The Quarterly Report

  • The Quarterly Report
  • Fourth Quarter 2013
  • Chuck Osborne

Pride Comes Before a Fall

We live in the world of Facebook and Twitter. My generation grew up with the advent of fast food and McEverything. It is no surprise that today’s technology generation grew up with iEverything, starting with the iPod, iTunes, iPhone, iPad, iMac, etc. “Look at me” is the universal cry, so much so that I constantly see people so busy taking pictures of themselves and their friends in what look like fun places that I wonder if they might be forgetting to actually have fun.

Of course this is nothing new, it is the human condition. Our ancient myths are full of stories of prideful heroes being cut down to size and learning that a little humility is a good thing. Recall the story of Daedalus and Icarus from Greek mythology. Locked in a tower by King Minos, the great inventor, Daedalus fashioned wings for himself and his son Icarus so they could escape their prison. The wings were made of feathers held together with wax. Before taking flight Daedalus told his son, “Icarus, my son, I charge you to keep at a moderate height, for if you fly too low the damp will clog your wings, and if too high the heat will melt them. Keep near me and you will be safe.” Of course we all know how it ended: Icarus, so full of himself and the thrill of flying like a god, went higher and higher as if to reach heaven and his wings melted away. Daedalus, in grief over the loss of his son, made it onto Sicily, where he built a temple to the sun god Apollo and hung up his wings as an offering. The great concession: he was only human after all.

Even today in our often narcissistic culture we can see references to the wisdom of humility. In the 2006 hit James Bond movie “Casino Royale” Dame Judith Dench, playing the role of M, delivers what I think is one of the greatest lines in the whole James Bond series while speaking to Bond: “This may be too much for a blunt instrument like yourself to understand, but arrogance and self-awareness seldom go hand in hand.” C.S. Lewis, in “Mere Christianity,” was a little more blunt than M. He refers to pride as the “anti-God state of mind”. He believed it was the route of all evil. Whether that may be a little over-the-top is a discussion for another time, but he makes one of the most insightful comments I have ever read on the subject. “There is no fault which makes a man more unpopular, and no fault which we are more unconscious of in ourselves,” Lewis writes of pride. There is a reason the word arrogant is frequently followed by another word starting with a, which we won’t publish in our family newsletter, almost as often as the word fool.

I do not know if C.S. Lewis is correct about pride, arrogance, hubris or whatever you wish to call it, being the greatest sin overall, but I can guarantee you that it is the greatest sin in investing. It is incredibly dangerous, largely because it is so hard to see in ourselves. As a result it is the number one mistake made by professional investors. Amateurs make all kinds of mistakes; pros usually make only one, but it is a big one. The most notorious example was of course Long-term Capital Management, otherwise known as the hedge fund that almost destroyed the world. If you are interested you can read the book “When Genius Failed” by Roger Lowenstein. The short version is: Two Nobel laureates run a hedge fund that did great until it blew up and required a $3.6 billion bailout to keep the entire financial world from collapsing. It happened in the late 1990s, so much of the world was too wrapped up in the internet bubble to care, but those of us in the industry will never forget.

Not forgetting and learning are too often two different things. In the Spring of 2007, I attended a lunch presentation delivered by a money manager from Chapel Hill, NC. He was a great presenter. He said several things that were just plain wrong, but he said them with such confidence it was amazing. He was running a strategy that was popular at the time: purchasing mortgagebacked securities, which he promised were completely safe, and he was using leverage – which is industry speak for borrowing money for the purpose of investing it – to raise the rate of return to whatever percentage you wanted. To understand how this works let’s assume you had $100,000 to invest. You want to get a 10 percent return which would be $10,000 on a $100,000 investment. Mortgage-backed securities were paying approximately 5 percent. He then suggested you could just borrow another $100,000, invest the $200,000 in 5 percent mortgage bonds (5 percent of $200,000 would be $10,000) to make your $10,000 “without risk.” Of course you would also have to factor in the cost of borrowing the money etc., but this is the basic idea behind leverage.

There was just one problem: Mortgage bonds were not risk-free. Some went down in value well over 50 percent, and in this scenario that means your $200,000 investment would be worth less than $100,000, which is the amount you borrowed. You end up losing more than you ever had. I was in shock hearing this presentation, and then the person next to me looks over and says “Isn’t this guy great?” I told my fellow audience member as politely as I could – which in all honesty was probably less polite than I should – that our speaker was an arrogant fool. I don’t know if the gentleman next to me invested or not, but he was sold.

I have often wondered what ever happened to the speaker from that day in the aftermath of the financial crisis. I don’t wonder about his clients, because I know what happened to them. I do wonder about the arrogant fool. My guess is he is back at it. In my experience the problem with arrogant fools is that they never admit to themselves that they are arrogant or fools, and therefore no matter how many times it comes back to haunt them, they never cease to be either.

The other problem, especially in my business, is that arrogance can often be convincing. As Mohammed Ali once said, “It ain’t bragging if you can back it up.” He did back it up, and many people loved him for it. This is what happens on Wall Street. There has been a loud theme over the last several years that what caused the financial crisis was greed. I have worked in the investment world my entire adult life, and frankly I have not seen much greed. Sure I have seen some, but not like most claim and certainly nowhere near as much as I have seen pride. I could be accused of splitting hairs here, but even the seemingly never-ending appetite to make more money isn’t always rooted in greed. So many of them never spend the money, because that is not what it is about. It’s about pride – being able to claim that you are the best in a game where money is not something you make to enrich yourself but simply a way of keeping score. You are, as Ali was also fond of saying, the “Champ of the world!”

Some may not see the difference between pride and greed, but I think it is an important point. There are not nearly as many greedy crooks in my business as there are prideful fools who really begin to believe that they can do no wrong, and then all of a sudden they meet Joe Frazier. They get stunned in the 11th round by a left hook and then in the 15th another left and “Down goes Ali, down goes Ali!” They don’t intend to hurt anyone; they truly believe their own propaganda. They are blind to their hubris right up to the point when Frazier hits them with that left hook, or until the sun melts the wax on their wings, or until it turns out that even virtual companies have to make actual money, or when people who can’t afford the house they bought stop paying their mortgages.

One of the best salesmen I have ever known used to tell me all the time that he was often wrong but never in doubt. I would laugh and respond that I try to be seldom wrong, but always in doubt. That is the way one must be if they are going to be making decisions about money, especially other people’s money.

Western culture used to value age. Youth was associated with arrogance, and “coming of age” often meant being humbled. With age comes humility and wisdom, and that is what we strive for everyday at Iron Capital. We will never be perfect but we keep striving, keep making progress. One might wonder why we would choose to write such a newsletter now. Certainly this message would be better suited for the end of 2008 than the end of 2013? Well, pride comes before a fall, and that is when one must be on guard. 2013 was a great year, but as Han Solo told the young Luke Skywalker after Luke shot down an imperial fighter, “Way to go kid. Now don’t get cocky.”

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Charles E. Osborne, CFA, Managing Director

Review of Economy

Growth is accelerating. Third quarter GDP growth was 4.1%. We expect it slowed to 2% in the 4th quarter but the second half of 2013 was certainly better than the first half. The improving fiscal outlook has gotten the private sector in growth mode once more. The official unemployment rate has dropped to 6.7%. Unfortunately the biggest part of that drop is from people exiting the workforce. Workforce participation is now the lowest it has been since 1978 and continues to deteriorate. The Federal Reserve Bank (Fed) has begun to taper but they will maintain very loose monetary policy until the unemployment situation sees more than headline improvement.

Review of Market

What a quarter and what a year.The S&P 500 finished up 10.51% for the quarter and 32.39% for the year. It was really the tale of two halves however. Junk stocks dominated early and a rotation towards quality seems to have taken hold in the second half. Bonds can lose money. The Barclay’s Capital U.S. Aggregate bond index ended the year down 2.02%. The 4th quarter was relatively flat, posting a return of negative 0.14% but with interest rates still very low, the outlook is not great. International markets continued their comeback with the MSCI EAFE being up 5.75% for the quarter and 23.29% for the year. MSCI Emerging Markets index actually ended the year in negative territory down 2.27%. Markets can stay irrational for a long time, but the valuations in emerging markets look very attractive.

 

Market Forecast

We remain cautiously optimistic about the equity markets. For the most part, valuations on equities are reasonable, and that cannot be said of almost any other asset at the moment. There may be a short-term correction after such a lofty 2013, but the long-term outlook is positive. U.S. large-cap stocks still look attractive but International stocks are looking better than they have over the last few years. Emerging markets are perhaps the most attractive on a valuation basis but risks remain and momentum has turned negative. Small company stocks are the only area that appears overvalued. Bonds remain our biggest concern over the long term. Yields have risen but remain near all-time lows. Stocks may actually be safer.