09/24/08   The Demise of Investment Banking

Editor’s Corner

The Demise of Investment Banking

Ron Rowland

Was it the bottom? Last Thursday brought a volatility spike and sharp intraday losses in the major equity benchmarks. Then, when things were their bleakest, two forces combined to spark a massive rally: rumors of a Treasury plan to unburden financial institutions of toxic mortgage paper and harsh new SEC restrictions on short-selling of financial stocks. The Mother of All Short Squeezes propelled the Dow almost 800 points higher in two days – or more than 1,000 points from the low. So far this week, more than half of that gain has been retraced. Yet the fact that part of it remains is reason for guarded optimism.

The Paulson-Bernanke bailout plan is being roundly criticized from all directions, and justifiably so. While we concede some type of extraordinary intervention may be justified, it is not at all clear that this proposal is the best way to do it. However, since we do not have a better idea, we will try to curb our criticism. The current plan is running into stiff opposition on Capitol Hill, and it appears likely there will, at the very least, be major modifications. Time is not on Paulson’s side in this battle. His prime argument is that a financial meltdown will occur within days unless Congress approves the plan immediately. If no bailout plan is passed this week, and the world does not end on Monday, the sense of urgency will be gone. At that point all bets will be off.

Warren Buffett, and Berkshire Hathaway (BRK), pumped $5 billion into Goldman Sachs (GS) today, and as usual he managed to drive a hard bargain. Yet the fact that Goldman was able to raise capital at all is an encouraging sign. The Buffett seal of approval may give other institutions the confidence they need to make similar investments. Having been backed into a corner, Wall Street may find ways to bail itself out of its mess. The landscape is definitely changing, with both Goldman and Morgan Stanley (MS) converting into commercial banks. This suggests the “investment bank” business model may be a thing of the past.

All segments of the bond market took a hit this week, even U.S. Treasuries. The Vanguard Extended Duration Treasury ETF (EDV) dropped -8.8% in the last five days. Banks appear to still be hoarding cash, with overnight lending rates like LIBOR jumping higher. Cash remains king for now, especially cash of the green folding variety. Much depends on the outcome of the bailout plan and its impact on the national debt. If the foreign investors who have financed our deficit spending in recent years lose confidence in the U.S., the consequences could be devastating.


Financials moved up to the #2 spot in our sector rankings, leaping ahead of Health Care and Consumer Discretionary. Consumer Staples are still in the lead, but no sector has positive intermediate-term momentum in absolute terms. Energy gained relative strength since crude oil appears to have reversed, or at least paused, the downtrend that began in July. Basic Materials remain on the bottom of the list.


There were only minor changes in our Style rankings over the last week. Small Value is still in the lead and is showing a little more upward momentum. Micro Caps continued to improve both absolute and relative strength. Dispersion in the Style rankings is on the rise again and the current spread is wider than the Sector and Global rankings. We do not know if this is a first, but it is certainly a rare phenomenon.


Canada jumped to the top of the list, helped by major gains in the Canadian Dollar and higher oil prices. Latin America, China, and other Emerging Markets remained weak but did manage to slow their downward momentum slightly. Every global equity market is still in an intermediate-term downtrend, and it will probably take more than one or two good weeks to change that condition.


The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

“It’s nice to have a lot of money, but you know, you don’t want to keep it around forever. I prefer buying things. Otherwise, it’s a little like saving sex for your old age.”

Warren Buffet (b 1930)
American Billionaire, Chairman & CEO of Berkshire Hathaway


Grab a Piece of Buffett’s Cash: BRK.B

Brandon Clay

Pick of the Week: JNJ


Cash is the best asset in a falling market. Even the shorts may agree with that statement. Last week, many were squeezed out of their positions when the SEC temporarily forbade short selling financials. But there’s another reason cash is so valuable: cash equals choices. That’s why investors say cash is king. The king can do whatever he wants. So whoever has the cash, is the king.

Here’s how it works in real life: Warren Buffett’s Berkshire Hathaway (BRK.B) has the cash. Latest filings show Berkshire holding $31 billion. With that much in the bank, Warren has options. Just like a king, cash-rich Buffett can pick the best stocks in a decimated market. For Buffett, it’s good to be the king.

Value or Vulture Investing

Cash is his tool of the trade. Being the quintessential value investor, Buffett is always looking for a good deal. Finding undiscovered value is how he became the richest man on the planet. He patiently waits for the right opportunity instead of jumping on every stock.

That’s why value investors are sometimes called ‘vultures’. Vulture investors pick up the pieces the rest of the market waylaid. In time, it works out for them. Depressed stocks are eventually discovered and vulture investors ride the wave up. Who better to describe this philosophy than Buffett himself?

“You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”

Buffett’s Bank Idea

Recently, Warren Buffett had an idea. He decided it was time to buy a bank. This morning, Bloomberg reported Berkshire Hathaway bought $5 billion of perpetual preferred stock in Goldman Sachs (GS). But Warren’s cash infusion was not a donation. Despite Buffett’s philanthropic leanings, he’s more interested in ROI than tax write-offs this time around.

Here’s what he’s getting out of the deal. Buffett’s $5 billion is gathering 10% dividends every year it’s at Goldman. If GS pays off Berkshire, they pay another 10% premium for the buyback. Not only that, but Buffett got another $1.5 billion of warrants (similar to options). Goldman is also presumably backed by former CEO and current U.S. Treasury Secretary Hank Paulson, so they should be able to weather the current financial storm. From the looks of it, Buffett came out way ahead on this one. We think it’s another Buffett coup that demonstrates he still has the touch.

Berkshire Caveats

As you well know, nothing is sure in this business. Even though the world’s most successful investor heads Berkshire, succession is always a concern. At 78 years old, Buffett won’t be around forever. Aware of the concerns, Buffett has assured shareholders of a plan to split his job into three parts: Chairman, CEO, & Chief Investment Officer. Internal and external candidates appear lined up to fill his shoes. Buffett is taking the necessary precautions.

Another concern would be Berkshire’s underlying business. Berkshire Hathaway is a holding company. As such, they only do as well as their current assets – and they are vested in the success of the U.S. economy. Their retail and financial services properties are particularly vulnerable. Still, Buffett’s reputation for long-term success bolsters our confidence in the underlying stock. Buffett will sell his most vulnerable positions to free up cash for better prospects.

We’re not promising giant leaps in your portfolio, but we think Berkshire Hathaway is still a good long-haul investment. To participate in Warren Buffett’s future gains, go with Berkshire Hathaway B-Shares: BRK.B

All the best.

P.S. Berkshire Hathaway’s B-Shares are just as good as their A-Shares. However, they are much more affordable than their A-Shares, which closed at $133,300 today. It’s much easier to purchase the “only-$4,475” B-Shares.


Keep in mind, the Pick of the Week is usually intended for aggressive investors. Don’t risk money you can’t afford to lose. You will need to decide when (and if) it is time to sell.

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