The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
There are two myths regarding policy that I take pleasure in dispelling, the first being that our two political parties are somehow wedded to certain policies that they own. Such as Republicans cut taxes and Democrats raise them; Democrats increase welfare programs and Republicans decrease them; Democrats regulate and Republicans deregulate.
The laws of economics are not just about bean-counting at some fictional company or make-believe nation. They are real and they impact our lives in much the same ways of the laws of physics. Diminishing returns are everywhere, including the ingestion of candy. The first bite is always the best and no matter how good something tastes, eventually your body will say, “no more.”
I have a confession to make. I found myself at the end of the first quarter of 2016 needing to write a newsletter and for the first time in memory I had no idea what to write.
Dorian Gray is a fascinating character. For those who can’t quite place him, he is the guy who had a magical self-portrait. He stayed young while his portrait aged As long as he did not look at his portrait he could do whatever he pleased without ever facing the consequences.
A few years back I had the pleasure of meeting Emanuel Derman. A pioneer in the movement of physicists migrating to Wall Street, Derman was there when investors started using sophisticated mathematical models to make investment decisions. Derman has a Ph.D. in theoretical physics from Columbia University and had been a scientist at Bell Labs before […]
Every four years in our country we have a presidential race, which means every four years we get at least some real discussion on government policy. At least that is the normal course of action; this year most rules don’t seem to apply. But, since the current state of our politics has the vast majority of us disgusted, we will pretend this is a normal year and there are policies to discuss. Iron Capital is honored to serve a diverse group of clients and it is our role to make investment decisions, not to weigh in on politics. Policy, unlike politics, affects the economy, which impacts your investments.
There are two myths regarding policy that I take pleasure in dispelling, the first being that our two political parties are somehow wedded to certain policies that they own. Such as Republicans cut taxes and Democrats raise them; Democrats increase welfare programs and Republicans decrease them; Democrats regulate and Republicans deregulate. These are all myths. John F. Kennedy cut taxes while Richard Nixon expanded welfare programs and George W. Bush created the first new entitlement program since LBJ’s Great Society. Jimmy Carter began the de-regulatory movement of the 1980s and 1990s. I could go on and on. Part of this phenomenon is because economic philosophy and political philosophy are not as tied together as many are led to believe, and part of it is that Congress, not the president, actually controls policy.
The second myth is that different areas of policy are unrelated to one another. This, I believe, is because of the presidential debate system. Granted this year’s version looks more like mud wrestling, but in more normal election cycles we get a debate about this policy, then a separate debate about that policy. The problem is that all policies actually relate to one another in the real world. For example, let’s take two policies we have heard a lot about in this election: international trade and regulation of corporate America.
Let’s begin with trade. Free trade between countries is under attack this year, but before we go into those details we need to understand why trade exists in the first place. To make things simple we will use two countries, both of which make only two products: they grow wheat and raise cattle. Country A is very good at growing wheat and not so good at raising cattle, while Country B is really good at raising cattle but not so good at growing wheat. In Country A they have really good bread, but the meat isn’t very good. In Country B they have great meat but the bread leaves a lot to be desired. They could go on living like this, separate from each other, but then none of the citizens of either country could have a great meal with both great meat and great bread. To do that, the two countries would need to trade with one another. Country A should sell its superior wheat to Country B in return for some of Country B’s superior meat.
In fact, if every person in each country is going to get to enjoy the superior product, then Country A should stop producing cattle altogether and only produce wheat. Country B should do the opposite and concentrate on raising cattle. If both countries did this, then everyone’s lives would be improved. Except for one problem: Half of the people in Country A work to raise cattle, and half of the people in Country B work to grow wheat. Both countries need to keep these people employed.
So what happens if everyone in Country A can now buy the better meat from Country B? Their lives have been improved, but the local cattle industry will be hurt. In a perfect world the cattle ranchers, or at least most of them, in Country A would simply convert to growing wheat. Likewise, the wheat farmers in Country B would start raising cattle. Both countries would concentrate on what they were good at, and everyone would stay employed and enjoy a better life.
However, real life is seldom perfect. Both countries have rules and regulations. The wheat farmers in Country A enjoy the benefit of being able to sell their product to the citizens of Country B. This has greatly increased the demand for their product and as a result profits have increased. They have a vested interest in protecting those profits – profits which would likely disappear if the displaced cattle ranchers start growing wheat. They will lobby their government to create rules which make it harder for cattle ranchers to convert to wheat farms. This will be done as a “protection” for consumers. After all, what do cattle ranchers know about growing wheat?
If the wheat farmers are successful in using their new-found wealth to make it harder for people to compete with them, then Country A will have an employment problem. The cattle ranchers can’t compete with Country B cattle ranchers and now, because of regulation, they can’t convert to producing wheat. Most will go out of business and their employees will be unemployed. Those that survive will likely do so by cutting prices and that will mean they must pay their employees less. Country A will now be separated into two classes – those in the wheat business who are doing wonderfully, and those who have been left behind in the new “global” world. Inequality will grow. The unemployed and under-employed cattle workers will be upset, and the most obvious target will be trade. They want a job and the only job they have known has been in the cattle industry. They will demand protection from the competition of Country B.
Trade barriers will be raised and Country B will retaliate. Before long everyone is back where they started, except now they have hurt feelings (but that is foreign policy, which is another subject entirely, right?). This less-than-ideal reality comes from a misunderstanding of what the original problem was in Country A. Humans have a tendency to focus on symptoms instead of problems. Country A did not like their cattle ranchers going out of business while the wheat farmers got rich; but the real problem is that regulation made it impossible for the cattle ranchers to convert to growing wheat. A policy of free trade does make everyone better off, if it is paired with a regulatory policy that promotes new business instead of preventing it.
Joseph Schumpeter was a midtwentieth century economist who coined the phrase “creative destruction” to describe the process of the death of an old industry making way for the new. In our example the cattle farmers in Country A that were forced out of business, aka destruction, could then start farming wheat, or in a more realistic example with more than two products perhaps grow grapes (after all, what good is good meat and good bread without some wine?). This is what happens in real life as long as the rules allow, or better yet encourage, the creative renewal.
My wife and I recently had a rare evening where we could sit together and just watch a movie. We watched “The Intern,” in which Robert DeNiro plays a retiree who signs up for a senior citizen internship at an online retailer run by a young entrepreneur (Anne Hathaway). DeNiro’s character had produced phone books, and now the business in which he had spent his career was obsolete. In a neat twist, Hathaway’s Internet business occupies the same building in which DeNiro spent his entire career. I can’t imagine a more poignant example of creative destruction. The phone book company was gone, but in its place was a new company the existence of which would be beyond the imagination of DeNiro’s character when he was beginning his career.
This is how free economies are supposed to work. We look a lot like Country A today. Economists know that trade protectionism was a major cause of the Great Depression. This led ultimately to strained international relations and the rise of Nazi Germany and World War II. Because of this knowledge trade relations, until very recently, have been improving to the benefit of many industries. Approximately half of the earnings of the S&P 500 companies, roughly the largest 500 companies in the U.S., come from overseas. Many people have been like the wheat farmers that benefited from free (or at least freer) trade. Others have been left behind as some industries have had trouble competing and factories have shut down.
Our problem is that while trade policies have become increasingly liberal, we have simultaneously been growing the regulatory leviathan which has made it more and more difficult to create the new. This puts us in a place with the worst of both worlds: We have the destruction that can come from free trade, but without the creation that comes from free markets. The Wall Street Journal recently pointed out that the number of initial public offerings (IPOs) on Wall Street is the lowest it has been in 20 years. This means we are not creating new businesses to take over the old. Harvard professor Robert Barro wrote an op-ed published in The Wall Street Journal on September 20, 2016, in which he outlined why the recovery from the 2008 financial crisis has been so slow. He blamed it on a lack of growth in productivity and went on to say, “Variables that encourage economic growth include strong rule of law and property rights, free trade, rolling back inefficient regulations and other constraints on market activity…”. In other words, our problem isn’t trade; our problem is regulation.
This is a policy issue which should not be a political issue. Former Senators Bill Bradley (D-N.J.) and Alan Simpson (R-Wyo.) both sit on the advisory board of an organization called the Common Good, whose mission is to overhaul government and legal systems to allow people to make sensible choices. They speak of restoring common sense. They claim polls show that huge, bipartisan majorities of America’s voters support their initiatives. I believe them.
Wouldn’t be nice to hear two intelligent, thoughtful, maybe even dignified Americans debate the details of restoring our creative economic engine? Instead we get crude sexism and illegal emails. One candidate promises protectionism and the other promises to double down on the regulatory explosion of the last 16 years. Sometimes it looks like the worst of both worlds.
This brings me back to the beginning. One of the reasons that the economic policies of different presidents did not always jive with our perception of party identity is because Congress, not the president, creates policy. One of my personal political pet peeves is that I have to wait in a long line to vote for the president, but two years later get to walk right in to vote for my congressman. Iron Capital has never endorsed a candidate or suggested to our clients how they should vote, but this year I will say this: Please vote. Especially to those clients who are among the majority of Americans who would select “none of the above” were it an option. Vote for your congressman, your senator, all of your local open seats and any ballot initiatives. Vote for all those things that don’t get the national attention of the presidential race, and do it again in two years. It is these things that create the direction of government policy, and policy matters.
Charles E. Osborne, CFA
~Worst of Both Worlds?
The Law of Diminishing Returns
What kid does not like Tootsie Rolls? I know I liked Tootsie Rolls when I was young. In fact, I loved them. I couldn’t get enough of them…until my Mom took me on a trip to visit my oldest sister. She was out on her own and we were going to visit her for a few days. My sister had a candy jar full of Tootsie Rolls. I don’t remember if I asked for permission or if I thought I was being sneaky, but I ate a lot of Tootsie Rolls that day. I ate and I ate and then…well let’s just say I didn’t feel so good.
To this day I can’t stand the thought of ever eating a Tootsie Roll. Even writing this is making my stomach a little queasy. However, I learned a very valuable lesson that day: the economic law of diminishing returns. It was an important lesson.
If one were to look up the law of diminishing returns he would see something boring like an explanation about why incremental productivity gains of adding an employee get smaller with every employee added. If a company has only one employee then adding a second doubles productivity. Adding a third will increase productivity by a third, etc. These types of explanations, while accurate, are probably why so many don’t understand or like economics.
Fortunately for me I had some good teachers who brought these concepts alive. The laws of economics are not just about bean-counting at some fictional company or make-believe nation. They are real and they impact our lives in much the same ways of the laws of physics. Diminishing returns are everywhere, including the ingestion of candy. The first bite is always the best and no matter how good something tastes, eventually your body will say, “no more.”
Kids today don’t even know what a newspaper is, let alone a newspaper vending machine. For those of us that remember these contraptions, there is a reason those machines were structured differently than drink vending machines. The value of some items diminishes faster than others. A second Coke might not be as good as the first, but it is still
pretty good; a second newspaper is worthless. Once one has read it she is done with it. That is why the old newspaper vending machines opened up and allowed anyone who wished to take every single paper for the price of one. Other than the occasional Good Samaritan who would take them all out and place them on top of the machine allowing others to enjoy a free paper, or the unscrupulous entrepreneur who would take them all and re-sell them, most people would take their one paper and leave the stack inside. That would not likely be the case with a drink machine.
This also works with exercise. There have been many studies out recently saying that a short burst of strenuous activity is better than hours and hours on a treadmill. There have been studies showing that excessive exercise can even be harmful to one’s longevity. Of course our culture is full of such warnings: “Too much of a good thing.” “Everything in moderation.” Grandma may not have had a degree in economics, but she understood the law of diminishing returns.
It is really too bad that Grandma is not a central banker. The law of diminishing returns impacts many parts of our lives but it is most obvious with economic decisions. (It is an economic law after all.) Central bankers learned many years ago that they could stimulate economic activity by lowering interest rates. The theory is pretty simple: Interest rates represent the cost of borrowing money. The lower that cost, the more willing one might be to borrow money. That money would be used for many activities from buying houses to starting a new business. If the central bank could lower the cost of borrowing, then all kinds of people might be more willing to borrow and use those funds to produce economic activity.
Why is this important? This realization gave government two tools to use in its ongoing effort to control the direction of the economy: the government could use fiscal policy, which is the ability to tax its citizens and spend that money on various projects; or it could use monetary policy, which is the ability to manipulate the amount of money in the system through interest rates. Both tools are about putting more money into the system. The government could lower taxes, which would allow people to keep more money and therefore spend more. It could increase spending, which would put money directly where the government wanted it. It could also lower interest rates, allowing for more borrowing of money. Through the 20th century governments tried all of the above. They found that the third tool, lowering interest rates, was actually the most effective way to stimulate the economy.
Governments did not, however, count on the law of diminishing returns. The last time any government around the world saw fit to go the other direction – to actually slow the rate of growth in the money supply – was when Paul Volcker was appointed Chairman of the Federal Reserve by President Jimmy Carter. Volcker raised interest rates in an effort to combat inflation. Mortgage rates, which today are around 3.5 percent, topped out at 18.5 percent during Volcker’s tenure.
His war on inflation did two things. One, it worked in defeating inflation and stabilizing the value of the dollar. Two, it set up an interest rate environment where central bankers could constantly lower rates for more than 35 years. Rates have been dropping ever since and today much of the world actually has negative interest rates. Switzerland’s rates actually went negative all the way out to thirty years. People are buying Switzerland’s bonds knowing that they will get less money back should they hold on until maturity. This is simply amazing and is probably the biggest market story of our generation.
How did we get here? So much of it has to do with politics. To claim that central bankers are not influenced by politics would be quite naïve. However, the other control government has, fiscal policy, is governed directly by politicians. There is politics and then there is professional politics. As a result there are lots of politicians who are fans of so-called Keynesian economic policy. John Maynard Keynes was a famous economist in the early part of the 20th Century who theorized that governments could stimulate the economy through running budget deficits, aka spending more money than they have. Politicians love that. The only problem with this is that Keynes also said the budget should balance during normal periods and the government should actually run a surplus during boom times in order to pay for the deficits. The politicians didn’t do so well on those fronts.
In addition, politicians often don’t agree on how such deficit spending should be spent, or even generated. Should the government tax less or spend more? They usually compromised and decided to do both. This has led to an abdication of any reasonable fiscal policy in much of the developed world, which means the government has only one weapon left: monetary policy. For almost a generation this has been possible because rates got so high in the early 1980s that there was a lot of room to lower, and lower, and lower rates. Now those guns are empty as well. Further, as the law of diminishing returns would predict, they do not appear to be working. Once we reached zero interest rates central banks began so called quantitative easing, which is the actual government purchase of its own debt. That didn’t work, again diminishing returns.
Now we have negative rates. This has the potential of ending as badly as my little tootsie roll binge. So what are we to do? What do we do as citizens and what do we do as investors?
As citizens we need to remember that there is another way that government impacts our lives and influences economic growth. Government makes the rules. Often lost in conversations about the economic miracle that was the 1980’s and 1990’s in our country is the role of regulatory reform. This was started by Jimmy Carter and continued by Ronald Reagan and eventually Bill Clinton. How powerful is this force?
When I was young rail roads and the phone company were both heavily regulated. Jimmy Carter freed the phone company but not the rail roads. When I was young everyone had one of two phones. They did not go with you when you left the house and long distance phone calls were incredibly expensive. Today, our phones fit in our pockets, and they run an entire Internet economy which was not even a dream forty years ago. Trains, on the other hand, still look the same. Regulation has an enormous impact on growth.
The problem with reforming regulation is what economists call rent-seeking. Unlike fiscal policy and monetary policy, which impact everyone who either pays taxes or receives
government aid, and everyone who has borrowed any money (in other words, everyone), regulation has a large impact on the industry being regulated but a negligible impact on most. This gives rise to an effort by those impacted to use their resources to influence regulation through lobbying efforts. Economists refer to this as rent-seeking; people on the political right call it cronyism; and those on the left call it rigging the system. Poor regulation slows the economy and moves what rewards still exist increasingly toward those who are skilled at seeking rents. In 1962 Milton Freidman showed that the more regulated a society becomes, the more inequality exists. This is logical. After all, the more regulated a society, the more important it is to be connected and able to influence regulation. In other words, rent-seeking is a vicious cycle which leads to more and more rent-seeking…until an economy grinds to a halt as ours did in the 1970s, and as Europe’s is now, thereby forcing reform.
As investors we must hope for improvements but plan on living in the world as it is. Political risk is alive and well. We must now pay attention to the future of economic alliances such as the European Union. We must pay attention to the political landscape of an industry. We have to think about whether the government will be friendly to this company or not. This may be unfortunate but it is our current reality.
It also makes it that much more important to look at every investment from the bottom-up. We need to know what we own and why we own it. In a world where so much is out of our control we have to focus on getting right that which is in our control. One way or the other, the world will learn (again) the lesson of diminishing returns. Hopefully we learn it the easy way and begin to see real reform, not only here at home but throughout the developed world. Or we might get sick. If we do, it will pass and then perhaps a lesson will be learned. I know I’ll never eat a Tootsie Roll ever again.
Charles E. Osborne, CFA
~Too Many Tootsie Rolls
The following is an imagined dialog with the Roman philosopher Cato. It was written by the orator and statesman Cicero who lived from 106–43 B.C.:
Scipio: “When Gaius Laelius and I are talking, Marcus Cato, we often admire your outstanding and perfect wisdom in general, but more particularly that growing old never seems a burden to you. This is quite different from the complaints of most older men, who claim that aging is a heavier load to bear than Mount Etna.”
Cato: “I think my young friends, that you are admiring me for something that isn’t so difficult. Those who lack within themselves the means for blessed and happy life will find any age painful. But for those who seek good things within themselves, nothing imposed on them by nature will seem troublesome. Growing older is a prime example of this. Everyone hopes to reach old age but when it comes, most of us complain about it. People can be foolish and inconsistent.”
I have a confession to make. I found myself at the end of the first quarter of 2016 needing to write a newsletter and for the first time in memory I had no idea what I was going to write. So instead of writing I read The Wall Street Journal and I fell upon this quote. According to The Journal, the classicist Philip Freeman has published a new translation of this ancient dialog. As I read the short exerpt, inspiration struck.
What could possibly better sum up where we are today in our national discourse than this conversation which took place more than two thousand years ago? In all that time human nature has not changed.
Nowhere is this as clear as in our politics. In both major parties we see a large shift to what economists refer to as populist policies. These are policies that sound good as sound bites, but often have very adverse consequences – con- sequences which the same policy-maker will often rail against. The analogy I have used in the past is like telling a five-year-old that they can eat all the candy they want without ever having to eat their vegetables. Five-year-olds love that idea. They also love the idea of growing big and strong. Of course as adults we recognize that those policies are inconsistent, but try convincing a five-year-old of that.
As I have been writing, one of the leading candidates for president has been on television complaining about Ford Motor Company’s plans to build a plant in Mexico. He finished by saying we can’t allow that to happen. Think about that for a second. We – the United States of America, home of the brave and land of the free – cannot allow a private company to build its plant where it wants to build it? Here is the real kicker: this candidate is running in the party that claims to be for smaller government and more freedom, and he is currently winning among those supposedly freedom-loving people.
Trade has always been one of those issues upon which populists can pounce. Protectionism, the policy of building trade barriers – like a wall, for example – was a major contributor to the Great Depression. This fear of outside compe- tition is nothing new. Trade, however, is a net positive, and for most of our history has been one of our strengths. Prior to our current globalization move- ment, trade within the U.S. was a major advantage to us globally. Civics classes are not what they used to be and many people have forgotten that our nation is a federation of 50 independent states. Our ability to trade freely between the states has long been one of America’s secrets to success. That was a huge incentive to our cousins in Europe to create the European Union, so that Europe as a whole could compete with the U.S.
Why does trade work? Think about it in the micro sense. Let’s say you have a family of four and a long list of weekend chores. The yard has to be mowed, bathrooms cleaned, laundry done and dinner cooked. Does each member of the family mow one fourth of the yard, clean their section of the bathroom, do only their laundry, and then cook four different dinners? Or, are different duties split up among the group? At the micro level it is easy to see how everyone benefits from working as a team. That is really all trade is about.
Trade as a whole is almost always a net job creator, but there is often someone who no longer has a job to do. Trade creates jobs for the trans- portation industry. Goods made in one place and sold in another must be moved. Trade lowers the cost of goods creating more demand and helping the retail industry. But, if something that was made here is now made somewhere else, then those jobs are lost.
From an economic perspective this is not a bad thing. We want to be rid of some jobs. My wife’s family has a cabin in Virginia. It is heated by a stove and a fireplace. Meals can be cooked on the grill outside or on a wood burning stove. Chopping wood is a job that has to be done every day you are there. It is a neat thing to do for a day or so, then you start to realize that losing some jobs may not be a bad thing.
Creativity takes time. We marvel today at the technological advances mankind has made in such a short period of time. My grandmother grew up in a world where cars were a novelty. Her first phone was a “party line,” and anyone could join in to a conversation. Today, ten-year- olds have smart phones and the FBI has to hack into one to get any infor- mation. Why have we come so far in such a short time? Because we lost our jobs on the farm. When it became more effective to trade with a farmer than to be one, people with great ideas were allowed to pursue them. The legendary economist Joseph Schumpeter referred to this process as creative destruction.
Granted it is hard to see. It is as hard to see as it is for the five-year- old to understand why broccoli is better to eat than chocolate. It can also be harsh, and we should do what we can to help those impacted. This is why civilized societies have for the last hundred years or so offered various safety nets. Those nets have varying degrees of success and come with their own issues. This is why policy should be an adult conversation. These issues are real and need to be thoughtfully addressed.
While trade is a bi-partisan move- ment this year – isolation is the one thing both parties seem to agree on now – it is not the only populist issue. Free college is another good example. Really, “free” anything is a good example. My grandmother’s generation understood that free did not exist. The old saying, “There is no free lunch,” exists for a reason. That does not stop some politician from insisting that something needs to be free of cost just about every election cycle. One of those things this year is college.
Like trade, this is an understandable target. The cost of higher education is absurd. Too many young adults have been saddled with questionable degrees and huge student loans. The tuition at Wake Forest University was approximately $12,000 the year I graduated. After graduation I purchased a Toyota Camry, which cost $16,000. Today a similar Camry costs around $23,000. Tuition at Wake Forest is a little more than $44,000 – that is just tuition mind you. Total cost of attendance is approaching $60,000 per year. This brings to mind another legendary economist, Herbert Stein, who has an economic law named after him. Stein’s law states that, “Things that can’t go on forever, don’t.”
Higher education cost must come down, but in the meantime let’s just make it free. We will waive our magic wands and poof – free education. This increasing belief that things can and should be free is horrifying. Cost is precisely the tool free economies use to balance supply with demand. It is what allows for prudent decision-making.
Ironically, this belief centers on the first issue, trade. In a world where everyone had to provide everything for themselves, they understood cost. Only with the benefits of trade do we forget that free doesn’t exist. My children have no idea that water isn’t free. Just the other day they were supposed to be cleaning our deck from the pollen when a water fight broke out, soaking both my children and my neighbor’s kids as well. While they were having a great time lots of water was being wasted. My wife went out and informed them that water is not cheap.
There are still too many places in this world where children spend much of their days having to fetch water from the river and carry it home. They know all too well that it is not free, nor to be wasted. No resource is free. The truth is, what the politicians really want is someone else to pay for it. Of course in the economic history of the world, nothing allows inefficiency and higher cost more than a system where the consumer is not the one paying. In fact, one of the primary elements which has led to the huge rise in the cost of higher education is the ability to have someone else pay for it, at least up front, through the use of student loans.
While this populist movement is cause for concern, it is also understandable. Real people have been hurt by things like trade and the high cost of higher education. There are many other eco- nomic issues we could use as examples. People are angry in many cases, and frankly they don’t know who to direct their anger towards. So one side blames the “one percent” and the other side blames “Washington elite.”
We have not changed. Just like the ancient Romans who wanted to grow old but complained about old age, we want our modern life with easy access to cheap goods, but we complain about free trade. We want higher education for all but we don’t want to pay for it. In the effort to have it both ways we often make things worse. This is the danger. Populism makes easy promises but brings with it economic disaster. It is like promising that one can grow old without any of the concerns of old age. It sounds great but does not work out in real life. A nation cannot fight against the laws of economics any more than an aging person can fight against nature.
Our role at Iron Capital is to manage our clients’ investment portfolios. We don’t like to weigh in on things like politics and frankly we are proud to have a diverse group of clients. But as the late Senator Daniel Patrick Moynihan was fond of saying, “Everyone is entitled to his own opin- ion, but not his own facts.” Regardless of whether our next president approaches the issues of today from the right or the left, we need someone who will approach them as an adult.
Cato finished his conversation thusly, “So if you compliment me on being wise – and I wish I were worthy of that estimate and my name – in this way alone do I deserve it: I follow nature as the best guide and obey her like a god…. Fighting against nature is as pointless as the battles of the giants against the gods.”
Charles E. Osborne, CFA
~Be Careful What You Ask For
Dorian Gray is a fascinating character. For those who can’t quite place him, he is the guy who had a magical self-portrait. He stayed young while his portrait aged As long as he did not look at his portrait he could do whatever he pleased without ever facing the consequences. It was his portrait that aged and carried the marks of hard living, until one day he saw his portrait and what he had really done to himself. Beneath his youthful facade he had turned to ash. The sight of his portrait, of facing the truth, destroyed him.
From a line in this story we get the cliché, “the price of everything and the value of nothing.” An old friend of mine was fond of saying that clichés exist for a reason. They are often true, and 2015 was certainly a year where we saw this particular cliché alive and well in the financial markets. The S&P 500, the most watched and quoted index, finished the year up 1.38 percent. However, if one were to take away the four top gainers, the index would have finished the year down 4 percent. Beneath the positive facade was really nothing but ash.
The top two stocks for the year were Netflix and Amazon. Both are good companies, and I am personally customers of both. My wife and I don’t know how we could pull off Christmas without the convenience of Amazon Prime. Just about every day in December we came home to find a brown box with a smile on the side (never mind how many we sent), then after Christmas one of those familiar boxes arrived with the book I asked for that Santa forgot (and no, it wasn’t available on the Kindle).
Meanwhile, my eight-year-old son is into Pokémon. Pokémon is a trading card game based on a cartoon and video game that came out about twenty years ago. My son has discovered that he can watch all of the original cartoons on Netflix; in fact, he can watch just about any cartoon he wants whenever he wants on Netflix. If he is being nice, he can even start Barbie cartoons for his little sister.
These are great companies with excellent products. However, there is more to being a good investment than just being a great company; investors usually want a business to be profitable and sustainable. This is one thing the anti-capitalist crowd never seems to understand: any organization must be profitable if they wish to be sustainable. A few years ago I was on the board of a not-for-profit organization that actually understood this fact. They presented the board with their five-year plan and the budget portion was entitled, “Not-for- profit is a tax status, not a business plan.”
I think this is an important point, because profit has become a dirty word ever since the financial crisis. A company’s profit is the difference between revenue (money in) and expenses (money out). To be profitable simply means that an organization, or a person for that matter, spent less money than they had. That is really not such an evil thing, and in fact it really doesn’t matter what kind of organization one runs; spending less than you have is essential for long-term survival.
While I was glad to know that this small local organization understood the importance of spending less money than they had, the large boards at places like Amazon and Netflix don’t seem to think such laws apply to them. Netflix does show some profit, but not much, while Amazon has not been profitable for most of its history and doesn’t seem to care. As a result, an investor who wishes to purchase a share of stock in Netflix must pay $284.25 for $1 of earnings. If you think that sounds expensive, Amazon’s stock cost $929.35 for $1 of earnings. Both stocks more than doubled in value last year.
That is great if one took a gamble on these two one year ago, but is it real? Is it sustainable? No, it is not. Benjamin Graham, the father of security analysis, used to say that, “In the short-term the market is a voting machine; in the long-term it is a weighing machine.”
Popularity, momentum, and the madness of crowds can drive the price of investments in the short term, but eventually value matters. Those who invested in Netflix and Amazon last year will say otherwise. They will brag that they made money while just about everyone else lost it. They will say this time it is different. How do I know? Because that is what they said in the late 1990s when the tech bubble was still building. That is what they said in the 1960s with the “nifty fifty.” That is always what they say when, in the midst of an otherwise down market, a few companies whose stocks make absolutely no sense seem to standout. Let us not forget that most of the wisdom of Benjamin Graham came from the fact that he witnessed, and survived, the bubble of the 1920s and the subsequent Great Depression.
They were saying it back then too – “This time it is different.” The Amazons and Netflixs of the world are too cool to worry about old-fashioned ideas like value. At least they are today, but what is cool today often looks, well…I’m trying to think of a word nicer than stupid…several years later. If you don’t believe me, just try to explain to your children how cool that outfit you were wearing in high school was when the picture was taken.
Part of the issue today is that many of the decisions being made about investing in the market are being made by machines and not humans. This is a key distinction. The machines I am referring to are computer programs run to trade into and out of stocks very rapidly, often based on breaking news. So if the news for a company is positive the computer buys, and if the news is negative the computer sells.
This makes perfect sense on the surface, however, the one thing that is not accounted for is that news is often priced into the stock already. What does that mean? If one invests in Amazon at $929.35 for every $1 in earnings, that implies that he has a very optimistic view of Amazon’s business. One willing to pay such a price is assuming that the earnings will grow at a substantial rate. Thus most investors would say that a lot of good news has been priced into the stock. When news breaks and it is positive a human being would say, of course we are expecting positive news, but a computer program isn’t that clever. Expectations don’t seem to matter to the computerized traders, and as a result the winners keep on winning.
This works for losers as well. For example, that investor who paid $929.35 for Amazon’s $1 in earnings could have paid $1.56 for $1 in earn- ings at Atwood Oceanics. Atwood is an off-shore oil drilling company. Most of the news in the oil business has been negative. Of course, when an investor is paying less than $2 for every $1 in earnings, it would seem that a lot of negative news has been priced into the stock already. The price of oil has been dropping over the last year. At some point it would seem that this ceases to be a surprise, which is true for humans but computers…not so much. (By the way, Atwood’s earnings are not only still positive, they are still growing.)
This is textbook market overreaction in both directions. What is unusual is that it is happening at the same time, and it just keeps going. Of course it will stop. The only way it doesn’t stop is if Amazon literally takes over the world and we are not allowed to purchase anything that does not get delivered in a brown box with a smile on the side, and simultaneously we stop using oil forever. Understanding that these are ludicrous assumptions is what separates prudent humans from simple computer models.
Prudent investing is not always as easy as it sounds. Paying attention to what one owns and understanding why she owns it sounds simple, but it is work. Focusing on hitting an absolute rate of return over time can be tough when it seems that nothing which would provide that return is popular at the moment. The hardest thing to do, though, is to understand the risk. What could be risky about owning the stock of two of the most popular companies in America today?
What could risky about buying a house? How could one go wrong investing in this internet thing? What does Chuck mean when he’s talking about value, doesn’t he know this is a brave new world?
One of my favorite quotes from Mark Twain is, “History doesn’t repeat itself, but it does rhyme.” The last time Amazon was this popular it was 1999. 2015 was no exact repeat of 1999, but there may be a little rhyme. Amazon lost more than 80 percent of its value back then and it took a decade to recover. That time was a brave new world as well. Joel Greenblatt, Columbia University professor, hedge fund manager and author of “The Little Blue Book That Beats the Market,” said it best; what we call prudent investing always works over time precisely because it doesn’t work all the time. If everyone was prudent, then there would be no investing opportunities to be had.
But there are opportunities. Cheap prices mean low risk of losing money, but the stocks that are cheap are always the ones that are not popular. It is hard to conceive of a world where investing in a profitable company for $1.56 per $1 earned isn’t a long-term winner. It is also hard to like the oil business. What seems risky is often safe and what feels safe is often risky. That dynamic is one of the toughest things to overcome when trying to invest prudently.
Substance and value didn’t seem to matter in 2015. That does not mean that the world has changed. We have seen this before and we know how it ends; eventually what one pays for an investment is what determines its long- term success. If being prudent is out of style, then so be it. Fashion has a way of drifting back toward the classic faster than most believe. Patience is in order for the prudent investor.
Charles E. Osborne, CFA, Managing Director
A few years back I had the pleasure of meeting Emanuel Derman. A pioneer in the movement of physicists migrating to Wall Street, Derman was there when investors started using sophisticated mathematical models to make investment decisions. Derman has a Ph.D. in theoretical physics from Columbia University and had been a scientist at Bell Labs before moving on to a career in investing. We met at a lunch where he spoke about the difference between models in finance and models in physics.
As part of the talk he went through the history of thought in physics and the great thinkers who had changed people’s view of how the world works – people like Newton and Einstein. The one interesting thing I took away was that each individual that had furthered the science of physics had first spent an entire lifetime doing little but studying physics as it was understood before them. In other words, the true pioneers that really did think “outside the box,” as we are so fond of saying today, first dedicated their lives to learning more about the box itself than anyone else who had come before.
This revelation really hit me. It makes complete sense, but it is completely foreign to the world we live in today. Social media is about shouting your opinion and having it confirmed by like-minded friends, not about understanding. Unfortunately this phenomenon is not isolated to the lowest common denominator that often drives pop culture.
We have interns here at Iron Capital. Typically we will have one undergraduate and one grad student per semester. It is a very popular program because we actually let them see under the hood– they get to analyze investment opportunities using the models we have created. Most of our interns are very good, and we have hired more than one after their graduation, but occasionally we get one who does not get it. Once we had one who really enjoyed thinking outside the box. He decided that he could drastically improve the model we use to analyze the stocks of growth companies. Sales growth should be the only thing we look at because, he informed me, it was the only thing that really matters. Grow sales and everything else falls in place.
I then asked him whether he had heard of Webvan? Of course he was too young to remember the pioneer if Internet- based grocery delivery. Webvan is a great example of a company that imploded because they grew sales too quickly. The service was fantastic. I remember within months after it came to Atlanta the vans would be in my neighborhood almost every evening delivering groceries to my neighbors. It cost no more than the regular grocery store, which ultimately was the problem. Webvan grew sales like crazy, and lost money on just about every delivery right up until the day it disappeared.
I explained to our intern something that his self-esteem generation ears were not used to hearing: more than 20 years of investing experience had gone into these models, and when he had been running these models for that long, then he could tweak them. In the meantime he needed to learn. I came from a generation in which this was made clear to me. I didn’t need my first boss to tell me that I didn’t know anything; I knew that I didn’t know anything. This intern wasn’t interested in understanding what went into our models, but he was interested in expressing his own opinion.
Seek first to understand. Stephen Covey, in his book “Seven Habits of Highly Effective People,” lists habit number five as seeking first to understand, then to be understood. Of course that bit of wisdom did not begin with him; it is as old as the scriptures. I often tell my daughter that God gave her two ears but only one mouth, and she should learn to use them in the same proportion. (My son, on the other hand, I have to encourage to speak up, but that is a topic for another newsletter.) A thirst for understanding is helpful in every field I am sure, but it is crucial if one’s chosen profession is investment management.
Where does one go to obtain understanding? Many may think the university is a good place to start. I would suggest that this is certainly true in fields like dead languages, medieval Russian literature, or Egyptology; however, if one goes to school to learn about economics and finance, these are practical fields which can be practiced in real life. There was a time when I considered going back to school to get a Ph.D., and I was discussing this once with a hedge fund manager who had a PhD in mathematics. He asked me what I would study, and I said finance. “Why the hell would you do that?” was his response.
I was shocked, but he went on to say, “You can practice finance, you don’t need to study it in a university.” That made me think: Every really successful investor I knew of who had a Ph.D. had one in some field other than finance – most commonly in math, physics or psychology. Then I started thinking of other people I knew or knew of. My brother-in-law, a successful institutional bond trader for thirty years, has his MBA. I remember him telling me that he learned more the first six weeks of work than in the six years combined he spent in college and graduate school. Seth Klarman, the famous hedge fund manager, suggests the same thing in his book, “Margin of Safety.” Klarman has an undergraduate degree from Cornell and an MBA from Harvard, but says he learned more working for Max Heine and Michael Price at Mutual Shares (now part of Franklin Templeton).
Please do not misunderstand: I put a very high value on education. In fact, I believe in education for education’s sake. It is my opinion that an educated person will lead a more fulfilled life. I also recognize that there are many areas in life where the greatest minds probably are at the university. But when it comes to investment management, the old cliché holds true: those that can, do; those that can’t, teach.
Why is this important? Because most of what passes for financial education these days comes from higher education and is then filtered by Wall Street. Nowhere is this more prevalent than the cult of index investing. It stems from this idea that markets are “efficient.” I use quotation marks because what is meant by this is that markets are always correct, not that they operate in an efficient manner.
Of course this is complete nonsense. As C.S. Lewis liked to observe, this is an example of humankind’s propensity to be oblivious to the obvious. Oil cost more than $100 a barrel just a year ago and today costs $45. The actual supply and demand relationship has not really changed, so which is the correct price? If $100 was correct, why did it drop? If $45 is correct, why did it ever go to $100?
Even most academics have given up on the idea that markets are efficient all the time and recognize that at least occasionally market participants act irrationally. However they still won’t give up their holy grail of index investing. They continually site studies showing that the average manager underperforms. This is a fact; average is not very good in my business. Of course my business is not alone, and this is a little bit like making the bold prediction that C students don’t get straight As.
Iron Capital has been in business now for more than twelve years. One of our primary functions for both our insti- tutional and individual clients is to pick investment managers, usually through mutual funds. We track how well we do this task every quarter. On average 81 percent of the managers we selected at least five years ago are better than average over the five year period. Over 59 percent of the managers we select end up in the top quartile over five years, and a whopping 73 percent beat their index. So much for that “can’t identify superior managers” theory.
Of course, we have had a slight advantage – for a decade, from 2000 to 2010, almost every active manager beat his benchmark. The index crowd never admitted defeat, they just got quiet. However, over the last few years the indexes have been winning. I’ve been doing this for a long time, and these trends certainly do occur. What I have noticed is that the index will tend to outperform active managers when something is not right in the market, usually in the last phase of a bubble.
The index crowd does not seem interested in understanding why the aggregate of professionally trained investors, who through various techniques and strategies pick investments that seem sound, might be underperforming the index. They just wish to shout their opinion. It seems to me that one might ask why?
If active investment managers are doing worse than a market index, that means the managers either do not own or own less of the stocks within the index that are seeing the highest growth in price. It would seem to me that if we go through a period where almost no professional investor wishes to invest in these companies, then one should question whether something is amiss. That certainly happened in the late 1990s when this craze first took flight, and it turns out that most managers not buying worthless dot-com companies were pretty smart. The next time the largest index, S&P 500, had a solid winning streak was right before the 2008 crash. It was happening again over the past year and guess what, we are now in a downturn.
This will not convince any of the true believers – not the academics who can’t do it themselves and therefore believe no one can, or the Wall Street product-pushers who make more money the more people trade. Most managers own fewer stocks than are in the index, which means fewer trades and less money for Wall Street. Of course better, in their view, than the mutual fund is the exchange traded fund (ETF). Wall Street makes money on each trade into and out of these funds, as well as all the buys and sells which are created when the ETF sponsor must increase or decrease its holdings.
Carl Icahn has warned that ETFs will be the next bomb to blow up in Wall Street’s face. Who is he but an old-time active investor who has not been doing so well relatively speaking over the last year or so? Perhaps I’m wrong – are we the fools who fail to understand but delight in our own opinions? I don’t think so, if for no other reason than the fact I often ask myself that very question.
There is no doubt that our approach at Iron Capital is currently considered out-of-the-box, but we have collectively studied that box for a long time. I think we have earned the right to step outside.
Charles E. Osborne, CFA, Managing Director
~Thinking Outside the Box