In case you failed to catch it in our previous articles this year, we thought we’d state it outright for our readers this month: the United States Government is on a trajectory to default on their obligations. In its current financial condition, it will not be able to fund its forecasted budget deficits and unfunded Social Security and Medicare promises on top of its current debt obligations. This isn’t official yet, and we don’t know when the market will react to it, but there is no longer any doubt about the extent of their trajectory. There simply isn’t enough taxing power, value creation or outside capital willing to support its egregious spending.
Stating the obvious may be construed by some as fear mongering, ‘talking up our book’ or worse, but our view is not as severe as you might think. In the Federal Reserve Bank of St. Louis’ Review from July/August 2006, Lawrence Kotlikoff stated that “partial-equilibrium analysis strongly suggests that the U.S. government is, indeed, bankrupt, insofar as it will be unable to pay its creditors, who, in this context, are current and future generations to whom it has explicitly or implicitly promised future net payments of various kinds.” He went on to suggest that the US should immediately close the Social Security program to reduce future liabilities (could you imagine?), use a voucher system for Medicare to limit costs, and replace personal, corporate, payroll and estate taxes with a single federal sales tax. All this, published in an article from 2006, well before the credit crisis and subsequent meltdown had even begun!
I can’t tell you how surprised, even embarrassed I was to get the Nobel Prize in chemistry. Yes, I had passed the dreaded chemistry A-level for 18-year-olds back in
“THERE they are!” exclaimed Howard G. Buffett, the Illinois corn farmer, philanthropist and down-home son of one of the world’s richest men, as he steered his dusty Toyota Land Cruiser toward a pair of nature’s fastest and most majestic creatures.
Orion and Titan — cheetahs bought at $2,000 apiece for the cheetah conservation reserve he established here — sat smack in the middle of the dirt road. They licked each other’s faces and ambled languorously into the bush. Then one of them scented prey. His elegant body elongated into a tensile creep, the tip of his tail twitching.
Despite his affection for Orion and Titan, Mr. Buffett’s recent drive through the Jubatus Cheetah Reserve is likely to be among his last. He has decided to sell the 6,000 acres of bush in
The reserve was his original philanthropic stake in
The making of this accidental philanthropist — the accidental part being his birth as the son of the legendary investor Warren E. Buffett — is an American tale of wealth and conscience passed on to a second generation. The elder Mr. Buffett, 79, did not believe in giving his money to his children to spend on themselves, but decades ago he did begin preparing them to give some of it away.
Related link: The Charlie Rose Show (Howard Buffett is on the show that aired on 10/16/09 – use the ‘Archive’ tab to locate)
Last summer I attended a talk by Michelle Rhee, the dynamic chancellor of public schools in
There’s something to that. While the subprime mortgage mess involved a huge ethical breakdown on Wall Street, it coincided with an education breakdown on
In our subprime era, we thought we could have the American dream — a house and yard — with nothing down. This version of the American dream was delivered not by improving education, productivity and savings, but by Wall Street alchemy and borrowed money from
A year ago, it all exploded. Now that we are picking up the pieces, we need to understand that it is not only our financial system that needs a reboot and an upgrade, but also our public school system. Otherwise, the jobless recovery won’t be just a passing phase, but our future.
The first thing you got to look at is, "I am not buying a stock, but I am buying a business." And you only buy the business if you were willing to buy the entire business if you had money for it. So, for example, if Reliance Industries has a market cap of $100 billion and you had a $300 billion, the question you would ask yourself is, would I buy the entire business for a $100 billion?
The first thing is that you are not buying pieces of paper, but you are buying an entire business. The second is that you ask yourself, do I understand the business? Do I truly understand how it will work, how it makes money, how will it do in the future?
Then the third thing is, if Reliance produces$3 billion a year cash flow and it trades for $100 billion, I have no intention of buying it at 33 times cash flow. It is like I have no interest in putting money in an account that pays 3% interest.
So I love Reliance, maybe, if the fair value of business is 15 times cash flow, which is $45 billion. And since I am cheapskate, I don't want to buy it for more than half its fair value, so I just say to myself, that if it goes below $20 billion in value -- or one-fifth the current price -- then I will look at it again.
If the quote at the top of this page looks somewhat familiar to our long-term shareholders, it may be because the practice of tending to the present moment – responding to prevailing conditions rather than relying on forecasts – is central to our investment discipline.
Focusing on the present moment doesn't imply ignoring the past or failing to consider the future. It's clear, for example, that we put a great deal of attention on estimating future cash flows and discounting them appropriately in order to evaluate whether various investments are priced to deliver satisfactory long-term returns. We certainly devote our attention to macroeconomic pressures and latent risks that threaten to become full-blown crises later. Still, we rarely make near term forecasts. Nor do we answer surveys like “where do you think the S&P 500 will be at year-end?” – a question that falls entirely outside of our way of thinking – like asking Columbus what sort of trees he thinks are planted along the edge of the Earth. The reason we avoid forecasts, very simply, is that they are not required, and that they can be a hindrance.
Well, dear readers, happy thoughts and wishful thinking do not make it so; 30 precious years have passed, and there is now no safety margin. We must prepare ourselves for waves of higher resource prices and periods of shortages unlike anything we have faced outside of wartime conditions. In fact, I believe we are already several years into this painful transition but are still mostly invested in denying it. Everything within the investment business will be affected as well as everything outside of the business.
One of the nice aspects of trying to solve investment puzzles is recognizing that even though I am not always going to be right, I don’t have to be. Decent portfolio management allows for some bad luck and some bad decisions. When something does go wrong, I like to think about the bad decisions and learn from them so that hopefully I don’t repeat the same mistakes. This leaves me plenty of room to make fresh mistakes going forward. I’d like to start today by reviewing a bad decision I made and share with you what I’ve learned from that error and how I am attempting to apply the lessons to improve our funds’ prospects.
The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the long-short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time.
Thanks to Will for passing this along.
In January 1931, a lawyer named Benjamin Roth, 38 years old, solidly Republican, a solo practitioner in
Mr. Roth’s diaries have just been published in book form — “The Great Depression: A Diary” — edited by his son Daniel, who worked in his father’s law practice for many years, and James Ledbetter, the editor of The Big Money, a financial site run by Slate. It is an eye-opening read, though not necessarily in the ways you might think.
A few months later, he wrote: “As I re-read some of the predictions made by outstanding economists in past few years, I must laugh. They were all wrong. None of them foresaw the 1937-1939 collapse and many predicted inflation before this.” Mr. Roth comes to the conclusion that relying on experts is a waste of time.
Maybe the fact that the Dow crossed the 10,000 mark this week really does signal that the crisis has ebbed, as The Journal put it on Thursday. Or maybe the poor earnings by Bank of America and Citigroup this week suggest we’re merely in the eye of the hurricane, as 1935 and 1936 turned out to be.
There are plenty of experts who will tell you the worst is over, and I hope they’re right. But as Mr. Roth discovered in the 1930s, the experts can’t predict the future any better than the rest of us. When you are living through a financial crisis, all you can do is wait and see. Governments take action they hope will have the desired effect — but who knows if they really will? It only becomes clear much later, and far too late for those of us living through it.
On that same day in early 1937 that Mr. Roth mistakenly wrote that the Depression had ended, he concluded that instead of relying on experts, the only proper course was to “use your own judgment and do your own thinking.”
In these particular experiments I was being asked to engage in a probability guessing experiment that required a lot of conscious thought, much like playing a game of checkers or backgammon. Simultaneously, I was being presented with a much more basic stimulus, which was that I was getting little sips of sugar water. And there was a pattern to the sips of sugar water that my conscious brain paid no attention to because I was trying to solve the more complicated problem. But the unconscious part of my brain soon detected what was happening with the sugar water. And the next thing I knew, I was pressing madly with my right index finger to indicate that I had solved the problem, even though I had no idea how I had done it. And it was simply that the pattern of sugar water had started to repeat and that part of my brain recognized this repetition, while the conscious part of my brain was still searching for a solution.
That sort of thing goes on all the time in the financial markets. And individual investors do it, and financial advisors too do it, without realizing it. You may end up investing more in a particular stock because you saw the CEO on TV and his necktie was your favorite color. It sounds absurd to think that people would make financial decisions based on irrelevant factors like that but they do. And the reason they do is that things like colors and sounds and smells and tastes and associations with our past and with ourselves increase our comfort and familiarity with a frightening world.
These kinds of effects are everywhere, and they surround investors, and they shape a lot of people's decision-making without their ever realizing it. The reason I harp on this issue again and again is that the single most exciting frontier in contemporary psychology is the exploration of these unconscious biases and the fact that unconscious influences on our behavior can skew our decisions in ways that are incredible to people.
Because of that, it's especially important to have really good decision structures. So the first thing is to have a checklist, and to study your past decisions, and to study the decisions of the world's best investors, and learn from your mistakes and theirs and come up with a set of criteria that every investment has to meet in order to be eligible for inclusion in your portfolio. I suggest a few in my book, but for individual investors, probably the most important rule would be never buy an investment purely because it has been going up in price, and never sell it purely because it has been going down.
I would put the expense ratio first for mutual funds. I would say, I will never consider a fund with expenses over X. And then I would probably factor in portfolio turnover, I would factor in tax efficiency, I would put in a measure of risk, and I would put performance dead last. In fact, I would also have a decision rule that I can't actually look at the performance of the fund at all until I've determined a short list of funds that passed all the other screens. And only then would I look at performance. Because if you look at performance first, it then becomes an unconscious bias, and it will skew your analysis of everything else you look at. So you have to put performance dead last because otherwise it would be first no matter where you happened to think you're ranking it.
Related book: Your Money and Your Brain
Perfectionists have a hard time starting things and an even harder time finishing them. At the beginning, it's they who aren't ready. At the end, it's their product that's not. So either they don't start the screenplay or it sits in their drawer for ten years because they don't want to show it to anyone.
But the world doesn't reward perfection. It rewards productivity. And productivity can only be achieved through imperfection. Make a decision. Follow through. Learn from the outcome. Repeat over and over and over again. It's the scientific method of trial and error. Only by wading through the imperfect can we begin to achieve glimpses of the perfect.
Were we top-down investors, we might have done much more. In Jan-Mar, opportunities abounded; now clearcut bargains are few. Three months ago, we were already refocussing on risk, and on judgments of relative resilience. As valuations have become more extended, these concerns remain to the fore. Part of the explanation for current inactivity lies in our 1Q decision to focus on companies with sustainable competitive strengths and growth potential, which we would wish to buy and hold for the long haul, rather than on the large number of deep value plays then available. While our excitement has dwindled as prices have risen, the shares we own are in good businesses, with valuations which remain justifiable, and which we are therefore reluctant to sell (unless our risk appraisal changes) until equally confident of alternatives.
In July I wrote that the stock market advance, then four months old, appeared consistent with a rally in a bear market. Three months on, it still does. The rally extended, and recovered 50% of its losses: it would be no surprise if it now broke down. The economic problems of the developed world are enormous, and major faultlines have been papered over rather than durably tackled. Although the Fund's NAV is a touch above its May '08 peak, the outlook seems much bleaker (with problems compounded rather than worked through). Environmental crises are intensifying, and some resource constraints are becoming clearer and more pressing. It seems possible that we may see a prolonged global depression in which successive financial, economic, political, environmental and resource crises overlap and interact.
So far, such thoughts have served mainly to heighten awareness of some risks which are commonly overlooked, and which may be remote but could be game-changing. We have had less success in identifying new winners (which may be due to a deficiency of imagination, or because there would be far more losers). It seems plausible that more decisive action is warranted, but for the time being we continue to take baby-steps on the equity mix. Moreover we remain relatively fully invested, on the basis that we own resilient businesses which collectively generate respectable internal returns and cashflows from a reasonably broad range of economic activity, and that if such businesses in a difficult year are giving us an earnings yield of 6.8% when rates on bank deposits are derisory, it may be better to moderate our return expectations and compound those earnings rather than speculating on the recurrence of better buying opportunities.
Probably my clearest drawback as an investment manager is that I have too often assumed that investors should recognize what seemed to me to be patently obvious dangers (the predictable collapse of the dot-com bubble, the tech bubble, the housing bubble, the oil and commodities bubble, etc) with a longer lead-time. Unfortunately, we inevitably experience a period of frustration – at least temporarily – for assuming such foresight. Still, none of those has caused trouble for us like they did for the rest of the world. Sustainable long-term returns require the avoidance of major losses, and the best way to avoid major losses is to avoid a) securities where the probable long-term cash flows do not justify the price, and b) markets where the probable returns from accepting risk are unlikely to be durable. There are a lot of investments that can be bought for short-term speculation that fail this test, but advance anyway - until they don't. The most important lesson I keep having to re-learn is how utterly myopic investors can be when there's an uptrend to be played.
Since I have no plans to risk the financial security of our shareholders on securities that are not worth their price, or premises that I believe are dangerously false or irrational, I can't say that learning this lesson will make us strikingly more responsive to speculative runs in the future. But there may be some middle ground that we can exploit. Our objective remains constant: to significantly outperform our benchmarks over the complete bull/bear market cycle, with smaller periodic losses than experienced by a passive buy-and-hold strategy.
There are many big picture items in the market that are important, but not all of them are knowable. If one was buying an index fund or investing in the market in a broad fashion, having the information at hand to tell him or her whether the market was in bubble territory, bargain territory, or somewhere in between would be important and, at the extremes, somewhat knowable. The Graham/Shiller PE is one way to estimate the overall level of market valuation – and even though value investors focus on buying individual bargains, there may be reasons to keep an eye on this type of information to help manage risk in one’s portfolio.
The Graham/Shiller PE is a tool used to estimate the fair value of the market (S&P 500). It is like a PE ratio on a stock, except that it comprises all stocks in the S&P 500 and is based on a 10-year moving average of earnings instead of just using earnings over the past year. This is done to smooth out the results that occur as a result of the business cycle and other year to year fluctuations. The average Graham/Shiller PE over time is just north of 15 although, as you can see from the graph, the index spends little time fixed on that value. As you can also see from the graph, this tool has been very good at identifying stock market bubbles, such as the 1929 bubble and the Internet bubble that peaked in 2000.
As of mid-September, with the S&P 500 priced at 1049 (close to today’s price), the Graham/Shiller PE was at 18.77. A month earlier, Frank Martin – a well-respected investor whom I admire – made the following observation: “With one exception, no bubble market in the last 130 years—defined as one in which the Graham/Shiller PE rose above 20 times earnings—escaped the ignominy of sinking to single-digit PEs in the bust that followed. The exception, at least thus far, is the current bear market (or is this a new bull market?).” At the March 2009 low, the Graham/Shiller PE bottomed just north of 13. So that brings up the question: Are we destined for another major fall?
Before I answer that question, let’s briefly explore the final stage of an asset bubble: revulsion. According to the late economist Hyman P. Minsky, the revulsion stage develops along these lines: Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap credit or some unanticipated piece of news. But whatever may be, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in; prices start to tumble downwards, credit dries up, and losses start to accumulate. Have we already seen the revulsion stage in this market or are we currently in a bull market rally on the way to reaching a lower level? Has the accessibility of information made us more or less prone to overshooting on the downside? Has the increased role of institutions in the market made us more or less prone to overshooting on the downside?
The answer to these questions may only be known in hindsight. However, it may be useful to keep in mind one of the rules of investing from Bob Farrell, a retired Wall Street “guru”: Excesses in one direction will lead to an excess in the opposite direction: Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.
In what many are calling the worst recession since the Great Depression, maybe a Graham/Shiller PE of 13 will be as low as we see. After all, Mr. Farrell didn’t say the overshoot on the downside would equal the overshoot on the upside, and I certainly don’t think
To repeat a question above: Are we destined for another major fall? My answer is one that I can say with absolute conviction…..I don’t know. The focus of a value investor should be on finding business that are significantly undervalued even under the most stressful of economic assumptions. So why should we even pay attention to such information?
As 2008 and early 2009 showed, in an abnormally distressed market, the good gets thrown out with the bad and there are opportunities for profit that one may only see once every couple of decades…..but to profit, you must have the liquidity available to take advantage of those opportunities. As such, it may be a good idea to set the bar a little higher for putting money to work and use some of the recent market strength to build a larger cash position. There are some big news items on the horizon – most notably the continued trend in mortgage delinquencies and foreclosures, the Alt-A and Option ARM resets that really just began and will continue for the next couple of years, more bank write offs, bank closures, and the resumption of the deleveraging process by the U.S. consumer, among other things – and although we can’t know if they’ll lead to the revulsion we’ve seen in the past, it is probably wise to focus on maintaining a portfolio that you think can weather all storms and one that will allow you to take advantage of opportunities should they present themselves.
I am analyst for Chanticleer Holdings, Inc. and Chanticleer Advisors, LLC and am based out of Charlotte, NC. This article should not be taken as investment advice. Please do your own research before making investment decisions.
Other sources for the article:
Mr. Bentham knows everything. He went to Stanford, then to the Kennedy school before getting a business degree. He’s got multivariate regressions coming out of his ears, and he sprinkles C.B.O. reports on his corn flakes for added fiber.
Mr. Hume is very smart, too, but he doesn’t seem to make much use of his intelligence. He worked on Wall Street for a little while, but he never could accurately predict how the market was going to move tomorrow or the day after that.
Mr. Bentham is a great lunch partner. If you ask him to recommend a bottle of wine, he’ll reel off the six best vintages on the wine list, in ranked preference. Mr. Hume can’t even tell you which entree to order because he doesn’t know what you like.
I’ve introduced you to my friends Mr. Bentham and Mr. Hume because they represent the choices we face on issue after issue. This country is about to have a big debate on the role of government. The polarizers on cable TV think it’s going to be a debate between socialism and free-market purism. But it’s really going to be a debate about how to promote innovation.
The people on Mr. Bentham’s side believe that government can get actively involved in organizing innovation. (I’ve taken his proposals from the Waxman-Markey energy bill and the Baucus health care bill.)
The people on Mr. Hume’s side believe government should actively tilt the playing field to promote social goods and set off decentralized networks of reform, but they don’t think government knows enough to intimately organize dynamic innovation.
So let’s have the debate. But before we do, let’s understand that Mr. Bentham is going to win. The lobbyists love Bentham’s intricacies and his stacks of spending proposals, which they need in order to advance their agendas. If you want to pass anything through Congress, Bentham’s your man.