Those who talk finance with me know that I have an abiding respect for investor Bill Ackman.  It comes close to man-love, I must admit.  Bill is eloquent, thoughtful, intelligent, well-informed and any other adjective that gives praise.

My first experience reading about and listening to Bill came about this time last year when I was struggling with whether to invest in General Growth Properties.  At the time last April, GGP was entering bankruptcy.  But the market and economy had just begun to turn and I had personal experience with GGP properties and management and thought the company had excellent mall properties and was well run.  I wanted to invest in GGP which was then selling for only $0.65 per share and had a total capitalization only around $200M on a business with properties once valued at $30B.  If it were possible to solve the debt problem at GGP, then the company had an excellent chance of survival.

Enter Bill Ackman into my life.  As I was researching GGP, I came across research that Bill had put together as his hedge fund, Pershing Square Capital Management.  He had done a very thorough job researching GGP and was able to show that with even modest "cap rate" assumptions, GGP would do very well.  All it needed was time to restructure its debt.  Ackman proceeded to take an active role in buying time for GGP, first by offering to provide bridge (DIP) financing (later provided by another party), helping convince the court of the merits of GGPs survival and later by joining the GGP Board of Directors. 

As the year 2009 progressed, Ackman's activism and my confidence in his research proved very profitable for both of us.  I have now exited my GGP investment (much too early) but Ackman, to my knowledge, remains on board and has seen his investment return over 20-fold.  I admire this type of clear vision and the courage to act on it.

Ackman was a noted short trader earlier in his career.  He gained notoriety for his big short position in credit card company MBIA in 2005, for which he was investigated by the now-notorious Elliot Spitzer, then New York State Attorney General.  He was able to demonstrate to Mr. Spitzer his innocence and turned the table on MBIA by exposing the Attorney General their fraudulent practices, the reason for his short position  (presaging the debt crisis to come).  He took a "sow's ear" and turned it into the proverbial "silk purse".  That taxes moxy.  That takes class.

Given his career path and the level to which he has risen, Ackman is very intimate with the inner workings of Wall Street.  He shows himself to be rational and level-headed and has a thorough, first-hand understanding of the arcane financial instruments that Wall Street has created.  So, when he gives his opinion on the Goldman Sachs situation, I listen (much more so than to EF Hutton).  Today as guest host on CNBC Squawk Box, Bill Ackman shared with us his assessment.  He comes down on the side of Goldman Sachs for all the reasons I have provided in the past two weeks, but with the conviction that can come from only an insider.  Here is an excerpt from the show:

Goldman Sachs did not commit fraud and the insurance company that bought the product that is the subject of a government investigation should have known the risks, Bill Ackman, founder and CEO of hedge fund Pershing Square Capital Management, told CNBC Tuesday.

“I don’t believe that Goldman committed fraud,” Ackman told “Squawk Box Europe.” “(ACA, the counterparty to Goldman - Paulson Partners) took their own risks.  "They’re sophisticated investors.” “I don’t think the (Securities and Exchange Commission) has a good case,”  Ackman said.

“Having been the subject of investigation in the past  (for the MBIA case referenced earlier)… I don’t feel sorry for Goldman Sachs, but they’re not being treated fairly (either).”

Not only does Ackman contend that Goldman is innocent of the charges of fraud, as I also maintain, in addition, it would even have been unethical if Goldman had disclosed that hedge fund manager John Paulson was shorting the housing trade to any investors taking long positions, Ackman said.

Ackman argued that sophisticated investors (the German and Dutch bank that bought the long positions from ACA) have the information at their disposal to make their own decisions, and are also responsible for their own mistakes.

“Imagine that Soros and Buffett were on the two sides of this transaction,” he said. “We wouldn’t even be talking about this now.” 

But later in the interview, Ackman states that the true victims are the taxpayers as they do not know they are party to the trade via "too big to fail" and taxpayer rescues.  This is true in Germany and the UK, as well as in America.  It is the taxpayer that has to cover the losses made by overly aggressive bank managers who are playing with OTM (other people's money) in order to win large bonuses.

So, it is not Goldman Sachs that should be taking the fall for the financial crisis, but the bank managers that lost money and the regulators / government officials that are charged by the public with protecting the financial system.  The "witch hunt" that is today's Congressional hearing is completely misdirected and intended to make the Congressmen who failed in their sworn responsibilities, look better, much better, than they really are. 

At the end of this segment, the former SEC general counsel, Simon Lorne, appeared with Bill Ackman. Mr. Lorne offered his highly informed opinion that the case by the SEC against Goldman Sachs is "weak". This is the position I have maintained. The facts will show that there was no "fraud". If anything, there may have been some technical error of omission where disclosure is involved. This might justify a fine of some sort, even a large fine given the stakes involved. But Mr. Lorne says it all much better than me:

Disclosure: I am long GS with October Call contracts; If I could be, I would be short the Congress;

I think not.  This is a politically motivated action brought against GS by an SEC controlled by the Obama Administration.  That motive is to demonstrate to the public that the Federal government will hold accountable banks for activities leading to economic damage.  There is a lot of pressure on the Obama Whitehouse to attack and punish "Wall Street" in retribution for the economic crisis and housing crash.  Goldman is the "poster child" for perceived banker abuses and is seen by some as the cynical and greedy conductor of fraud to take advantage of innocents.  But in reality, the processes charged in the SEC case as fraudulent are typical everyday practice. 

The people on both sides of the sub-prime mortgage CDO trade are large, institutional investors who should know their risks and be prepared to accept losses.  This is true of any trade.  There are buyers and sellers of every financial instrument and subsequent winners and losers.  It is common, in fact, for financial instruments to be created by "market makers" like Goldman Sachs at the request of a buyer or seller who believe they have insights that will allow them to profit at someone else's expense. 

This is how financial markets work.  The market maker may have an opinion of its own about which side is right and which side is wrong.  For this reason, an independent third party is brought into to assess and vet the investment vehicle to insure it is fairly created and accurately represented.  This appears to have happened with the GS CDO in question. 

Jim Cramer, who at one time in the early 1980s, worked for Goldman Sachs and understands the inner workings of the investment banking world, explains what happened:

Before people went too far in their attacks on Goldman Sachs, as today’s charge of fraud by the SEC will train even more proverbial guns on the Wall Street titan, Cramer felt the need to clarify the case. He wasn’t exactly defending the firm, but he wanted viewers to know exactly what happened.

First, full disclosure: Cramer got his start on Wall Street at Goldman [GS  160.70    -23.57  (-12.79%)   ] , and he still has friends there. But he insisted that that was in no way the reason he was challenging the SEC. He said that while he wouldn’t want to be associated with the trade, that didn’t mean there was anything “illegal … immoral or even unethical about it when you pull it apart,” he said.

So here it is pulled apart:

Goldman created a product, a collateralized debt obligation, for hedge fund Paulson & Co., which “at the time wasn’t known as a particularly smart client,” Cramer said, that allowed for a bet against the value of housing. To make sure the product was vetted ahead of its sale, Goldman hired an independent company, ACA Management, to do just that. And they released a report telling potential buyers exactly what was in there.
 

Now, Cramer would never have bought the CDO, but not everyone was as bearish on housing as he was in late 2006, which is when the product was put together. Though he could see how less informed clients may have found it attractive. But in the end, no one forced people to buy this CDO. And “a sucker was born the minute the trade was made,” he said, “and the loss booked soon after.”

So did Goldman do something illegal when it vetted the product, letting everyone know what was in it? Or was the buyer just plain stupid for wanting it in the first place?

“I think the latter,” Cramer said.

He likened the situation to the tech boom of the late ‘90s. If someone created a similar product to bet against these stocks, it would have been an entirely legal, but losing proposition until 2000. It was only after that run that the bet would have paid off. Well, housing was exactly like that, Cramer said, going into 2007. And the buyer of this CDO fully expected to continue making money, only to be shocked awake when the market collapsed. Now Paulson & Co. is known as a house of genius, while the people who went long on housing are the fools.

We learned today that Goldman sunk $90 million of its own money into the CDO. While Cramer’s not sure if that absolves the company, he does know one thing: The SEC is under tremendous pressure to bring cases against Wall Street right now. And he knows that Democrats in Washington are fighting for financial reform. So this is a great time to bring this case before the public and punish the firm perceived as the most arrogant and least reformed in the room.

But while arrogance may be a terrible personality trait, Cramer said, it isn’t illegal. And he’d be the first person to call out Goldman if the company were wrong. But he doesn’t think this is one of those cases. If anything, this was a case of “overzealous prosecution,” he said.

“That’s exactly what I think happened today against Goldman Sachs,” Cramer said. “And I think you’ll see it exactly as I do as time goes by.”

In the Land of the Rising Sun, the financial sun is apparently setting. I have zero investments today in Japan for the reasons outlined in the story linked below. Credit Default Swaps (CDS) are showing the Japanese banks are under great stress. Those bank debt insurance policies are at levels close to where American banks were in September 2008 before the big crash and bank implosion.

I have business associates in Japan, and the economy has been in virtual depression for many years. They have a homeless problem like you would not believe with tent villages on public grounds in the cities, especially around the old castles (but being Japanese, they are very tidy tent villages).

From my take on the Japanese people, the problem is mostly to do with their domestic reluctance to consume. They have a domestic consumption economy much too small for the size of the country (by population). The older generation that came of age post WW2, was reluctant to spend on anything, understandably so given what they went through in the years after 1945. Even the business leaders who make a very nice income by American standards, are very frugal in how they live. The wages for the workers among the younger generations are very modest. I was able to determine that a sales person selling the same products as me, with the same skill set and experience, was making half the wage. The Japanese I know can’t believe how well we live here in America and some consider us wasteful and decadent (though they enjoy participating in the decadence when they visit).

And with the WW2 generation being very conservative about their own future, they had small families with birth rates below the "replacement rate" of about 2.2 children per family. This, along with virtually no immigration, leads to the well known problem of Japan’s gentrification. Who is going to take care of all the older people on government pension and healthcare?

And now Japan has lost the one thing that kept it going and growing the past 40-50 years: a leading global position in manufacture and export of consumer goods. China and its siblings (Taiwan, Singapore, Thailand, Vietnam, etc) are taking over this role on the world stage. Japan is left to try and export capital goods and engineering know-how to China and siblings, much like America. But America has a population that always expands from immigration (a reason I am VERY pro-immigration) and an established consumer psychology that will recover within the next few years, Bill Gross’ proclamations to the contrary. Our desire to consume is genetic. It is the source of the proverbial "American Dream".

A second significant problem for Japan is that Japan has no natural resources to export. So, they have lost their consumables export leadership and have nothing left to sell the rest of the world to drive their economy. Japan does not consume enough as a nation to fully utilize its own productive capacity for domestic demand and to keep its younger workers employed to pay for the retirements of the older workers. This is the source of Japanese deflation.

I think Japan will either evolve out of necessity into a consumer nation over the next 20 years as the younger generations with Western ideals take over management of the country, or Japan's financial system will go into default. In October last year, the world financial system came to the rescue of America with its heavy importation of manufactured products and its reserve currency. The world had to save American banks in order to save itself. But for Japan, there will be no such salvation. Its banks will be allowed to fail and the Japanese people will have to build the country all over.

If Japan defaults, it will be VERY ugly (Iceland times 100). So, I expect global financial interests to push the Japanese to avoid that fate before it happens. Ironically, the Japanese need to spend their savings (those infamous Postal accounts). That is their one chance to save themselves and the rest of the planet a lot of pain. Strange as it seems for Americans with our low national savings rate, it is possible for a nation to be too thrifty (called "The Paradox of Thrift"). There is a need for balance in a sustainable economy: not too little savings, but not too much; not too little social security, but not too much (Obamacare for example); not too little immigration, and not too much. And so on.

Just be glad this is happening now and not in 1990. The Japanese economy (including real estate and stock market) has already deflated by 80%. The crash if it happens, will not be as precipitous from these levels as it could have been. But it is shocking to contemplate. I think the weakness of Japan's economic system, its lack of domestic consumption and its long term social liabilitites, is the reason the Yen will never become the world reserve currency. The dollar remains safe in that role for some time to come.

Here is a link to the article that inspired this post published in the UK Telegraph on Sunday (bottom of post). It is somewhat frightening reading. But as mentioned, I don't think the Japanese economy has a great deal of direct influence on the Rest of the World. Besides, as Warren Buffet says (quoting someone Ben Graham I believe), "Buy when everyone is Fearful and Sell when everyone is Greedy". He did that today when he acquired ALL of Burlington Northern Santa Fe rail (BNI) for $44B.

"It is Japan We Should Be Worrying About, not America"

Fluor Engineering has many positive attributes.  FLR has a P/E of 12 and an almost guaranteed profit for the next 12 months due to the contractual backlog that is inherent to engineering construction companies.  Its Revenue / backlog is $23B while its Market Cap is only $8.6B for a very low P/S ratio of 0.37. This while the ROE is 26.71%.  Engineering construction is a high margin business. (all numbers as of October 2, 2009)

The long term outlook for engineering construction is very good globally with infrastructure and natural resource processing required in Emerging Markets and as a form of stimulus in developed markets. FLR was at 100 in June 2008 and tracks very close with energy and materials stocks as that is where FLR does most of its projects. Its five year low was 28.60 on Nov 20 during the panic. I can't imagine prices getting back to that level again:

Take a look at this ITM call spread. Underlying: FLR at $47.60 (Friday close)

Buy APR '10 $40 CALL (FLRDH) for $10.50

Sell APR '10 $65 CALL (FLRDM) for $1.10

Net Cost = $9.40 per contract (100 shares

Upside is 166% Return in 6.5 months (note that the time premium degrades closer to expiration which causes return to decrease)

Downside is 40 - 1.10 = 38.90; return = zero;

Any close above $49.40 at April expiration will be profitable

A $9400 investment would buy 10 contracts and allow the possibility of a $15,600 return

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To provide a little better downside protection in return for giving up some upside, go deeper in the money to the $35 CALL:

Buy APR '10 $35 CALL (FEMDG) for $14.60

Sell APR '10 $60 CALL (FLRDL) for $1.90

Net Cost = $12.70 per contract (100 shares)

Upside is 97% Return in 6.5 months (note that the time premium degrades closer to expiration which causes return to decrease)

Downside is 35 - 1.90 = 33.10; return = zero;

Any close above $47.70 at April expiration will be profitable (basically, just above the current price)

A $13,970 investment would buy 10 contracts and allow the possibility of a $13,530 return

Another possibility is to just buy the shares outright and then sell a $60 April Call against them for $1.90. But that reduces the return and really doesn't provide much benefit in reduced risk. Chances are the time premium on option 1 of $2 between now and April will be rewarded. It is not much to pay for the chance at a 100% return in 6 months

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I attribute recent price weakness (past two weeks) to profit taking.  The past nine months had seen an almost 100% price rally from the November low.  But fundamentally, FLR is very sound.  If you believe as I do, that global growth will continue, especially in the Emerging Markets, FLR is very well positioned regardless of problems in the American economy.

There are many doomsayers on the economy and markets. They all say roughly the same thing: we have been profligate as a nation and as a world, and there is a big price to pay. This price will be paid in the form of a very long period of economic stagnation and declining markets. The doomsayers give many seemingly sound reasons for their outlook, that to some may seem irrefutable evidence of a coming economic armageddon.

Unfortunately, history does not support their thesis. If anything, what economic history proves is that there is a wired-in persistence of growth in the economy. When we look at our financial surroundings on a day to day basis, we get confused by the noise. Daily, monthly, even quarterly data might seem to indicate some watershed change in the economic future. But the facts show us that year after year, decade after decade, the economy continues to grow very evenly and consistently. The markets will mirror this growth in the long term, and once all the daily noise is removed.

Here is a chart I prepared showing this persistence. It dates from the earliest Gross National Product data available on the government economic data website. It shows that even the 1930s disaster looks relatively benign in an 80 year perspective.

The conclusion: invest for the future, not the next day. And you will be richly rewarded for your patience.