As we approach the Fiscal Cliff, or more properly Slope, I thought the Republican negotiating strategy was very revealing. Gerrymandering, the process by which Congressional districts are tortured into shapes that resemble something drawn by a drunk with a permanent marker, are certainly part of the issue. Although the original intention was  to allow for districts that reliably elect minority candidates, the result has been districts that don’t turn over. The strength of incumbency in the House of Representatives has the consequence that general elections matter less than the primary for the dominant party in that district. If a district reliably votes 60% Republican (or Democrat) the winner of the election will be the successful primary candidate from the party that normally prevails. Primaries matter a great deal for the House. Therefore, the failure of House Speaker John Boehner’s Plan B two weeks ago is not an example of Republican self-destruction, but rather of enlightened self-interest.

A House Republican is more concerned about a Tea Party primary challenge than a general election loss to a Democrat, given the polarization of so many districts. Therefore it makes little sense for Republicans to compromise their principles in trying to resolve the fiscal cliff. They have little upside in any case from strong economic growth (it is Obama’s Economy after all) and plenty of downside from a more Conservative challenger.

The New York Times added an interesting perspective to this last week, when they noted that on top of gerrymandering there appears to be a tendency of people to live in districts where their neighbors share similar views. This is not a welcome development for those who believe that compromise is the only solution to America’s fiscal challenges. In fact, further electoral polarization would seem likely to drive even more partisan disagreement in Washington.

This is one reason why optimism about the fiscal future is not warranted. The tight races in elections are steadily diminishing, and we are headed for now in a direction of increasingly shrill disagreements. But under these circumstances one decision does appear illogical. In an era during which both political parties appear to be moving away from one another and towards their base, why would any voter split their vote? For just as President Obama won a renewed mandate from the American people, so did the House Republicans who retained their majority. Some districts, and some voters, clearly split their vote between a Democratic President and a Republican member of the House of Representatives. This happened notably in Florida where Obama barely clinched the state’s electoral college votes with 50.0% while the state chose Republicans for 17 of its 27 members of the House of Representatives.

Clearly a substantial number of voters in Florida split their vote between a Democratic President and a Republican member of the House of Representatives. When Congressional relations were altogether more cordial such as under President Clinton the implicit desire for compromise possibly made sense. But following the last few years who can seriously expect compromise rather than the perpetual stalemate that has brought us to the edge of the Fiscal Cliff? The voters who split their vote don’t really hold a coherent view. The parties are sufficiently far apart that expecting grand compromise appears rather naive.

Instead of blaming Washington, a portion of the problem lies with an electorate that in some cases has failed to carefully consider what type of government they want. As a result, hasty, superficial decision making based on sound bites has brought us the government we deserve, rather than the one we need.

Hedge Funds will continue to deliver mediocre results at great expense for those unwisely hoping an over capitalized industry can emulate its smaller, formerly profitable and ever more distant past.

I had inexplicably missed this on Dec 14th, but The Hedge Fund Mirage made it on to this list.

Click Here for the article.

The Economist, without doubt my favorite weekly magazine (or newspaper as they refer to themselves) has brought its clear thinking and analytical skills to hedge fund returns. As usual they’ve provided a balanced perspective that includes important points. They note the poor decade hedge funds have had relative to a simple 60/40 stocks/bonds portfolio. They suggest that most likely hedge fund fees have exceeded the returns earned by investors (in fact fees have completely swamped overall returns for investors as I’ve noted in my book and on this blog). “The average hedge fund is a lousy bet” they note, and this is true. There are great hedge funds and happy clients, but this is not the norm.

The vast majority of hedge fund professionals have sensibly stayed away from this debate. Defending a diversified portfolio of hedge funds as vital to an institutional portfolio requires nimble debating skills given the absence of factual data in support. And I continue to find many open minds among hedge fund allocators and investors. The industry has drawn people with highly developed commercial skills and most recognize well the need to transfer more of the investment skill that does exist to their clients with less drag from high fees and mediocrity. I have no doubt that business models will evolve and improve in response to the sorry decade of results. Hedge funds will not disappear. The many problems with the existing structure will eventually be solved to the benefit of the clients.

However, Tom Schneeweis, a Finance professor at UMass Amherst,  has offered some criticisms of my book, including describing it recently as, “…baby hedge fund analysis 101 at best.” I imagine among the Ivory Tower crowd this must represent quite an insult. Further demonstrating Mr. Schneeweis isn’t overly reliant on hedge fund returns to provide a comfortable retirement, he asserts that investors should be indifferent to fees. He says that, “…if an investor is receiving a positive benefit from owning a  product, the net profit to the creators of the product may be regarded of  secondary concern.” That may pass for accepted wisdom in the classroom, but out in the real world investors care deeply about the fees they pay. The long-standing trend towards greater disclosure of fees in Finance is a natural response. Mr. Schneeweis sounds like someone who hasn’t spent much of his own money on hedge fund fees, just other people’s.

Fortunately, The Economist with its substantially wider readership is providing investors with more thoughtful advice.

I gave an interview yesterday to Stansberry Radio discussing hedge funds and our investment strategies. If you’re interested you can find it here.

One opinion shared by many investors nowadays is that stocks are risky, and the near term outlook is especially unclear. Today’s Wall Street Journal profiles a financial adviser in Chicago, Jeffrey Smith, who spends much of his time persuading clients that they should remain in equities in order to achieve their long term investment goals. One client apparently found his mind wandering to Edvard Munch’s painting titled,  “Scream” as he contemplated the many potential disasters waiting in the wings. Mr. Smith’s cause can’t be helped by daily headlines from Washington which largely serve to remind investors what a dysfunctional place it is. The very creation of a Fiscal Cliff was ill-considered, representing as it does a totally blunt instrument to control future deficits. While the original intent was to force tough decisions on a reluctant Congress so as to avoid automatic tax hikes and spending cuts, in fact the focus is really just on avoiding its consequences. News reports show that the most likely outcome is higher taxes on the 2%, some spending cuts and no doubt solemn commitments to do the heavy lifting of budgetary discipline next year.

It’s not what was intended but is the best we can expect. Congress created the cliff and Congress can modify it. It’s not really a tool to force action.

In fact, there’s little reason to be long term optimistic on the U.S. fiscal outlook. Opinion polls regularly expose the incongruity of voters’ desires for improved fiscal prudence combined with broadly unaltered tax policies and entitlements. On top of which, while there’s much hand wringing about the future there’s little visible cost to current policies. If Congress and the Administration did miraculously come together on a meaningful plan to achieve annual deficits of 2.5% of GDP (thought by many to be a long term sustainable target) bond yields could hardly fall very far in response. When Clinton raised taxes in the 90s to reduce the deficit interest rates fell and softened the blow somewhat. No such payback is likely today. So low expectations on this issue are appropriate.

Nonetheless the Math of equities remains compelling. $22 in the S&P 500 will deliver the same after tax return as ten year treasury notes held to maturity, assuming 4% dividend growth on the former. You can make your own synthetic bond with $78 in 0% yielding cash and $22 in 2% yielding equities. Even a disastrous 50% collapse in stocks would cause an $11 fall in your portfolio value or 11%. It would only take a 1.25% rise in bond yields to cause a similar 11% loss in ten year treasuries.

Choosing the stocks/cash combination with its range of possible outcomes instead of the fairly certain loss of purchasing power through bonds requires a long term perspective. However, that is the most reliable way to maintain the purchasing power of your savings.

Most recently we invested in Dollar General (DG). For some time we’ve followed this company as a comparison to Family Dollar (FDO) which we have owned in the past (although not at present). DG has better sales per square foot, operating margins and growth than FDO, but in recent months its valuation has slipped to where it’s now comparable to FDO. These businesses tend to hold up fairly well during tough economic times and although DG is weaker today following its earnings release we think it represents an attractive investment.

Well, of course they are! From my Bloomberg interview yesterday.

This morning’s news that Freeport McMoran is acquiring two E&P businesses (Plains Exploration and McMoran Exploration) is the first real M&A activity since BHP’s acquisition of Petrohawk in the middle of last year. Subsequently BHP had to take significant write downs on their newly acquired assets and the fervor for buying E&P names steadily cooled.

Some names in the sector are relatively attractively priced. Devon Energy (DVN) trades below the price of its proved reserves and is 100% U.S. so no geopolitical risk. At some point they could represent an attractive way to supplement depleting energy reserves for one of the major integrated oil companies. Range Resources (RRC) has also been weak lately and offers some significant upside if they can successfuly extract a good percentage of their 50 Trillion Cubic Feet Equivalent (TCFE) of potential natural gas reserves. Comstock Resources (CRK) is also at the low end of its recent range. With a market cap of less than $1BN it would be an easy acquisition for many big companies. The 25% short interest in CRK also reveals some healthy skepticism.

We are long DVN, RRC and CRK.

While various ideas are floated and journalists report on the state of negotiations, the market consensus seems to be settling on the idea that Congress and the White House will do enough to avoid the automatic tax hikes and sequestration that will follow if they fail to agree. The bounce in the S&P500 (SPY) over the past couple of weeks presumably reflects this conclusion. As well it should, for both sides will struggle to show any political gain out of imposing enough fiscal drag to cause a recession early next year. The negotiations will probably not be easy and key concessions ought to be expected at the end rather than the beginning. But an agreement of some sort is probably what we’ll get – some tax hikes on the wealthy, a few spending cuts and a solemn promise to do more next year.

This got me thinking about alternative scenarios. Most obviously, there could be no agreement. The talks could break up in acrimony as one or both sides conclude that shared responsibility for a recession is preferable to making big concessions on core parts of their platform. For Republicans this is Taxes, and for Democrats it’s Entitlements. It’s not made easier by opinion polls that show quite clearly what people want – fiscal discipline without cuts in Entitlements or broad tax increases. The fiscal discipline that would therefore be imposed automatically through a failure to agree could cause a GDP contraction of 3% or more and is unlikely to be greeted warmly by stocks.

Another possibility is negotiators go farther than expected. Somehow they reach a grand compromise, embracing part of Simpson-Bowles and reining in entitlements while simultaneously raising taxes. It’s of course not likely, but if it did happen this “good news” would likely cause greater fiscal drag than a more modest negotiated agreement. Indeed, it’s hard to see how you can reduce the ongoing fiscal stimulus that profligacy creates without some fiscal drag as a result. But in this case interest rates, which in the past have softened the blow of such events by falling, wouldn’t be much help. Bond yields scarcely reflect any concern about the long term budget outlook – or if they do such concern has been effectively silenced by the Fed’s QE (1,2,3 etc). So the economy would endure the pain of newfound fiscal discipline without the salve of lower bond yields. This is also unlikely to be a good outcome for the market, in spite of the hand-wringing over business as usual.

So the more a modest negotiated settlement is expected by market participants, the less attractive the alternative outcomes appear.

We are holding around 10% cash in our Deep Value Equity Strategy, and currently think we have less than 90% of the short term volatility of the market since many of the names we own are fairly stable businesses. Many companies are issuing cautious guidance and so the bottom-up view has started to reflect some of the macro concerns many investors have felt for a long time. Among the names we do own Berkshire Hathaway (BRK-B) is one of our bigger holdings. It’s trading close to 10% above book value, the upper boundary at which the company has indicated it will buy back shares.  We recently added to McDonalds (MCD) on weakness since high single digits EPS growth and a P/E of 16 are a reasonable level at which to invest.

We’ve also added to Master Limited Partnership which had sold off along with other income generating sectors such as high dividend stocks and utilities. MLPs after tax returns may be even more attractive compared with traditional income generating sectors of the equity market depending on what Congress does to taxes on investment income.

Hewlett Packard (HPQ), a company that is earning records for large and expensive strategic errors, plummeted to new depths of incompetence today with their $8.8 BN write down of Autonomy, a software company they acquired in 2011. The list of enormous acquisitions about which nothing much positive subsequently emerged is shockingly long: Compaq in May 2002 for $25 BN; P&G IT in 2003 for $3BN; Mercury Interactive in 2006 for $4.5BN; Opsware in 2007 for $1.6BN; Electronic Data Systems in 2008 for $13.9BN; 3Com  for $2.7BN, Palm for $1.2BN, 3PAR for $2.35BN and ArcSight for $1.5BN all in 2010; Autonomy for $11BN in 2011. And these are just the $1Bn or greater deals. $66.75BN in acquisitions over the past ten years and the company’s market cap is less than half of that. None of today’s board members have served since 2002, but several joined in 2009 since when HPQ has spent $18.75BN including on the ill-fated Autonomy deal. Among those board members who have been around long enough to be responsible are G Kennedy Thompson and John Hammergren (both since 2005), and Marc Andreessen and Rajiv Gupta (both since 2009). There are only eleven board members including CEO Meg Whitman, and she was on the Board when they bought Autonomy prior to becoming CEO.

When you write a check for $11BN and subsequently find you were ripped off, you can’t seriously blame anyone but yourselves. Pointing the finger at the former management of Autonomy or the auditor just further confirms that none of these people should be managing anybody’s money but their own. For our part, while we’re thankful to have never been investors, we’re going to add the HPQ Rule to our investment process that rejects any investment in a company with one of these value destroyers on its board of directors.