Sticking To Your Convictions As A Value Investor Is Hard, Just Ask Whitney Tilson About Netflix

Back in December, Whitney Tilson, a fairly well known value investor with T2 Partners, published a letter outlining a compelling bear case for Netflix (NFLX), a stock he was shorting at around $180 per share. After seeing the position go against him, Tilson was feeling pressure from his clients. After all, shorting a high-flying technology company with a cult-like following, as it is soaring in value, can be a tough psychological exercise. Tilson’s argument for betting against Netflix was clear, concise, and thorough. He boiled it down to this, in his December piece entitled Why We’re Short Netflix:

“We don’t think there are any easy answers for Netflix. It is already having to pay much more for streaming content and may soon have to pay for bandwidth usage as well, which will result in both margin compression (Netflix’s margins are currently double Amazon’s) and also increased prices to its customers, which will slow growth.

Under this scenario, Netflix will continue to be a profitable and growing company, but not nearly profitable and rapidly growing enough to justify today’s stock price, which is why we believe it will fall dramatically over the next year.”

The main bearish argument seemed reasonable at the time; customers were moving away from DVD by mail and towards streaming content. In order to secure content for their streaming library, Netflix would have to pay more than in the past, when they could just buy a DVD once and send it out to dozens of customers. But at the time subscribers were signing up at a record pace and were highly satisfied.

In February Tilson threw in the towel. The stock had continued its ascent, rising to $220. Again, Tilson went public with his changed view, writing a letter called Why We Covered Our Netflix Short. The bulls loved the fact that Tilson was admitting defeat. The stock continued soaring and hit an all-time high of $304 in July. Tilson summed up his reasoning as follows:

Our short thesis was predicated on the following stream of logic:

1) Netflix’s future depends on its streaming video business (rather than its traditional DVD-by-mail business);

2) The company’s streaming library is weak, which would lead to customer dissatisfaction and declining usage;

3) This would either cause subscriber growth to wither or force Netflix to pay large amounts to license more content, which would compress margins and profits;

4) Either of these two outcomes would crush the share price.

We are no longer convinced that #2 and #3 are true.

This was interesting because very little in the way of fundamentals had changed at that time. Tilson cited three reasons why he was doubting his earlier bearish thesis:

1) The company reported a very strong quarter that weakened key pillars of our investment thesis, especially as it relates to margins;

2) We conducted a survey, completed by more than 500 Netflix subscribers, that showed significantly higher satisfaction with and usage of Netflix’s streaming service than we anticipated (the results of our survey are posted; and 

3) Our article generated a great deal of feedback, including an open letter from Netflix’s CEO, Reed Hastings, some of which caused us to question a number of our assumptions.

In hindsight these reasons seem even more suspect than they did at the time, but it is worth pointing out the mistakes anyway so value investors can learn from each other.

First, Tilson cited that Netflix reported a strong fourth quarter. Tilson’s bearish view was never predicated on Netflix blowing the next quarter. It was the longer term trend of rising content costs, which would give Netflix two choices; maintain a weak streaming library and risk losing customers, or pay up for strong content and be forced to either raise prices (which would hurt subscriber growth and reduce profitability) or keep prices steady and lose profitability that way. The fact that Netflix reported one strong quarter really didn’t make a dent in the bearish thesis.

Second, Tilson surveyed 500 Netflix customers and found they were quite happy with the service. Again, his thesis didn’t claim that current customers were unhappy (after all, they were signing up in droves in part because streaming was free with your subscription at the time). Rather, it was about the future and how those customers would react if Netflix had to either raise prices or offer less in the way of viewing choices.

Third, and this one was perhaps the most bizarre, Tilson was evidently persuaded by Netflix’s own CEO, Reed Hastings. I find this one odd because I have never seen a CEO on TV or elsewhere who was publicly negative about their company’s prospects, regardless of how good or bad things were going at the time. In fact, many investors believe it is a huge red flag when CEOs of public companies take time to personally rebuff bearish claims from short sellers. Hastings did just that, responding to Tilson’s short case with a letter of his own that suggested that he cover his short immediately. Generally speaking, the fact that the CEO of a company you are short thinks you are wrong is not a good reason to cover your short.

And so we had a situation where Tilson’s short thesis appeared sound, albeit unresolved, but the stock price kept soaring and he was feeling heat for the position, which was losing money. Then, just a few months later, Netflix decided to raise their prices and customers canceled in droves. Tilson’s bearish thesis proved exactly correct, but he no longer had the short bet to capitalize on it.

Today in pre-market trading Netflix stock is down about 30% to $83 per share after forecasting higher than expected customer cancellations, lower than expected fourth quarter profits, and operating losses during the first half of 2012 due to higher content costs, slowing subscriber growth, and expenses for the company’s expansion into the U.K. and Ireland. Analysts were expecting Netflix to earn $6 per share in 2012 and in July investors were willing to pay 50 times that figure for the stock. Now it is unclear if Netflix will even be profitable in 2012 after forecasting losses for the first “few quarters” of next year.

This is a perfect example of why value investing is a tougher investment strategy to implement than many realize, but offers tremendous opportunity to outperform. By definition you have to take a contrarian view; either going long a stock that people don’t like, or shorting a stock that everyone loves. The bottom line is that your analysis is what is important. If you do your homework and get it right, the market will reward you. It may take more than a quarter or two, but you need to stick to your convictions unless there is extremely solid evidence that you are wrong. In this case, Tilson’s bearish thesis was never really debunked by the CEO’s defensive posture or the fact that customers were satisfied when they were getting streaming content for free. In hindsight, Tilson understood the outlook for Netflix better than the company’s own CEO. However, both are likely feeling very uneasy this morning.

Interestingly, the question now may be whether there is a point at which Netflix stock becomes too cheap and warrants consideration on the long side. I suspect the answer is yes, though probably not quite yet. If the stock keeps falling and we see $60 or $70 per share, maybe the time will be right for value investors like Tilson to go against the crowd again and buy the stock when everybody hates it.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

UPDATE: 3:00PM ET on 10/25

The WSJ is reporting that Tilson initiated a small long position in Netflix this morning:

Mr. Tilson tells us in an e-mail that he bought the stock this morning after it tumbled 35%:

“It’s been frustrating to see our original investment thesis validated, yet not profit from it. It certainly highlights the importance of getting the timing right and maintaining your conviction even when the market moves against you. The core of our short thesis was always Netflix’s high valuation. In light of the stock’s collapse, we now think it’s cheap and today established a small long position. We hope it gets cheaper so we can add to it.”

Coinstar Shares Look Very Cheap After Guiding Down Earnings Expectations

Consumers should know Coinstar (CSTR)very well as the maker of coin counting machines found at grocery stores and more recently the owner of the Redbox DVD rental kiosks found in even more retail locations such as McDonald’s and Wal-Mart. I believe the stock, which has gotten hammered lately after an earnings miss for the fourth quarter, represents tremendous value. CSTR gives investors a rare combination of value and growth potential.

At around $39 per share (down from $67 late last year), Coinstar stock fetches only 6 times trailing cash flow. To put that in perspective, Microsoft sells for 7 times, Cisco for 8 times, and IBM for 9 times. Investors are clearly getting a valuation that is otherwise reserved for larger, slower growth businesses. This despite the fact that the company just reported that 2010 revenue soared 39% on the heels of a 50% jump in DVD rental sales (the more mature coin counting business grew by 7%). Despite giving more conservative guidance going forward after the company missed Wall Street’s fourth quarter expectations, Coinstar expects 2011 revenue to jump by about 24% with cash flow rising by 18%, as it continues to invest in growing the business. If management can deliver on these numbers this year (and after an earnings miss we should think they might give out forecasts they feel quite confident in reaching), the stock trades at only 5 times current year cash flow, unheard-of for a company growing like Coinstar.

Now, as with any investment, expectations and forecasts of future growth and valuation are not the only things to consider. Analysts would be quick to argue (and I would not disagree) that movie rentals are moving from disc-based to cloud-based, with the emergence of Netflix and other streaming platforms. Any market share gains that Coinstar’s Redbox kiosks might see with the pending bankruptcy of Blockbuster could very well be negated by more and more people signing up for Netflix streaming.

However, I still believe that the market for Redbox kiosks is bright, for two main reasons. First, with nearly 25,000 kiosks installed in grocery stores and retail outlets across the country, the convenience and cost ($1 a day) of Redbox rentals will make them attractive to both cost conscience movie watchers (if you only watch a couple movies per month you will likely opt for Redbox over an $8/month Netflix streaming plan) and those who enjoy the convenience of grabbing a movie on their way out of McDonald’s, Wal-Mart, or their local grocery store (just picture how easy children can convince mom and dad to get a movie for $1 before they leave the store).

The second reason I think it will be years before physical disc rentals will become completely obsolete is that there are still millions of Americans who are afraid of technology to a large degree (either due to things such as identity theft, or simply out of not being comfortable with operating high tech toys such as wi-fi enabled DVD players). To illustrate this point, let me share an encounter I had with a woman a couple of weekends ago.

After noticing that several Blockbuster locations were being liquidated near where we live, my fiancee and I decided to stop by and see if we could land any ridiculous deals (they were literally selling the store’s shelves as well as the DVDs sitting on them). Everything was for sale, and if you had a spare $350 sitting in your bank account you could buy the giant gum ball machine from your local Blockbuster store (we saw one being carried out by a man as we entered the store).

As I was perusing the aisles I helped explain the pricing structure to a woman in her 50’s or 60’s who was confused. We got to talking and she was mostly rambling about how disappointed she was that this store was closing because all of the other DVD rental places had also closed and now there was nowhere for her to go. I mentioned Netflix and she immediately dismissed it as a viable option “because you need a credit card for the box.” She was clearly confusing Netflix with Redbox, but the fact that she refused to use a credit card to rent a movie told me that Netflix would not be any better in her mind.

I bring this up because I think people like this woman are exactly the ones who will shun new technology like Netflix streaming. Eventually she will have to cave and start using Redbox for movie rentals most likely, and think about how many people like her there are out there. Not only that, but even if she felt comfortable using the Internet to order movies by mail (I don’t see her using Netflix mail order anytime soon, given that her explanation for why that wouldn’t work for her was that her printer has been broken for months and she can’t figure out how to fix it), I really don’t think she would proactively adopt such a technology when there are other “lower-tech” ways of getting a DVD such as Redbox (granted, a credit card will still likely be required).

In short, I think there will be room for both technologies for several years to come. While I subscribe to Netflix and have never actually used a Redbox kiosk, there are plenty of middle aged and older Americans who will. Not only that, but the Redbox kiosk in the grocery store I visit is often crowded with college kids as there are several universities in the area. Cost is probably the main factor there, as young kids can certainly operate Netflix streaming movies, but more likely lack the discretionary income to afford an expensive box with wi-fi and a monthly plan. So, there is definitely a market for Redbox with younger people too.

With Blockbuster in liquidation, Redbox should continue to grow, although Coinstar’s current stock price seems to not fully be factoring in such strong demand for their kiosks. I do not see any reason CSTR shares should not fetch 7-8 times cash flow, which makes a stock price of $60 quite a reasonable expectation.

Full Disclosure: Long CSTR at the time of writing but positions may change at any time

Apple iPad is Nice, Probably Not a Game Changer Yet

After seeing Apple’s unveiling of the new iPad tablet yesterday my overall conclusion is that the product is very solid and will probably find a niche with certain users, but it hardly seems to be the game changer for old media that many had hoped for.

Essentially the iPad is a thin, light-weight, extremely mobile device that can be described as a supersized iPhone or a thin netbook computer. You can surf the web, check email, play iTunes, and download iPhone-like apps customized for the device.

The real issue I see is that the iPad is not all that different than a netbook or iPhone, other than its physical design. The only unique feature of the iPad seems to be a new e-book store. In addition to buying songs, movies, and television shows from iTunes you will be able to buy e-books from an e-book store, modeled after the iPhone app store and the iTunes media store. Think thin netbook combined with an Amazon Kindle.

The clear loser here is Amazon, whose Kindle overnight gets a strong competitor. The clear winners were supposed to be the content publishers, including magazine and newspaper companies, not just book publishers. On that end, I think the expanded distribution of e-books will be good for those publishers, but the gains for newspapers and magazines is less apparent.

The problem those publishers face today is that most are giving away their content on the web and the advertising revenue they earn from web visitors pales in comparison to the subscription revenue they used to collect. Some have been able to charge for web content (Wall Street Journal) and others are starting to put pay walls on their sites (New York Times) but with so many free news sources on the web, it will be hard for most publishers to convince consumers to pay a monthly fee for their content.

I am not convinced the iPad solves this problem. The content companies will build apps for the iPad, just as they did for the iPhone, but the core issue is the same; will people pay for the content when there are other free options? If the answer is yes, then the publishers will get stronger going forward. If not, nothing will change.

If you put your content on the iPad for free, that is no different than the free web site people are using to access your content. If people are not willing to pay to use your web site today, why would they be willing to pay for an iPhone or iPad app with the same content?

Even after seeing the iPad in action, I think the content game is unchanged. If you truly have valuable content that is unique and in strong demand (Wall Street Journal), you can make good money with online content. If not, people will simply go to free news sites and your profits will evaporate as subscription revenue continues to decline.

Where does this leave Apple stock? They will likely sell a good number of iPads going forward so the product is certainly an incremental positive for the company and the stock. Believe it or not, the shares have been treading water for a while now, and therefore are not overly expensive. At $207 per share Apple sports a P/E ratio of about 18x based on $11-$12 of earnings power this year. Add in the $27 per share ($25 billion) of cash that is wasting away on their balance sheet and you can see that the stock is not super-cheap but is not overly expensive by any means.

Full Disclosure: Peridot Capital was long shares of Apple at the time of writing, but positions may change at any time

Comcast Making Another Bid For Mega Content Deal

You may remember a few years back when Comcast (CMCSA) made a bid for Disney (DIS) only to be turned down. Reports today have them once again making a play for a blockbuster media content deal. Initial reports out of a Hollywood web site last night had Comcast buying NBC Universal outright from General Electric (GE) for $35 billion but that story has conflicted with more reliable news sources today that have Comcast forming a joint venture with GE’s NBCU division. Comcast would contribute cash ($6-$7 billion is the rumored figure) and combine its own content assets with NBCU, spin the new company off, and retain 51% ownership (with GE having the other 49%).

As Peridot Capital clients own shares in both Comcast and GE, this deal is of great interest to me. I am not convinced Comcast making a huge push into content is the right move (cable service and content creation are quite different businesses) but I can see why Comcast CEO Brian Roberts might want to expand his net.

After all, they are already the largest cable operator and moves to boost that position will draw anti-trust concerns. Given that phone companies like Verizon are making a big play into cable, not to mention the typical satellite competition, owning solid content providers would make Comcast less concerned with how many people are using their pipes for cable access.

How does this play out for investors? Well, in the short term it will be seen as a negative for Comcast as people wonder if content is really where the company should be turning its focus, especially if it means spending billions of dollars in cash to do so. Longer term, as long as Comcast does not make any significant changes that threaten the profitability of NBCU, it could contribute a nice chunk of stable cash flow and diversify their business.

The impact on GE is harder to predict. On one hand, investors worried about GE’s balance sheet would be happy to see the company unload some of NBCU’s debt and also collect some cash in exchange for giving up 31% ownership (GE currently owns 80% of NBC, with Vivendi owning 20%). On the other hand, GE would become even more concentrated in cyclical and financial services business lines for its earnings. In a weak economic environment, the stable cash flow from NBCU has been helping, not hurting them.

Overall, I would be slightly more bullish on Comcast should this deal go through, mainly because I think CMSA stock would trade down more in the near term. Comcast is a stock I really like already, and although people will question a foray into media, I don’t think Comcast’s long term profitability will be negatively impacted by this deal. The uncertainty might just provide investors a nice entry point.

As for GE stock, I still think it represents a good value longer term (assuming you think the global economy will slowly improve) but I don’t think reducing its NBC stake would warrant as much of a change for the company relative to the impact on Comcast). I would not chase GE stock if it moved higher on this deal, but if both stocks dropped on the uncertainty surrounding it, both would be good values at the right price. That said, I would give the nod to Comcast for value investors looking to make an initial investment post-deal.

Full Disclosure: Peridot clients owned positions in both Comcast and GE at the time of writing, but positions may change at any time

Time Warner Completes Cable Spin-Off, Sets Stage For AOL Split Next

Time Warner (TWX) has long been a media conglomerate difficult for investors to dissect. However, that may be about to change and the moves could finally extract some value for Time Warner shareholders. The company will complete its spin-off of Time Warner Cable at the end of the month, which offloads billions of debt to the cable company and frees up cash flow at TWX.

Time Warner is also making some moves at its AOL division. AOL has hired Tim Armstrong, formerly the head of U.S. sales at Google, as its new CEO. The conventional wisdom is that Time Warner will spin off AOL as well, in order to allow Armstrong to maximize profit and growth potential at the online unit.

All of this should be good news for Time Warner shareholders, whose stock has been cut in half over the last year and sits near its lows. Time Warner retains some very strong brands, including HBO. With less debt from the cable division, coupled with a $9 billion cash infusion from the spin-off and a new strong management team at AOL, investors might finally begin to look at the stock again in the intermediate term.

As a result, bargain hunters who prefer strong large cap companies might be interested in checking out TWX shares at $8 each. Not only do they sit near their lows, but they yield 3% and trade for less than 5 times trailing cash flow.

Full Disclosure: No position in TWX at the time of writing, but positions may change at any time

CNBC Documentary by David Faber, “House of Cards,” Is Worth Your Time

One of CNBC’s finest, David Faber, recently completed a two hour documentary about the housing bubble and the credit crisis. I had the chance to watch it on Sunday and it is very well done. For those of you who are interested in how the combination of mortgage brokers, Wall Street, and consumers led to the dire financial predicament we find ourselves in right now. Faber really hits on all of the major culprits and explains them well along with his superb guests.

CNBC replays House of Cards in prime time during the week and over the weekends. According to my Comcast program guide, the next airing is Wednesday from 8-10pm ET but check your local listings and set your VCR or Tivo.

With Consumers Paring Back, Netflix Business Gets Stronger

If people are looking to cut back on discretionary spending, the Netflix (NFLX) mail order DVD service can obviously help. Rather than spending $30 at a theater for a couple to see a movie and order some snacks, a Netflix subscription can cost half that for an entire month. Not surprising, fourth quarter sales and earnings at Netflix (reported last night) were very impressive and the stock is soaring today, trading up near $35 per share.

Despite being relatively recession-proof, Netflix stock at current levels doesn’t get me very excited from a value standpoint. One can certainly justify a 2009 P/E north of 20, as it is today, but as a value investor that is not cheap enough for me to get overly excited, despite the strong business fundamentals. I will, however, continue to make good use of my Netflix subscription, and I highly recommend it.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

Gift Idea

When I was growing up the gift option of choice was federal savings bonds. When I was old enough to be allowed to make my own financial decisions I promptly sold them and invested the proceeds in the stock market, where my long term inflation-adjusted returns would be much higher. Among both my high school and college graduation gifts were shares of stock and the returns from those have been impressive, but the advantages of such gifts often go beyond dollars and cents.

Garnering interest in the markets was never a problem with me, but that was clearly the exception. Giving children shares of stock not only gives them a valuable financial asset, but it also allows one to expand the financial education process with them at an early age. At some point (perhaps not at first depending on how old they are), recipients are going to ask what that framed share of Disney stock is, and at that point you can explain it to them. Such a conversation might, at the very least, start them toward a path of being very educated when it comes to the responsibility of managing their finances.

Are All Consumers in the Same Boat?

Last weekend I attended some festivities for a friend’s birthday that included dinner at the Landmark Buffet at the Ameristar Casino and Hotel (ASCA) in St. Charles, Missouri. Along with spending some time with good friends, I was also especially interested to see how busy the casino was on a Friday night. If you simply looked at the stock prices of the major casino companies in the United States, you would have predicted the place would be empty. Gaming stocks have been crushed lately on consumer spending worries. ASCA stock, for example, is down about 45%, from a high of $38 to the current quote of $21 per share.

Such large drops are fairly surprising given that gaming stocks are widely believed to be fairly recession-proof. Rather than take lavish vacations, or even hop on a plane heading to Vegas, people tend to scale back and just drive to a local riverboat casino instead. Despite the typical feeling that gaming holds up okay in recession, the casino stocks this time around have really taken it on the chin, so investors are clearly betting that this time is different.

Surprisingly, the Ameristar Casino was as crowded last Friday as I have ever seen it. At the buffet, for example, people are still standing in line for at least an hour for a $21.99 crab leg, steak, and shrimp dinner. After seeing such a large crowd, I came to the conclusion that the health of the consumer likely depends largely on where the person lives. Here in the Midwest, the housing market downturn has been less severe because it never really got crazy to start with. Compared with hot areas like California, Nevada, Arizona, and Florida, states like Missouri had much more subdued housing speculation.

The result of that is that things aren’t that bad here. You don’t hear about huge numbers of foreclosures or see evidence that the consumer is largely tapped out. The main problem here with respect to housing is simply a supply-demand imbalance. There is still a decent amount of building going on, in the face of high levels of for-sale signs out already, so houses aren’t selling. However, people are simply sitting on them, reluctant to lower prices to motivate buyers, much like other places across the country. But without extreme speculative activity, the negative impact on consumer spending does not appear to be as drastic as other places across the nation.

How can we make investment decisions based on this? Well, my opinion is that many consumer related stocks have been beaten down way too much. Companies focused on the roughest housing markets will likely see the brunt of the negative impact. Other areas such as the Midwest will likely hold up well on a relative basis. For a company like Ameristar, which owns properties in Missouri, Nebraska, and Mississippi, things might wind up being okay.

Additionally, the upscale consumer sector should still do relatively well. Sure, things will slow down, but the high end of the market will drop off less than the lower end, and likely will rebound faster once things turn around. After all, rich people probably aren’t scaling back too much due to elevated inflation levels.

One other area I think is poised to hold up well is the restaurant sector. Wall Street is bracing for people to stop eating out during the current economic downturn, but I would argue that eating out is due more to a secular shift in behavior than a bi-product of easy credit. People nowadays work longer hours than they used to and have less time to make dinner every night. I’m not saying dining spending won’t drop when things get tough, but I think if you look at the hits the stocks have taken and what that implies about business expectations, things won’t be nearly as bad as investors are pricing into the stock prices of restaurant chains.

All in all, I think investors should differentiate between the varying degrees of consumer stocks. A lower end company operating in California or Florida is going to fare differently than a high end company in the Midwest. A Vegas casino might not do as well as one based in St. Charles, MO in uncertain economic times. Traffic declines at a clothing retailer will likely be more dramatic than at a restaurant chain, if indeed eating out is a decision made for convenience more than monetary reasons. A new wardrobe is much easier to postpone than making time to prepare dinner at home.

As we allocate money to the consumer discretionary sector, it might serve us well to think about these things.

Full Disclosure: No position in ASCA at the time of writing

Thoughts on the Financial Media

Since it came up in discussions regarding my last post, I wanted to touch upon the issue of the financial media a bit more. I think it is important for investors to understand why media outfits like the NY Times (NYT) might not be the best resources to use when making investment decisions. Recent events involving a story the aforementioned paper published about Warren Buffett’s interest in buying a 20% stake in Bear Stearns (BSC) bring the issue to light even more.

For those that didn’t hear about it, shares of Bear Stearns rose more than 10% on Wednesday after the NY Times reported that Buffett was one of several parties discussing the purchase of a minority stake in the troubled investment bank. Within minutes other reporters were playing down the story after speaking with sources they have within the industry. The next morning, Bear even refuted the story itself on a call with investors. Lots of people have lost money due to what looks to be an erroneous report. Most likely someone leaked the story to a NY Times reporter, assuming they might publish it, causing a temporary jump in the stock price, allowing them to sell some stock at a nice profit right before the end of the quarter.

Now, yes, that explanation as to why it all happened is purely speculation on my part. However, based on what happens all the time on Wall Street, coupled with the fact that the story was immediately rebuffed by numerous sources, including Bear Stearns, leads me to be cynical and suspect that the Times did not check with many reliable sources before reporting Buffett’s supposed interest.

I bring this up because media outlets are not the most trustworthy of resources when trying to gauge the merit of a particular investment. The NY Times is often guilty of this because they are based in the financial capital of the world and have access to lots of Wall Street people, but many other media people make the same mistakes.

It shouldn’t really be all that surprising though, that is, the fact that newspapers and the media in general is often biased in their reporting. In recent months, the NY Times has published numerous stories, from numerous reporters, regarding many different financial corporations including student lending firms, credit card issuers, and mortgage companies. Some of these firms I am invested in, so although I don’t read the NY Times regularly, I have seen some of the “journalism” that has been published to the extent that it has caused stock price movements that interest me.

It is no secret that the Times has a liberal bias in many cases, and some of their attacks on large consumer lending companies makes it clear that some of their reporters are purposely trying to criticize large financial institutions for their lending practices, whether it be to college students, sub-prime home owners, or credit card dependent consumers. I guess it’s just the world we live in.

Now don’t get me wrong, I am all for throwing the book at companies that break the law or act in extremely unethical ways. By no means am I arguing that unlawful acts should not be punished to the fullest extent, and please don’t assume that I am writing strictly to make a political point. Most times I am successful in separating my political beliefs from my job as a stock picker, not only because it serves me and my clients best by doing so, but also because the views are often at opposite ends of the spectrum.

However, since consumer lending activities have become such a big issue lately, the media has started to really cross the line, in my view. It has, in part, I believe contributed to the fact that many Americans feel like they are constant victims of big business, whether it be the oil companies’ supposed price gauging (which there is no evidence of), or any type of consumer lending that has been called predatory in nature without any evidence to support the claim.

Stories in recent months from the likes of the NY Times have sharply criticized many financial institutions, and in some cases, have even gone as far as insinuated that they are breaking the law. Some examples of these horrible activities include student loan companies that factor in things like career path and which college you attend when determining your loan eligibility and interest rate, or mortgage companies that are offering wealthier white borrowers loans more often, and at more attractive terms, than minority, less wealthy borrowers. It turns out, in fact, that mortgage companies also offer their sales people higher commissions for more profitable adjustable rate mortgages than they do for fixed rate versions (much like stock brokers usually try to sell clients annuities — they have high fees and sales commissions of up to 8%!).

Now, if you read these stories without a cynical tilt you are more likely than not going to conclude that companies like Countrywide (CFC), Sallie Mae (SLM), and JP Morgan Chase (JPM) are crooks who are discriminating against anyone and everyone in the name of profitability. Those profits in the end wind up in the hands of wealthy executives and shareholders, which results in an ever-widening gap between the wealthy people making the loans and the less wealthy ones receiving them. This press coverage does result, at least in the short term, to lower stock prices and a general anger toward big business in general. In my view, these attacks are not only often unfair, but in some cases completely one-sided and oftentimes based on assumptions that are simply untrue.

For instance, is it fair to imply that it is at most illegal, and at least unethical, to factor in what degree you are seeking and what school you plan on attending when deciding whether or not to offer you a student loan and at what interest rate? Believe it or not, lenders offer loans to people based on what they think the odds are of being repaid. The better your credit, the more likely you are to not only get a loan, but also a low interest rate. Lenders need to consider this issue more than any other when deciding who to lend money to. The higher the risk, the less often you will qualify for a loan, and even when you do get approved, your increased credit risk results in higher interest rates.

Now, does anyone think that which college you attend and which career path you are pursuing might be relevant factors in determining a borrower’s creditworthiness? The fact is, there is a direct correlation between education, career, and annual income. It also stands to reason that the more money you end up making, the higher probability there is that you will be able to pay back your student loan. Therefore, is it unfair to accuse Sallie Mae of illegally discriminating based on school choice or career path? Most economists would say “yes.”

The same arguments can be made on any number of fronts. Do a smaller percentage of minority borrowers get low interest rate loans because of their skin color and ethnic background, or is it because of their credit worthiness? Most likely, the latter. That does not mean we should not strive to put in place policies that seek to get minority education levels and incomes on par with everyone else, it just means that accusing the banks of racism is probably crossing the line.

The current mortgage and housing industry downturn we are seeing is partly due to the fact that lenders actually abandoned these basic lending principles. Traditionally, the better your credit history, the better loan you were offered. Not surprisingly, the housing boom led companies to get greedy. The more loans they made, the more money they made (at least in the short term, as we are finding out now).

The result was that the lenders completely turned their lending practices on their head. If you couldn’t afford a standard 30 year fixed rate mortgage with 20% down, a new type of loan was created for you allowing little or no down payment and an attractive teaser interest rate. All of the sudden, people who couldn’t get loans were able to go out and buy houses they couldn’t normally afford. And that’s how we got ourselves in this mess.

Amazingly, we lived in a world where the better your credit, the worse your loan terms! High quality borrowers put 20% down on their house and paid 6% interest while sub-prime borrowers put less down and got low single digit introductory rates. How on earth does that make any sense?

It doesn’t, but people are paying for it now. Many lenders have either gone out of business or are losing money hand over fist now since they failed to align the credit worthiness of the borrower with the loans they were offered. And yet, some people want to criticize smart lenders for doing their due diligence and aligning credit histories with interest rates.

Consumers are also to blame since those facing possible foreclosure are constantly being quoted as saying they were so intent on getting their house that they didn’t read the loan agreement before signing it. Well, if you were about to be loaned hundreds of thousands of dollars and didn’t bother to take the time to read the paperwork to find out how much that loan was going to cost, maybe it’s your fault for taking the money just as much as it was the lender’s fault for offering it to you.

I’m getting a little sidetracked here, but the basic point is this. It is imperative that lenders size up the creditworthiness of borrowers to determine loan terms that are appropriate to compensate them for the repayment risk they are taking. Doing so is not illegal or unethical, although hundreds of biased press stories will try to convince you otherwise. These issues are all coming to a head in 2007 and due to the highly divided political landscape our country is facing, people are becoming more and more inherently biased. It’s a shame that this is the case, but it is simply reality. And it’s not just the Times, of course. Conservative papers will be coming from the exact opposite end of the spectrum. It’s just the world we live in today.

This is important from an investing standpoint because you need to consider these issues if you are going to allow the media to play a role in your investment decisions. I would recommend that you not base your investing on what you read in the media. Due to inherent biases, there is going to be information left out because it doesn’t prove a certain desired point, and other information is going to be embellished to make a certain case seem even stronger.

The best thing to do is to base your decision on the facts, not on opinions. In many cases that means taking what public companies say at face value. It is true that there will always be Enrons and WorldComs in this world. However, there are far more biased press reports that ignore facts than there are crooked companies and executives. If you are trying to research a company’s mortgage portfolio, for instance, and the company is willing to break out in agonizing detail exactly what loans they have made (what the delinquency rates are, what the credit scores of the borrowers are, etc.), then you are probably better off analyzing that data than the opinions expressed in the media.

If a company is unwilling to disclose the data you feel you need to make an appropriate investment decision, then find another company that will. In the world we live in today there are too many people with an agenda or a bias that colors what they feel, think, and publish. Heck, I’m guilty of it too. If I’m going to write about a stock that I am invested in, won’t I tend to be bullish? Of course.

However, the merit of my opinion can be greatly increased if I use facts to back up my assumptions. If someone offers up facts and you agree with their underlying assumptions, it is far more likely they will be right. If you read or hear something with a lot of opinion and speculation, but little in the way of facts (say, for instance, in the case of Warren Buffett’s supposed interest in buying Bear Stearns), perhaps it is prudent to be more skeptical.

Take the case of Bear Stearns, for example. On Wednesday the NY Times reported that Warren Buffett was discussing taking a 20% stake in the company. There was no evidence in the story that suggested the rumor had any merit. Within 24 hours numerous reporters were doubting the story after talking with their sources and Bear dismissed the rumors directly. We cannot know for sure if Buffett will wind up buying a 20% stake in Bear Stearns, but based on the factual information we have, I wouldn’t be willing to bet any money on it.

Full Disclosure: No positions in the companies mentioned at the time of writing