why have the owners of Clayton Homes not defaulted? BRK's CEO Warren Buffett attributes it to the borrowers intent: "they took out a mortgage with the intention of paying it off, whatever the course of home prices." This seems excessive praise to the wrong group. Certainly, the borrowers at Clayton Homes were susceptible to the same greedy motives as the rest of us. So what is the real reason?

I believe that the borrowers were not given the opportunity by Clayton Homes to outborrow themselves. As I understand it, after some early losses, Clayton Homes established a policy of forcing the sales managers to split the losses of any bad loans. In this way, the anti-outborrowing gene was embedded in the culture at Clayton. The result is that current delinquincies are running at an extraordinarily low 3.6%.

A company has to be extremely careful about incentives. Excellent arguments have been made that when Wall Street went public, proper participation in the upside and downside of risk was lost and the resulting destruction was only a matter of time. Constructive improvements in compensation structures, aligning risk with compensation so that decision-makers share in the upside and the downside are likely to be more powerful than any regulatory reform.

Better Than Buyouts?

BusinessWeek just carried a well-written and thought-out "viewpoint" from Preston Henske and Tim van Bieson. The authors argue that rather than employ the armies of M&A people, create a gargantuan battle of egos and incur the takeover premium costs, the "r&d collaboration" model has a future. They write: "By effectively pooling research assets within a disease area, the industry would benefit in three ways. First, partners would make resource allocation decisions much earlier than before and fund only those projects with the highest likelihood of showing real differences in medical outcomes. For example, rather than pursuing several expensive late-stage programs in parallel, competitors could combine their resources and fund only the most promising candidate. Second, this approach will reduce the number of duplicative or "me-too" products, many of which now struggle to get access and reimbursement. Finally, the new model will distribute risk—and returns—across partners to increase the predictability of pipelines and long-term revenue." Assuming that this model does not lead to some anti-trust type of issue, this approach has significant merit.

Calpers "On Tilt"? May Pay "Dear"ly

The California Public Employees' Retirement System, also known as Calpers, is the largest in the nation with $180 billion in assets. Calpers, like most, had a miserable 2008 with a drop of nearly $60 billion. In response, Calpers has brought on Joseph A. Dear who gained a reputation as a daring investor while managing the Washington State pension fund.

Mr. Dear's approach is to dramatically increase high risk investments, such as private equity, hedge funds, junk bonds, California real estate and all things esoteric. Mr. Dear appears to be "on tilt." Going "on tilt" is a mindset familiar to gamblers, who recognize the impulse or seeming necessity to gamble recklessly after a big run of bad luck as the most dangerous of all. Everyone else gets rich at the expense of the mind-altered gambler.

Why doesn't Mr. Dear recognize this dynamic? Deep-seated beliefs. "Private investments, he asserts, will over the long haul outperform stocks by three percentage points a year" (NYT 7/23/09). He views this long haul outperformance as "necessary" to meet Calpers' funding objectives. Having discovered this seemingly God-given performance principle, Mr. Dear is now exploiting it for the benefit, or detriment, of 1.6 million California employees and families.

If these areas get increased funding, what will receive less? Domestic common stocks. This was the very asset class that saved Calpers last year by providing liquidity (at fire sale prices) to meet the continuing calls of "feed me!, feed me!" from private equity, hedge funds and real estate. At the time of the lowest domestic common stock valuations in years, Calpers is moving on. Rather than simply accepting a Buffett challenge to investing, "A fat wallet is the enemy of superior investment results" (BRK 1994 annual report), Calpers appears to be gearing up for stardom - of some type.

"Peak Drug"?

Seeming to be a version of "peak oil," in which discoveries inexorably decline at a greater rate than usage, the entire drug development system appears to be in a secular downward trend. Such a trend seems inconceivable. Our historical experience indicates that we simply need to try harder, spend more money, or "think outside the box." But thinking outside the box here may indicate that we have reached some limit where increased effort will simply yield decreasing results. If so, Big Pharma will continue to consolidate.

The Unforeseeable Future

Robert Rodriguez, the CEO of FPA funds, reminds us that it was on July 10, 2008 that Secretary Paulson said that ‘the lenders (Fannie and Freddie) have sufficient funds’ before the House Financial Services Committee. On the same day, the Office of Federal Enterprise Oversight, which regulates both Fannie and Freddie, said that ‘both are adequately capitalized.’ Finally, Senator Chris Dodd in a news conference the following day said, ‘These institutions are sound. They have adequate capital. They have access to that capital.’ Then on September 7, 2008, the Federal Housing Finance Agency announced the decision to place both of these institutions into a conservatorship that resulted in the debt and mortgage-backed securities being effectively guaranteed by the U.S. government. The Office of Management and Budget then projected that they needed an additional $92.2 billion by September 30 and this as supplementary to the $78.8 billion already received. Both companies have an emergency capital commitment from the Treasury for $200 billion each.

His point is to demonstrate how poorly the government forecasts; in fact, I would argue it demonstrates the fallibility of all of our forecasting. I believe it is for this reason that the 1994 BRK annual report notes: "We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen...Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak."