Bill Gross August 09 Investment Outlook Notes

Here are notes from Bill Gross's Aug 09 Investment Outlook article:

• Investment managers like the infamous Madame Rue sells hope instead of love but very few are able to seal the deal with performance anywhere close to compensating for the generous fees managers command.
• Hope has a legitimate price even if its promises are never fulfilled. It is why we put donation into the collection plate on Sunday mornings and why we risk money at the blackjack table. When promises are not fulfilled, we rationalize it as insurance in the former case and entertainment in the latter.
• Industry as a whole cannot outperform the market because they are the market and yet investors are willing to pay the generous fees to fund managers.
• Based on the new normal of 6% return that PIMCO envisioned, a 1% management fees paid by investors to funds equate to a 15% extraction of investors' income.
• Investors looking for hope in a deleveraging and reregulation economy must focus on some macro-oriented events rather than focus on typical news-dominated details.
• Common sense tells us that consumer spending growth comes from highly employed, well-compensated labor, and we are far-far from even approaching that elemental condition. In reality, near double-digit unemployment has resulted from numerous business models that are now broken: autos, home construction, commercial real estate development, finance and retail sales.
• Reflecting nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.
• Nominal GDP over the last 15 years increased 5-7%.
• 5% was the number capitalists rely on to justify employment hiring, investment spending plans and also serve as a close proxy for the return on capital that they should expect.
• Nominal GDP is in fact a decent proxy for a national economy's return on capital which serves to estimate the present value of cash flows, and price investment and related assets accordingly.
• Businesses' growth in demand, expenses and return on the economy's capital would mimic this 5% consistency. Debt was issued with yields that reflected the ability to service those payments through 5% growth in both real and inflationary terms, and stocks were issued and priced as well with the same foundation. So are pension obligations and similar liabilities, as well as government spending programs forecasting tax revenues and benefits.
• However, things have changed. Nominal GDP sunk below 5%. If this continues, a portion of the U.S. production capacity - massively overcapacity now as it is catered for 5% growth - and labor market will have to be permanently laid off.
• Economy may head towards a new normal where unemployment averages 8 instead of 5%, housing starts total 1.5 instead of 2 million, domestic auto sales 12 instead of 16 million annual units, if nominal GDP does not grow close to 5% so that long-term balance is to be maintained.
• Debts are haircutted via corporate defaults and home foreclosures and equity P/Es are cut based upon increase risk and substantially lower growth expectations, during the readjustment process.
• A modern capitalism economy based on levered financing and asset appreciation cannot thrive if its "return on capital" or nominal GDP suffers such a significant shock.
• Government interventions - low interest rates, quantitative easing, $1.5 trillion deficits - are not likely to successfully reflate to 5% nominal GDP growth. Substitution of government-backed vs private-leverage works against the possibility.
• Low rates financing provided by the TALF, TLGP, etc., comes with quality constraints (larger collateral haircuts and mortgage down payments, to name a few) that inhibit the "new normal" lenders from approaching the standards of the 5% nominal-based shadow banking system.
• "New normal" will likely be closer to 3%, for at least a few years. Diminished capitalistic risk taking and constrained policymaker releveraging will lead to this conclusion.
• A 3% nominal GDP "new normal" means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalism model.
• A readjustment to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.
• Steady income-producing bond and equity investments in companies with strong balance sheets and high dividend yields is recommended for this new environment.

Understanding a bank financial statements and its operations

Analyzing and understanding a bank's financial statement can be a daunting task. I have taken the past few months to learn more on the basics of banking operation. Bank's financial statements are vastly different from that of manufacturing or service companies. As a result, analyzing a bank's financial statement requires a different approach to decipher its unique risk.

HOW BANKS MAKE MONEY?

Primarily, banks acts as an intermediary between savers and borrowers by taking in deposits from savers and making out loans to borrowers. The bank makes a "spread" between the interest paid out to the depositors and interest received from the borrowers. This spread is known as the Net Interest Income (NII). As a result, banks as financial intermediaries, has inherently two kinds of risks: 1) interest rate risk - managing the spread between the interest paid on deposits and the interest received from loans; 2) credit risk - the probability that a borrower will default on its loan or lease. So, banks have to provide for a provision for loans and credit losses, which take a portion off the net interest income. Banks also makes a constellation of fees from services like credit cards fees, asset management and insurance business - known as Non-Interest Income. Banks also need to pay for employees salaries and benefits, rentals, office equipments, operating cost, etc. - these are non-interest related expenses and known as Non-Interest Expense. In summary, the following table depicts how a typical bank makes its money.

+ Interest income	Bank makes loans
- Interest expense	Bank receive deposits, debt financing and commercial papers
= net interest income	The spread between interest received and interest paid
- Provision for loan and credit losses	Bank takes risk for lending out
+ Non interest income	Sell investments, insurance, and other services
- Interest expense	Bank needs people, system, space and equipments
= Net operating income	Bank keeps what is left
- Tax expense	The country takes her share
= Net income	Bank's goal

INTEREST RATE

One of the avenue banks can grow its revenue is by widening the net interest margin. The size of this spread or margin determines the profit generated by a bank. Consider, a difference in 1% of net interest margin on $100 billion is $1 billion. Interest rates are important to banks because it determines the rate at which money is bought (garnering of deposits) and sold (extension of loans). But interest rates present its own risk. Interest rate risk is affected by the shape of the yield curve. Net interest income varies due to the changing of rates, the timing of accrual changes and also the yield curve relationship. Banks assume financial risk by making loans at an interest rate that differ from rates paid on deposit. Because deposit often have shorter maturities than loans and adjust to market rates changes faster than loans, it causes a mismatch in the balance sheet between assets (loans) and liabilities (deposits). An upward sloping yield curve - the steeper it is, the wider the spread - is favorable to a bank as the bulk of its deposits are short term while its loans are longer in term. This mismatch of maturities generates the net interest income banks enjoy. When the yield curve reverse or flattens, this mismatch causes the spread to diminish.

BALANCE SHEET

A bank's balance sheet is unlike that of a typical company. There's no inventory, account receivable, or account payable. Instead, you will find securities, investments and loans on the asset side and deposits, and borrowings on the liability side. On all bank's financial reports, you can find two kinds of balance sheet: 1) the ending period balance sheet and; 2) the average balances with the yield rates indicated. For a better understanding, it is better to use the "average balances" to explain. Below is an example.

AVERAGE BALANCES, YIELDS & RATES PAID
(In millions)	2008			2009
	Average balance	Yields/rates	Interest income/expense	Average balance	Yields/rates	Interest income/expense
EARNING ASSETS
Federal funds sold & securities	5293	1.70%	90	4468	4.99%	223
Trading assets	4971	3.80%	189	4291	4.38%	188
Debt securities available for sale	86345	6.46%	5577	57023	6.28%	3582
Mortgages held for sale	25656	6.13%	1573	33066	6.50%	2150
Loans held for sale	837	5.73%	48	896	7.81%	70
Loans	398460	6.94%	27651	344775	8.43%	29057
Other	1920	4.74%	91	1402	5.06%	71
Total earning assets	523482	6.73%	35219	445921	7.93%	35341
NONINTEREST EARNING ASSETS
Cash & due from banks	11175			11806
Goodwill	13353			11957
Other	56386			51068
Total noninterest earning assets	80914			74831
TOTAL ASSETS	604396			520752
INTEREST BEARING LIABILITIES
Deposits	266056	1.70%	4521	239178	3.41%	8152
Short term borrowings	65826	2.25%	1478	25854	4.82%	1245
Long term debt	102283	3.70%	3789	93193	5.18%	4824
Total interest bearing liabilities	434165	2.25%	9788	358225	3.97%	14221
NONINTEREST BEARING LIABILITIES & SOURCES
Deposits	87820			88907
Other liabilities	28939			26557
Preferred stockholders equity	4051			0
Common stockholders equity	49421			47063
Total noninterest bearing sources	170231			162527
TOTAL LIABILITIES AND EQUITY	604396			520752
NET INTEREST INCOME			25431			21120
GROSS INTEREST MARGIN		4.47%			3.96%
As percentage of earning assets:
Interest income		6.73%			7.93%
Interest expense		1.87%			3.19%
Net interest income		4.86%			4.74%

The numbers in the balance sheet is an average balance for each line item, rather than the balance at the end of the period. At the side of each line item, you will find there is a corresponding interest-related income or expense item, and the average yield or rate for the period. In this case, you can also see the slight steepening of the yield curve - caution: provided the bank reflects the market which may not be all the time because some banks manage interest rates better than others.

Let's start with the net interest income. The bank generated a higher net interest income even though its interest revenue was flat and interest rate was lower. This is because correspondingly, the bank managed to reduce its interest expense at a slightly higher rate and reducing its interest rate paid out. The reason for this could be either: 1) the yield curve had steepened or; 2) the bank manage its interest margin more efficiently. If the yield curve had steepened, the interest rate the bank pays on shorter term deposits tends to decrease faster than the rates it can earn from its loan during a period when interest rates are falling. This causes the net interest margin to widen, as you can draw from the table.

The bulk of a bank's assets are loans. Loans are the life blood because it can typically earn a higher interest rate. However, loans have its danger. If a bank makes bad loans, the bank can face credit problems when borrowers default on their loans. So it is also important to know the composition of the loans and also who the bank lends out to.

CREDIT RISK

When banks make loans, there's always a risk of defaults. The key is to manage the credit risk of the bank's loan portfolio. Credit risk is the potential that a borrower or counterparty will fail to meet its obligations in accordance with the agreed terms. When this happens, the bank will experience a loss of some or all of the credit it provided to the customer. An allowance for loan and lease losses is maintained by the banks to absorb such losses. In order for the allowance to be accurate to absorb actual losses, banks have to estimate the amount of probable losses in its loan portfolio.

Actual losses will be written off from the allowance for loan losses account in the balance sheet. As it is written off, banks need to replenish it. It is replenished via the income statement through the item "provision for loan and lease or credit losses." Some times banks replenish more than it write loans off. This happens when banks anticipate credit quality or probable loan losses is likely to increase in the coming quarters. In such cases when provision is more than write-offs, banks are building its loan-loss allowance. At other times, provision for loan losses could be lower than actual write-offs which in turn reduces the amount in the allowance for loan losses account. While this by itself may not necessarily means a problem, but if it is coupled with a flattening of the yield curve (long term rate converging with short term rate), then it may be suspect because it indicates there is a slow-down in economy or economy is in uncertainty and thus push marginal borrowers to the blink of default.

Providing a provision for loan losses is an art as well as a science. It involves a high degree of judgment and evaluation on the part of the management for approximating a loss reserve probability. Since it is a management judgment, the provision is a good source to manage a bank's earnings. In a given quarter where banks need to meet market's expectation and if its earnings fall short, banks can opt to under-provide for that quarter to hit the expectation. On the other hand, banks can also over-provide - not that it is a bad thing - but by overproviding, it ties up capital which otherwise can be deployed to generate more revenue.

The most concerning factor an investor should worry of is when banks isn't reserving sufficient allowance to cover its probably future loan and credit losses. If a bank under-reserves, they will have to face up to reality when more borrowers default on the loans. When the time comes, such banks must provide for loan and credit losses that not only covers actual write-offs but also build on the allowance. Thus the provision for loan losses will spike tremendously which often cause the bank to report a loss in income. When that happens, it depletes shareholder equity and if equity falls below and fails to meet regulatory requirements, regulators will take corrective action such as issuing additional capital, and in worst case, seize the bank, thus wiping out all shareholders' equity. Neither of these situations benefit investors.

WRAP UP

Analyzing banks are one of the most convoluted among other businesses. Moreover, banks are highly leveraged in order to generate the higher return on equity, and thus, a loss on any assets, also magnify the loss on shareholder's equity. So a real careful review and understanding of a bank financial statements is required because it can highlight the key factors that must be considered before making an investing decision. The yield curve as well as the business cycle have a major impact on the economic performance of banks. Credit risk must always be the most important factor when banks manage its loans portfolio because that is the life-blood of a bank. Running a stress-test for adverse economic conditions to evaluate how much losses banks can absorb before eating into capital is one way to evaluate the strength of the bank. Lastly, if you were to hand over money to others, you'd want a honest and trustworthy fellow to be the steward of your money. Same here, you want a good and honest banker who do not manipulate earnings for the short term.

Do You Know Your Broker Well?

Brokers - stock brokers, insurance brokers, bond salesman, etc. - are supposed to advise you on which securities to buy and sell, depending on your investment objectives. They offer a variety of products to help you shape a portfolio that fits your investment objectives. Brokers may seem like clever financial experts but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in the account they manage. Therefore, their interest is in conflict with you - the investor.

Brokers want you to buy things you don't own and sell things you own. Has an investor stuck to Berkshire Hathaway stock since 1965, they would have seen their net worth gone from $12 to $90,000. But for brokers who have recommended their clients to buy and hold would have starved. There are many forms of commissions. On a stock trade, it is a percentage of the total value of the transaction. For mutual funds, it can be an upfront commission (sales load) which are paid when you make an investment, or it can be a backend commission (deferred loan) which are paid when you take your money out. On bonds, brokers normally don't charge a commission. Instead, money is made off the "spread," or the difference between what the firm paid to buy the bond and the price at which the firm sells the bond to you.

In many cases, brokers are fine and honest people, but the system rewards them based on the number of transactions they execute and not on how well their client's portfolio performs. Even when the best course of action is to do nothing in a client's account, the commission system encourages brokers to recommend sometimes dubious trades. For example, placing secondary offerings - shares issued by companies that had already gone public but needed more capital - with clients would pay five times the normal commission. One hundred shares of JPMorgan, for example, at $35 a share paid a 1% commission for a total of $35. But the commission on the same 100 shares in a secondary offering of the same JPMorgan stock was 5 percent, or $175. Brokers could have recommended the same share a month, or even a week, ago had they thought it was a good investment. Why did brokers suddenly find JPMorgan attractive one day, when brokers weren't interested or recommending the stock the day or week before? More likely the motivation is self interest, pure and simple. However, not all brokers are commission-hungry wolves on the prowl for naive investors. Some are, others are just inept. Most are honest brokers but sadly, the brokerage industry has numerous flaws. Brokers are mostly good people stuck in a bad system.

There are mainly four problems in the system: 1) Brokers are not well-trained enough for the enormous task expected to be carried out; 2) The system in which brokers operate is geared towards volume selling, and dangling with carrots frequently and thus, weaken the fiduciary duty of giving objective advice; 3) To increase sales, firms use sales contests to get brokers to sell securities that investors may not need. Most brokers rarely, if ever, disclose to their clients how they are paid or how their bonuses are structured, even though such disclosures would go a long way to resolving the conflict of interest problem; 4) Branch managers and other supervisors who are paid commissions just like their brokers have an incentive to push everyone to sell more and turn a blind eye to questionable practices.

Behavior are often determined by rewards or compensations. It is hard to run out of space to create novel ways to use commission to motivate brokers - and take more money out of customers' pockets. One popular system is the grid. Typically, brokers receive a percentage of their generated commissions, ranging from 33 to 45 percent, depending on the volume of commission sales they bring in. As their commission sales increase, they can jump to a higher payout level on the grid. Imagine, it's December 27. Your broker's payout level is 33% and he has generated $470,000 in commissions so far this year. But if he hits $500,000 by December 31, his payout level jumps to 40 percent, applied retrospectively. To your broker, this means he can earn a windfall of $44,900 in additional compensation just by generating $30,000 in commission sales in four days. Unless a firm's ethical culture is impeccable or even rarer, the broker has an impenetrable moral compass, the temptation to sell anything to anyone, no matter how inappropriate, is overwhelming.

It is common practice for firms to lure star brokers away from his employer with large, upfront bonuses. Such bonuses can equal or exceed an entire year's pay. This sum is paid on the presumption that the broker will bring his customers with him to the new firm by telling them that his new firm offers better customer service and better research but never reveals the new firm is paying him a bundle to move. In such cases, customer accounts are bargaining chips that brokers use to increase their personal wealth, not their customers. Once the broker moves to the new firm, he must produce. Thus, the broker is more likely to push unwanted or unneeded products, especially those paying higher commissions.

Commissions distort brokers' recommendation in other ways as well. Some companies have special arrangement to sell mutual funds in exchange for above-average commissions. If your broker knows he'll get 25% more money for selling Fund A over Fund B, guess which fund he will sell you? Most large brokers also sponsor their own funds, so they may even steer you to one of those.

ONLINE BROKERS

Brokers come in many forms. There is the full-service brokerage houses like Merrill Lynch, Smith Barney, and UBS PaineWebber. Not only do they help clients to establish their investment goals and pass on customer orders to their trading desk for execution but they also provide research from in-house analysts and give advice on a wide range of securities. For these extras, customers pay more.

Then there are the discount houses - like E-Trade, Interactive Brokers which give minimal advice or none at all. Many do not provide proprietary research although they may make available research produced by other firms. For less services, investors are charged a moderate commission or pay a flat fee for each trade. Many online brokers are discount brokers. For a $50,000 asset, customers pay a flat fee of $9.95. Anyone can open an account and sell or buy up to 5,000 shares for as little as $8 or some $9.95. Firm touts its capability to fill orders within 10 seconds in most cases. The ease and low cost of online trading lured millions and millions of investors into opening online accounts. With the online trading revolution came powerful new computer networks, called electronic communications networks, that act much like electronic stock exchanges. It serves to match buyers and sellers up in a split second. Because it involves no human intervention, they do so at a fraction of the cost of the New York Stock Exchange or Nasdaq. But investors are not fully informed and caught unaware because the revolution of online trading comes with its own hidden dangers. The first is "payment for order flow," which is a rebate or payment received by the brokerage firm from market makers. Market makers are firms who post prices to buy and sell financial products for their own account and for others.

When you place orders to buy or sell a stock, you may not think about where or how your broker will be execute the trade. Placing an order through your online broker may not necessary be routed directly to the stock exchange for execution. But where and how the trade is executed impacts your transaction cost, though you may not notice it. Just as you have a choice of your brokers, your brokers also have a choice for the market of execution. When you place your order with your online broker, your order is routed to the market of the online broker's choice. Because market makers offer a rebate or "payment for order flow" to the brokerage for your order, the chances are pretty high that your order will be routed to the market maker to match your buy order with someone else's sell order, and only the transaction is reported to the exchange. The problem with payment for order flow is that your buy order may not be exposed to a large number of sell orders, and that may deprive you of a better price. For example, you place an order for 1,000 shares with your online broker, which then routes it to a market maker, who then rebates your broker a penny for every order it gets at the market price. But another market maker or exchange not paying a payment for order flow might be able to improve the price by 5 cents, saving you $50 ($0.05 x 1000 shares). That's five times what most online brokers charge in commission. The moral is: don't be fooled into saving $5 or $10 in commission charges and only to pay far more in hidden trading costs. And you have options to direct your orders, you can request your brokers to direct it to a market or exchange that you want your orders to be executed. But your brokers may charge you a fee.

If brokers tout about their speed of execution, they must not fail to warn investors of the possibility of significant delays. Usually, trade execution is fast and seamless, but it does takes time. During fast moving market, price can change quickly. Because price is quoted for a specific number of shares, investors may not always get the price they saw on their screen or the quote given by their brokers. By the time the order reaches the market, the price could be slightly, or very different. Under the Securities and Exchange Commission's rules, your broker is obligated to get the best execution - best possible price in the shortest time - available for your order.

Another hidden trap is internalization. This happens when your broker fills your order from the firm's own inventory instead of routing it to a market maker or exchange for execution. This is just like payment for order flow except that the parent company gets to keep all the payments and the "spread" - which is the difference between the buying and selling price. For the investor, it is the same, the buy order does not get expose to a wider universe of sell orders and may get executed at a higher price than the best available price the broader market is offering.

As an investor, the responsibilities are on you. The more you understand these, the more rewarding your investment journey will be.

Wells Fargo 2Q09 Results

Wells Fargo has once again defied expectations, coming in much strong than was expected. The Street expected 34 cents on average, while Wells Fargo earned 57 cents for the quarter. But yet, the stock took a beating - down by more than 7% at one point, before ending down about 3.5%. The worry is the quality of the earnings and more importantly, the worry on its worsening credit quality.

Let's touch on the earnings quality, the Street is worried that the company will not be able to reproduce the high revenue in the future quarters, especially on the contribution of $3B from Mortgage Banking alone. Well, even Mortgage Banking may not be as high in the next few quarters, it won't be zero for sure - perhaps maybe half of the $3B of revenue. But what is interesting is the company improved on its net interest margin (NII) to 4.3%. In the event that Mortgage Banking revenue decreases, the improvement in NII will help to offset it - not all but some as least. In the quarter, the company pretax preprovision for income came to $9.8B.

Now, the other worry is what spoked the market more than the revenue in my view - credit quality. But let's go through the numbers and comparison with how it came about to extract the reality behind it.

Prior to the merger, below are some numbers of the two companies as at end Dec 08 as if each is a separate entity:

1) Wachovia

• Total loans = $484.1 billion (When Wells bought over, only $446.1b was carried over)
• Nonperforming loans = $20.1 billion (When WFC bought over, only $97m is carried over)

2) Wells Fargo

• Total loans $418.7 billion
• Nonperforming loans = $6.7 billion

Now here is how the loan portfolio looks like as at end Dec 2008 with the merged entity.

Wachovia loans	476.6
Less Purchase Accounting & Write offs	-30.5
Plus WFC loans	418.7
	864.8

Essentially, after the application of Purchase Accounting and Write Off, the remaining loan applicable to Wachovia's legacy loans is all free from nonperforming loans.

Of the $864.8b loans, $446.1b is attributed to Wachovia and $418.7b is attributed to Wells Fargo.

As at December 31, 2008, the nonperforming loans left at Wachovia is $97 million, and $6.7 billion at Wells Fargo, for a total of $6.8 billion in nonperforming loans. Had Wells Fargo not acquired Wachovia, its ratio of nonperforming loans to total loans is 1.6% ($6.7b/$418.7b). But since both are merged, the nonperforming loans is $6.8b over a combined loan portfolio of $864.8B, which brings the ratio of nonperforming loans to total loans down substantially to 0.79%.

Below is a table on nonperforming loans numbers:

	2Q09	4Q08	Difference
Legacy Wells Fargo nonperforming loans	11.0	6.7	4.3
Wachovia nonperforming loans	4.8	0.1	4.7
Total nonperforming (legacy WFC & WA) loans	15.8	6.8	9.0
Legacy Wells Fargo total loans	398.7	418.7	-20.0
Wachovia total loans	422.9	446.1	-23.2
Total legacy WFC & WA loans	821.6	864.8	-43.2
NPL as a % of total loans
- Legacy Wells Fargo	2.76%	1.60%	1.16%
- Wachovia	1.13%	0.02%	1.11%
- Total loans	1.92%	0.79%	1.14%

Although, the Street worries about the huge quarter to quarter jump in nonperforming loans (50% increase), the increase for the past half a year isn't so bad at all as you can glean from the table. The rise in NPL as a % of total loans for this period is about 1.1%, whichever way you look at it - either solely by legacy WFC, Wachovia or as a total. This ratio is not that far off with all of the rest of the banks - JPM at 0.97%, USB at about 0.8%, BAC at 1.35%, STI at 1.38%, Citi at 1.19%. So, the increase in NPL seems somewhere in the middle of the pack when compared to its peers.

A Little History

One of the things I like and have done pretty well is history. So this post is sort of a short information, or rather history, on the evolution of the business world. The top businesses in the early 1900s and now are as different as chalk and cheese. Only a handful survive, and even a lesser number of them prosper. Indeed, GE is the only company survivor remaining from the original 12 companies listed in the Dow Jones Industrial Average (formed in 1896), although GE may not have been continuously been in the DJIA index.

Here're the other 11 companies on the original Dow index: 1) American Cotton Oil Company (a distant ancestor of Bestfoods, now part of Unilever); 2) American Sugar Company, now Domino Foods; 3) American Tobacco Company, broken up in 1911 due to antitrust law, remnants now include Reynolds, Lorrillard Tobacco (part of Loews Corp.) and Liggett Vector Brands; 4) Chicago Gas Company, now part of Integrys Energy Group; 5) Distilling & Cattle Feeding Company, a division of LyondellBasell (filed for Chapter 11 early this year); 6) Laclede Gas Light Company which is still in operation as Laclede Group; 7) National Lead Company, now NL Industries; 8) North American Company, broken up in 1940s, some of which are remaining; 9) Tennessee Coal, Iron and Railroad Company, now part of U.S. Steel; 10) U.S. Leather Company, liquidated in 1952; 11) United States Rubber Company, changed its name to Uniroyal, and bought by Michelin in 1990.

This teaches me something: Business, like natural selection, evolves as the stronger replaces the weaker and the weaker gets eliminated. 99.99% of businesses are not built to last for century. Businesses are mostly built to do good in one area, seldom in a few. The moment that area is not one that consumers need, they are called to the sideline. Some of them deteriorates gradually while others, steeply and rapidly. All the time, there're many eyes wanting a share of the economy pie. Competitors aim to destroy competitors or take away existing business from others. Some manage to create a new market but a new market may impair the moat of the others though they may not seem quite to be in direct competition with the new market. Internet, cars, airplanes, computers. Look who they destroyed. Newspapers, horses, ships, writing equipments were in less demand. Computers are clearly invented for a new market but it destroyed many businesses that are not longer demanded by consumers - people do not need to write as much when you can do your documents on the computer.

Newspapers used to be one heck of a business, advertisers hate them but need them to penetrate the market. The industry started its decline in the early 1990s with the advent of information technology, in particular the Internet. The decline was gradual until picking up speed in the 2000s, and exacerbated by the recent financial crisis. Pricing power for print advertisements is lost once advertisers switch to advertising on Google, Yahoo, and now Tweetering, to reach their targeted audience. When economics of a business is permanently impaired, no amount of funding can save the business. In fact, if Internet is discovered before the print business, newspapers will not be part of history.

American Online had a rapid decline economically and financially. The narrowband (dial-up) internet service provider business is a died trade as soon as broadband is commercialized. No one will opt for slower access while wasting precious time and being frustrated at the same time. AOL saw clearly the degeneration of the narrowband service. AOL merged with Time Warner using its lofty share price as buying currency. Time Warner's stockholders were clearly short changed - more so with AOL ended with 55% of the merged entity - while AOL shareholders averted, quite clearly, a wipeout of its share price had AOL been independent. The main job of the management is to position the business for survival and prosperity which is clearly lacking from both AOL and Time Warner.

Changes can also caused rapid advances. Had fridge not been invented, sales of Coca Cola would not have run up so quickly. Coke tastes better when chilled - no one I can think of drink room-temperature Coke. That is not to say it is the single biggest factor to Coke's success. Coke operates in a highly competitive environment. Why would you chose Coke over so many other brands and flavors of aerated drinks? Coke has a winning marketing, distribution and psychology strategy. They simply won over consumers' share of mind.

History tells us that once a fundamental better product or service is developed into something commercially and economically viable, it can push business to its downfall or bring it to stratospheric level. Horses were replaced by cars when Ford had a commercially and economically viable car. People used to travel by ships but ship travels were a thing of the past once the Wright brothers' idea evolves into airliner.

But that doesn't means that new technology eliminate totally the whole of the old-world technology. Like species, that thrive in niches, will have a share of the economy pie deservingly. Value Line, the investing publishing firm with its own periodical, has a niche of their own. Its successful, Value Line Investing Survey, is an almost must-have for many investors. They are in the print business, their products are desired and wanted by investors because of the share of mind that they had created in the minds of its users, even faced with bigger competitors thrown around its castle and the tons of free information on the internet.

Who knows what will be the fate of oil companies when and if battery technology can power our needs viably?

So all these partly explain why none except one of the companies in the original DJIA's list survive as an independent and successful entity till today, although a few are now be part of a bigger entity. Then there are a few which may still be independent but are unsuccessful - consider NL Industries, Integrys Energy and Laclede Group, the biggest of them is Laclede with a market capitalization of $2.4 billion, the others are less than $800 million.

MATHS

Now a little maths. When the Dow was first published, it stood at 40.94. Now it is 8500. For the Dow to go from 40.94 to 8500, it takes about every 15 years to double up. At this rate, the yearly return is compounded at 4.85% (excluding dividend).

Even if you take another period, from 1969 to 2009, Dow was about 900 in 1969. To go from 900 to 8500, it takes roughly every 13 years to double the index. The compounded rate of return is 5.7% roughly.

Of course, the measurement is taken at a time where the ending index is not normal. But even if we take a normal index, for example last year, it wouldn't affects too much, maybe add a percentage or so, and the years needed to double up is reduce by a year or so.

GENERAL ELECTRIC

When GE was traded for the first time on June 23, 1892, there was only 1 trade (opposed to millions of trades today) of 50 shares at $108 per share. Since then, GE went through nine stock splits. When you do all the maths, each share in split-adjusted terms is worth 2.34 cents. So when you compare the price then and now, the stock has returned a whopping 51,200%.

Another period taken is from 1969 to now. In split-adjusted terms, the stock was 75 cents in 1969. The stock still gave a 1,600% gain. No less than a feat.

Wow! 51,200% or 1,600%, that's one hell on a deal. Impressive it may sound, but the truth is:

• From 1892 to 2009, in a span of 117 years, it takes about every 13 years to double up, at a compounded rate of return of 5.54%.
• From 1969 to 2009, it takes every 10 years to double up, at a compounded rate of 7,2%.

Nevertheless, it is still impressive stuff, and it doesn't take away the credit that GE is still a Hall-of-Framer of the business world. Firstly, GE is the sole survivor of the original Dow's list. And more importantly, they perform better than the Dow average of return.

Just some maths.