Monday, October 4, 2010

Tradewinds - David Iben’s September 2010 Commentary: Slumdog Millionaire

We follow our last Commentary, which centered on the runner-up in this year’s Academy Awards, with one inspired by the film that took home the Oscar for Best Picture last year. As usual, I’ve found an investment message in a film. This film is filled with imagery.

I’m usually not much of an Academy Awards fan. Although I love the movies, I usually don’t care for events involving people from any industry spending hours publically congratulating each other. 2009, however, was an interesting year, perhaps reflective of the depressed mood surrounding the financial meltdown. I actually saw all five movies (yes—it was the last year before the Academy took a page from the NBA playbook and allowed almost everyone (save the Clippers and WALL·E) to make the playoffs). Am I the only one who finds 10 candidates excessive?

Hollywood put out four movies ending with dour outcomes, mostly death. The fifth contender was an outsider, a British film, shot in India. It, too, is filled with depression and death. Yet unlike the others, it is also about hope, perseverance, and the triumph of the human spirit. I like upbeat endings and was definitely rooting for Slumdog to take down the award. Yet, the award, like the movie, stirred mixed emotions. For example, what does this mean for America? I was born in a year of American pre-eminence in many things. There was auto manufacturing for example (’57 Chevy, T-bird, etc), but I was still a teen when the Japanese companies began to steam-roll us. We’ve since witnessed America’s loss of businesses such as consumer goods, TV and electronics, resource industries and, more recently, even some service businesses. Unpredictably (I suppose), I’m not going to lament the continuing loss of our hegemony in the film business. No, the question preoccupying my mind is, “when did we outsource the American Dream?”


[An additional excerpt that I think is brilliant and perfectly states and simplifies what I’ve come to believe is the ideal approach to investment: bottom-up analysis, but that paying attention to the macro and big picture things is a must from a risk management standpoint. The key, in my opinion, is to be a risk-identifier - not a forecaster - when it comes to those big picture things that aren’t directly related to an individual business. But it is also important to keep in mind that the market can stay irrational and that risks can take a long time before they are realized in the market, so it is also important to be careful about betting on the timing of those macro risks playing out (i.e. it is probably better to hold cash and/or try and find cheap insurance instead of making an investment that depends on the timing for mean reversion).]

Additional excerpt:

Before we continue, let’s veer off on a tangential discussion about why a disciplined bottom-up, value-oriented shop like Tradewinds spends time on these broader issues or sends out these topical missives.

I must confess to being a big fan of Charlie Munger, whom I’ve never met. He writes often about the importance of psychology, behavior and incentivization. He talks about a thorough understanding of accounting, mathematics and finance, not as an advantage but, as a necessity. Tradewinds agrees. We don’t believe that anyone ought to hire a money manager because they understand accounting and finance, but they surely shouldn’t hire them if they don’t. An appropriate analogy is a sports team. A team won’t win a game solely because they are in shape and have a decent playbook, but they likely don’t have a chance if they aren’t fit and don’t have plays. To excel, it is important to have a good coaching staff that has studied the other team and has developed a strategy to exploit its weaknesses. It is important to practice, to execute, to have the right attitude and desire. It is important to have talented players. Likewise, in the investment business, so many of us like to classify ourselves as ‘value’ investors or as ‘bottom-up’ investors. Tradewinds does not consider these approaches to be advantages; we view them as prerequisite! Overpaying for investments and/or buying franchises without thoroughly vetting the fundamentals is a tough way to make money. It is certainly no way to steward other people’s money. In addition to these fundamentally obvious disciplines, we believe that it is important to understand economics, psychology, behavioral finance, history and logic. A global, independent thought process is increasingly important. Conviction is necessary and integrity is an absolute prerequisite! Putting clients’ interests ahead of one’s own business interests is an unfortunately rare characteristic, and yet is so fundamentally important.

This was a necessarily long intro into the concept of bubbles. While bottom-up analysis and valuation remain absolutely prerequisite to sound investing, doing so while remaining oblivious to bubbles and other major dislocations in the economy equates to the proverbial ‘rearranging of the deck chairs on the Titanic.’ In 1929, it really didn’t matter what stocks you picked, what mattered was that you shouldn’t own stocks. During the ‘guns and butter’ days of LBJ, not owning bonds for the next fifteen years was much more important than picking the ‘right’ bonds to own. In 1980, with Paul Volcker reining in the money supply, getting out of gold, oil and other commodities should have been at the forefront of everyone’s mind. In the late 1980s, asking if there was any conceivable way that things could work out well for the Japanese market was all that mattered, rather than analyzing which Japanese stocks or buildings to own. In 1999, recognizing that there was no growth rate high enough to make the math work for investors in tech stocks was all that needed to be done. Analyzing tech stocks was generally a waste of time until 2002 (except for short-sellers). During the 2005 through 2008 period, asking the question - will mortgages on overpriced houses, extended to unqualified, over-extended borrowers likely be repaid? - was all that analysts needed to do when assessing financial stocks.

Which brings us to 2010! We believe that the most important analysis that a prospective investor can perform is to ask the question: will governments that have obligations that far exceed their wherewithal to honor, eventually make good on them? If you were considering making a loan to your neighbor for 10 years, you would want some data. High on the list might be: other obligations, integrity, employability, assets/collateral, and income. Low on the list (if there at all) might be: what do the government bureaucrats claim was the CPI or unemployment rate last quarter, what was the ‘output gap,’ whether Bernanke is speaking this week, or what economists are suggesting next quarter’s growth rate will be. Why should loans to governments be treated differently? That Japan, the U.S., and the U.K. won’t honor their commitments is a given in our opinion. When and how they renege is a more legitimate topic. We do not know the answer, but not knowing the answer, we do believe that loaning money to them for 10 years at a sub-3% yield is madness! While it may or may not ultimately work out for buyers, the risk is far greater than the prospective return.