It’s in the bag:  Stock prices will be up this year based on the Super Bowl indicator!  Stock market legend has it that years in which a team from the original NFL wins the Super Bowl, stock prices will go up.  If a team from the original AFL wins, stock prices are likely to fall.  Since the Saints are the NFC team this year and the Colts trace  their history back to the original NFL, stock prices should rise regardless of the outcome!

But before you call up your broker on Monday and buy stocks on heavy margin, consider the following:  stock prices are also positively correlated with butter production in Bangladesh.  MarketWatch.com has published an article with more details regarding the silliness behind the Super Bowl indicator and various derivative indicators that have been developed over the years.  While it is good for a few laughs, we can also draw some important lessons about the nature of statistics.

Lies, Damned Lies, and Statistics

One of the fun games that students often play in Econometrics classes involves finding correlations between seemingly unrelated data.  Computers today provide the tools required to quickly obtain large sets of data on nearly any activity.  It is very easy to develop correlations between such data and to come up with “insights” to prove a point.  The correlation between the Super Bowl winner and stock prices, or Bangladeshi butter production and stock prices are obviously silly.  Few would trade on the outcome.  However, it is also easy to come up with  correlations that are more persuasive.

Those who understand statistics are never fooled by such tactics.  However, others may easily mistake the presence of a correlation with causation.  It is one thing to say that Bangladeshi butter production is correlated with United States stock prices.  It is quite another to claim causation.

The next time you read an article that uses statistics to prove a point, whether the topic is related to investing, politics, or a pitch for a consumer product, consider whether the presenter is making an attempt to imply causation through the mere presence of a correlation.  If additional evidence is not produced to show causation, it is likely that you are being manipulated in some way.  Legitimate studies on causation will never merely present a correlation and expect readers to accept the presence of causation without additional evidence.

On January 12, 2010, Google announced that the company would re-evaluate its approach to doing business in China after the discovery of cyber attacks that appeared to target human rights activists.  While Google did not directly accuse the Chinese government of complicity in the attack, the company clearly stated that it is no longer willing to censor search results.  At a time when nearly every major company in the United States is trying to expand opportunities in China, Google has decided to buck the trend with a very controversial move that could result in a major setback for the business.  What could Google’s executives have been thinking when they made a decision that was sure to cause a political uproar?

Richard L. Brandt’s latest book, Inside Larry & Sergey’s Brain, presents a portrait of Larry Page and Sergey Brin that helps the reader understand what may have motivated the company to initially enter China by accepting some level of censorship.  Although the book was published prior to Google’s recent announcement, we can draw some important insights regarding the way Google’s founders think about the issue of doing business in China.  Perhaps more importantly, the book also allows the reader to glimpse into the psyche of the founders and draw some conclusions regarding entrepreneurship in general.  For anyone investing in early stage companies, the insights are invaluable.

Mr. Brandt’s book is not as well known as  Googled:  The End of the World as We Know It which we reviewed in November.  However, one can argue that Mr. Brandt succeeds in providing a more vivid background of both founders and he also makes a better effort to draw links between their core values and a number of decisions that were made which may appear “crazy” at first but actually led to Google’s stunning success.  It is easy to see in retrospect how conventional thinking could have destroyed Google’s ambitions at several points during the  early years.  The fact that Mr. Brin and Mr. Page stuck to their core values made all the difference.

Can Idealism Coexist with Good Business Sense?

Google’s idealism is hardly a well kept secret.  In fact, the idealism of the founders has often been mocked as disingenuous by outside observers.  However, Mr. Brandt clearly shows how Mr. Brin and Mr. Page kept Google on course with an idealistic view of the world that ultimately provided the differentiation required to succeed.

Perhaps the most important example was Google’s insistence to not permit advertisers to purchase ranking in search results and to keep all advertisements clearly distinct from search results.  Google could have easily maximized short term profitability in the early years by taking a less idealistic approach (as all their competitors did).  It must have been incredibly tempting to do so.  The founders did not come from wealthy families and were facing pressure to produce profits.  However, ultimately the decision to consider the needs of the search user first trumped short term profitability but led to the trust required for the company to gain traction in numerous other initiatives.

Pros and Cons of Entering China

Google’s founders struggled with the question of censorship for several years before deciding to accept restrictions in exchange for being permitted to enter China.  Mr. Brandt’s chapter on China asserts that the founders never lost sight of their determination to contribute to positive change within Chinese society.  The question was whether engagement, even with restrictions, could improve the free exchange of information within the country.  Google was the first search engine to insist on at least notifying users if the results of a query were censored.  This fact alone helped to expose the actions of government to restrict the information citizens are permitted to see.

It is difficult to maintain cynicism regarding Google’s intentions for China after the company announced a willingness to exit the country if the government continues to require censorship.  While some subsequent statements made by Google’s CEO Eric Schmidt appeared to soften Google’s stance to some extent, the company seems committed to follow through on the statements made on January 12.  At this point in time, the decision seems likely to cost Google some profits but so did the earlier decision to refuse to allow advertisers to influence search ranking.  Google may be making a long term profit maximizing move if the new policy builds trust in China and the government eventually is forced to back down.

Genius, Hard Work, and Entrepreneurship

Sergey Brin and Larry Page have IQs that are obviously off the charts.  They were also willing to work extremely hard and found a way to start Google with very little capital.  They started out of a garage and used second hand and improvised furniture.  They were able to secure venture capital funding and attracted other talented people to join the company.

But while IQ, hard work, and guts are required elements associated with any successful startup, these attributes alone are not sufficient to ensure success.  Silicon Valley’s history is full of startups that failed despite all of the wonderful qualities that Mr. Brin and Mr. Page brought to Google.  What made Google such a stunning success is what may have been initially viewed by outsiders as insanity on the part of the founders.  However, the unconventional thinking that failed to maximize profitability in the short run directly led to Google’s stunning rise.

Controversy Will Continue

Google will continue to be controversial in the future.  We recently asked whether Google’s recent re-pricing of employee stock options meant that the company’s “Don’t Be Evil” pledge does not apply to stockholders.  Apple CEO Steve Jobs recently declared that Google’s “Don’t Be Evil” mantra is “bullshit”.  Google is often accused of expanding well beyond search particularly with its emphasis on offering applications for cloud computing.  Will the company use dominance over search to gain unfair advantage in new ventures?

Mr. Brandt provides an important service to those who are interested in moving past simplistic sound bites and gaining a better understanding of what makes Sergey Brin and Larry Page tick.  One gets the distinct sense that these men will be rocking the boat in the technology world for decades to come.

Disclosure:  The author of this book review does not have a position in Google. Richard L. Brandt provided The Rational Walk with a copy of his book.

Standard & Poor’s has downgraded its long-term counterparty credit rating on Berkshire Hathaway to AA+ from AAA.  The action also lowered the financial strength rating on Berkshire’s insurance operations to AA+.  The ratings were removed from Standard & Poor’s credit watch and now have a stable outlook.  Standard & Poor’s action comes only weeks before Berkshire Hathaway is set to release results for 2009 which will almost certainly indicate that book value ended the year at a record high.

Standard & Poor’s initially established a negative outlook on Berkshire’s AAA credit rating last March but reaffirmed the AAA rating at the time.  In November, Standard & Poor’s placed Berkshire Hathaway on credit watch citing liquidity concerns related to the Burlington Northern acquisition.

“Risk Tolerances Have Increased”

Here are a few excerpts from Standard & Poor’s press release (free registration required):

“The rating actions are based on our view that Berkshire’s overall capital adequacy, as well as that of its insurance operations, has weakened to levels no longer consistent with a ‘AAA’ rating and is not expected to return to extremely strong levels in the near term,” said Mr. Iten. “Furthermore, we expect that the consolidated liquidity position of BRK will be reduced from extremely strong historical levels as a result of the acquisition.”

As capital adequacy and liquidity levels have declined, investment risk remains very high in our view, compounding the need for extremely strong capital and liquidity given potential investment volatility. A key concern is that BRK’s risk tolerances appear to have increased, yet we believe they remain ill defined while the organization increases in complexity.

It is not clear how Berkshire’s level of risk tolerance has increased as a result of the Burlington transaction.  While one can debate whether the transaction will add value for shareholders, our prior analysis of Burlington clearly indicates that the company generates significant free cash flow which is more than sufficient to service the incremental debt issued by Berkshire.  Warren Buffett has also indicated that the company plans to pay down the new debt within three years which is noted in S&P’s press release.

Succession Planning Concerns

Standard & Poor’s repeats the familiar concern regarding Berkshire’s succession planning issues:

Uncertainty surrounding management succession and management structure, corporate culture, and business strategy following an eventual transition of the company’s leadership from current CEO Warren Buffett is an ongoing concern. This, in our view, is only partially mitigated by a board-approved succession plan and the experienced management teams in place at the operating companies, given Mr. Buffett’s strong and positive influence on all aspects of operations at Berkshire.

It is hard to understand exactly what would satisfy critics of Berkshire’s succession planning short of Warren Buffett formally naming a successor.  We have previously discussed why management succession concerns at Berkshire are misguided.  It is also not as if Berkshire lacks talented managers such as David Sokol who are clearly capable of running the company if necessary.

Revisiting S&P Concerns from March 2009

Finally, it is worth noting that the concerns raised by Standard & Poor’s in March when the outlook was first lowered no longer apply.  At that time, Standard & Poor’s analyst John Iten cited concerns over Berkshire’s level of statutory capital due to the decline in the market value of the company’s equity investments.  In fact, Mr. Item specifically stated that if Berkshire’s equity investments were to recover, the negative outlook could be revised to stable at the AAA level:

If the value of the group’s substantial equity investment holdings were to stabilize or improve during this period, or if it appears that the group will be able to rebuild its capital position back to a level commensurate with the current ratings within a reasonable period of time (typically one to two years) through earnings or other means, we could revise the outlook back to stable.

With Berkshire’s book value almost certainly at a record high at the end of 2009, it is difficult to understand Standard & Poor’s decision today.  While it is true that Berkshire has used a significant amount of cash and debt to finance the Burlington transaction, the company is certainly in a much more solid position today than in March 2009 when S&P reaffirmed the company’s AAA rating.

The author owns shares of Berkshire Hathaway.

Those of us who completed our education prior to the mid 1990s often feel like students today have it easy in comparison.  Many of us still remember going to the library, finding books using a card catalog, and carrying stacks of books home.  High technology involved looking through old newspapers and magazines using microfiche.  Wikipedia, every student’s favorite reference source, did not exist.  It is easy to imagine how much time could have been saved and how much more could have been accomplished with access to today’s internet!

In the brief video clip shown below, Google CEO Eric Schmidt talks about how technology impacts the lives of younger people and whether the overall quality of education will be improved or hurt by instant access to information.  Mr. Schmidt points out that many aspects of modern technology have raised the bar and improved the quality of the young people hired at Google.  However, he is also concerned that long form reading may be on the decline since media is often consumed in much smaller portions.  This raises the important question of whether the internet may be creating a generation with knowledge that is a mile wide but only an inch deep.

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From the perspective of an outside observer, the debate over financial regulatory reform can seem like nothing more than the typical Beltway chatter full of shrill voices and political posturing.  While the current debate is not free of the usual nonsense, it is important to note that the discussion has at least refocused on the “too big to fail” problem rather than fixating on consumer protection issues that consumed a great deal of time last year.  There is nothing wrong with inquiries into whether credit card and overdraft fee regulations should be changed, but action in such areas will do nothing to prevent the next financial meltdown.

Bail Outs or Bail Ins?

One interesting proposal was recently presented by Paul Calello and Wilson Ervin in a guest article for The Economist.  Mr. Calello is the head of Credit Suisse’s investment bank and Mr. Ervin is the former chief risk officer of Credit Suisse.  The authors argue that regulators should not have to choose between massive taxpayer bailouts and the potential for a catastrophic systemic collapse.  Instead, they argue that a rapid modification of a troubled firm’s capital structure  can result in a “bail in” that reduces systemic risks and mitigates the need for taxpayer funded infusions.  Such a bail in would require regulators to have sufficient power to wipe out common equity holders and recapitalize the financial institution by converting preferred shares and debt into equity.

A Rapid Form of Pre-Packaged Bankruptcy

The authors are actually proposing a very rapid form of pre-packaged bankruptcy since such restructurings are not uncommon in other industries.  The problem with most negotiated recapitalizations is that the process can take a significant amount of time before all stakeholders agree to the terms.  With a major financial institution, such time is simply not available since confidence in the franchise would be harmed beyond repair in a matter of days.

In order to make this approach work, regulators will need to have the power to dictate terms of the recapitalization over a very short period of time – most likely over a “marathon” weekend working around the clock.  As a result, the process and terms of such a recapitalization would need to be known by all parties well ahead of time.  Looking at it from this perspective, the approach is not much different from the “living wills” that some have suggested all financial institutions must set up ahead of any crisis.

A Treatment, Not a Cure

The idea of a regulator having the power to make massive changes to a financial institutions capital structure over a 48 hour period is enough to make free market advocates cringe.  But if the alternative is to permit a massive systemic collapse of the financial system or to expose taxpayers to the costs of bailing out the banks, something like the “bail in” plan may be the best of several undesirable options.

From a free market perspective, the better approach is to examine ways to reduce the number of financial institutions that are too big to fail without creating systemic risks.  While it is true that regulations would need to be imposed that limit the size and/or scope of activities the banks are permitted to engage in, these regulations would be of the “blocking” variety rather than the “micromanagement” variety.  In other words, regulators would block banks from becoming systemically important but would otherwise leave management alone to run the business.  Then managers and owners of the business can be left to determine the appropriate level of risk to accept without putting the taxpayer on the hook for cleaning up after a failure.