RULE ONE: PRUDENT INVESTING IS DONE FROM THE BOTTOM UP.

My brother-in-law loves to ski. He and my sister had a winter wedding and honeymooned at a ski resort. Both were inexperienced skiers at the time but they thought it would be good fun to learn together. My brother-in-law took to skiing like a duck to water; my sister, not so much. My sister loves to tease about their “romantic honeymoon” with her groom skiing by every once in a while to see how she was doing on the bunny slopes. In my brotherin- law’s defense they have been happily married for 27 years so it couldn’t have been that bad. Their kids fell in love with skiing too, and later snowboarding as they grew up. Year after year they went on family ski trips where everyone had fun except for my sister, who just couldn’t get it. She tried, and would take lessons, but somehow it just didn’t click. Then about five years ago my whole family went on a ski trip together and my wife convinced my sister to take one more ski lesson together with her.

That evening when we all circled back together my sister was overjoyed. This instructor, for whatever reason, was able to communicate the art of skiing to my sister in a way that finally clicked (to this day neither my sister nor my wife has revealed his “secret”). She got it, and she finally had a great time skiing. I can only guess what the secret is – seriously, they won’t tell – but I suspect he didn’t say anything that the dozen or so other instructors hadn’t said. He just had a way of saying it that resonated with my sister at that moment.

It is funny how those things happen in life: Someone says something in a different way and it unlocks your understanding of a subject with which you had struggled. Or, sometimes you may be the teacher and you hear or read someone else’s description and you say, “Yes! That is exactly what I have been trying to say.” I had one of those moments earlier this year.

A friend loaned me the book, “Margin of Safety,” by Seth Klarman. Klarman is as famous as most investors ever get – with Warren Buffett being the glaring exception. He has an extraordinary track record of success with his firm, The Baupost Group, and he wrote this book about his investment philosophy in 1991. The book is famous not only because of Klarman’s reputation but also because he has refused to approve any more printing runs after the first, so it is hard to get and can sell for as much as $2,500. (Yes, I returned it.)

Klarman, like Buffett and many other very successful investors, is hugely influenced by Benjamin Graham and David Dodd; in fact the name of the book is directly borrowed from Graham, who coined the phrase “margin of safety.” As I suspected there was nothing in Klarman’s book that was actually new to me. However, just like my sister’s ski instructor, Klarman had a slightly different way of saying the same thing, and in one of his chapters in particular I heard something I have always known in a way I had never heard it.

Chapter seven: “At the Root of a Value-Investment Philosophy.” In an attempt to clear up some investment speak I am going to refer to it simply as prudent investing. There is a bit of editorial in that description but beyond that I think it is important to distinguish the difference between a value philosophy and “value style” which is often discussed. I have written about this in past newsletters, but for our purpose here let’s just say Klarman is describing what he and I would both agree is the prudent way to invest, which could accommodate various “styles.”

Klarman defined three central elements to this philosophy. First, prudent investing is a bottom-up strategy entailing the identification of specific investment opportunities. Second, prudent investing is absolute return, not relative return oriented. Finally, prudent investing is a risk-adverse approach where, as Klarman says, “attention is paid as much to what can go wrong (risk) as to what can go right (return).” Over the next three quarters I am going to discuss Klarman’s three rules, starting here with prudent investing always being done from the bottom-up.

The easiest way to understand what it means to invest from the bottom up may be to first understand the opposite approach, investing from the top down. Top-down investors start with economic analysis. They project what the big picture is going to look like; how the environment will affect specific industries; and then how an industry’s environment will impact the company in which one might invest. Today many of these types of investors don’t even invest in companies; instead they choose exchange-traded funds (ETFs), which represent industries or sectors of the economy. These investors must be correct about their economic forecast, which is nearly impossible; then they must correctly assess how that forecasted environment will actually impact any particular sector of the economy. Then they have to pick which specific industries will be the real winners, and if they still own stocks they have to pick which companies within the industry are best positioned. Not only do they have to do all of that without having any errors along the way, but they must do it faster than anyone else, otherwise the whole opportunity will be lost. Sound impossible?

Well there is a better and much easier way. The investor can look for quality companies one at a time, from the bottom up. We have often referred to this strategy as being owners of companies instead of traders of stocks. The common sense of this approach is pretty clear: It is much easier to understand a single company, its track record of results, the products it sells or services it provides, the strength of its balance sheet etc, then it is to know how much the entire global economy will grow. Once a company is understood it may be difficult to pin down an exact value for that company, but certainly one could come up with a range of what that company is actually worth. Then all one has to do is have the patience and discipline to buy the stock of that company when the stock is selling for less than the actual value of the company, and the further patience to wait for the market to realize that value. As Klarman puts it, “The entire strategy can be concisely described as buy a bargain and wait.”

This bottom-up philosophy is almost universal among successful investors. In fact, John Maynard Keynes, the famous and still controversial economist, was a fantastic investor and he paid no attention to his own economic forecast when managing the endowment of King’s College, Cambridge. Peter Lynch, the famous manager of the Fidelity Magellan Fund, is quoted as saying that “if one spends thirteen minutes reading a market forecast than he has wasted ten minutes.” True investing success is about making prudent investments from the bottom up.

Doing so, however, is far more difficult than one might imagine. All of Wall Street is geared towards a top-down approach, and for good reason: top-down economic forecasts change almost constantly, meaning those who use these forecasts as reasons to invest must trade constantly. Wall Street is in a transaction-oriented business; constant trading pays their bills, so they are more than happy to provide everyone with top-down oriented research. Bottom-up investing, on the other hand, involves patience. The market could recognize value shortly after one makes an investment (remember being a long-term investor is a mindset, not a timeframe), but usually one must wait for the value of a company to be recognized. While the prudent investor is waiting, Wall Street is not making a dime.

Bottom-up investors have little use for CNBC or any of the other 24 hours-a-day investing channels; what they say is of little value unless they happen to be talking about the specific company you have invested in, and the odds of that are fairly slim. Moreover, the fundamentals of a company really do not change very quickly, and things that do not change quickly make for bad television. Economic data, on the other hand, can bring excitement, and the more they can convince you that every piece of data is vital, the longer you will watch and boost their ratings. Yet most of what comes from these sources in really noise, not news.

This is not to say that economic data has no value; even Peter Lynch thinks that forecasts are worth three minutes of your time. Knowing what is happening in the economy gives one a better frame of reference when judging how well an individual company is performing. For example, Apple has grown at a rate of nearly sixty percent a year over the last five years; knowing that the last five years have been marked by anemic overall economic growth makes that accomplishment stand out all the more. Many technology companies saw that kind of growth in the roaring 1990s, but for a company to do that during the Great Recession is far more impressive.

At Iron Capital, we take it a step further. Our top-down forecast is actually built from the bottom up. While we track the macro economic data, what we pay the closest attention to is the fundamental valuation of various assets and the current dynamics being reported by individual companies within the various sectors. Are the mutual fund managers we like finding opportunities in their space or are we finding bottom-up opportunities? We have found this ground level data, so to speak, to be far more valuable in making asset allocation decisions than any economic or market forecast. We try to be prudent in everything we do, and the first rule of prudent investing is that it is built from the bottom up.

Charles E. Osborne, CFA, Managing Director

~The Three Rules of Prudent Investing

You have heard me say it before, but I really do believe that I could write a complete investment textbook solely on the basis of quotes from the 2003 Disney classic, “Pirates of the Caribbean: The Curse of the Black Pearl.” (If you have not yet seen the movie, it really is worth the watch. This article will be impactful all the same, please read on.) We have already written about market uncertainty, “Reason’s got nothing to do with it,” Mr. Gibbs. We could discuss risk management, “There’s just one question, how far are you willing to go?” Captain Jack Sparrow. We could talk about contrarian strategies, “This is either brilliance or madness,” Will Turner. We could discuss the deadly sin of over confidence, “There is only one rule – what a man can do and what a man can’t do,” Captain Jack Sparrow. But, without doubt, there is one quote that is the number one core lesson of all investing.

The scene takes place as Captain Jack Sparrow enters the secret cave on the Isla de Muerta for the second time. Captain Barbossa sees him and, after just stranding him on a deserted island for the second time, exclaims, “Impossible!” To which Sparrow simply waives his finger like Barbossa’s eighth grade grammar teacher and corrects him with one word, “Improbable.” I will admit that my own wife does not understand why this is my favorite scene from the movie, but investment geeks, like all different variation of geeks, have a humor that is ours alone, and ours primarily deals with the general public’s misunderstanding of probabilities. Barbossa thought Sparrow’s escape was impossible, but any wise investor would have told him that it was simply improbable.

The understanding of probabilities is taught in statistics. If one wants to have a future in the money management industry, he or she had better like statistics. Statistics is to our world what English is to the practice of law, what physics is to architecture, or what biology is to the practice of medicine. Investment professionals must make decisions today about a tomorrow which is, by definition, unknowable. We don’t have crystal balls; we simply have the knowledge of today, what is happening, our current trajectory, and a long list of probable futures. Our job is to understand those probabilities and position our clients’ portfolios in order to manage risk and put the odds in their favor.

This may sound complicated and the work involved is much more intense than most think, but at its essence it is really simple. The best analogy of what investment professionals do is found in the world of sports. Football coaches have to make decisions without the benefit of knowing the outcome. A few years ago my Wake Forest Demon Deacons had the local Georgia Tech Yellow Jackets on the ropes. Tech came back and tied the game to send it to overtime. Wake went first and had to settle for a field goal; Tech was then stopped and their new coach Paul Johnson decided to go for it on fourth down. They made it, scored a touch down and won the game.

Later I was talking to a Tech fan about the game. He was exuberant about their new coach and his bold decision-making. This is the classic response to judging decision making: the layperson waits until the outcome is known and then weighs in on the quality of the decision. The problem with that approach is that it does not separate luck from skill. After all, the best in every field will sometimes be wrong and even a broken clock is right twice a day. One of life’s difficulties is that when making decisions about an unknowable future, good decisions can turn out poorly and bad ones can turn out well. I informed my friend that I thought Johnson had made a poor decision. Sure it worked out, but the odds were against him and if one consistently goes against the odds, one will lose more than one wins. Most of the Tech fans I know are now ready for Mr. Johnson to practice his poor decision making elsewhere.

Another football coach who is famous for going for it is LSU’s Les Miles. He is known by the LSU faithful as the Mad Hatter because he says things that are crazy and he entirely disregards probabilities. In 2007 Miles led his LSU Tigers to the national championship largely by “going for it” seemingly all the time. He completely disregards the odds, and in many ways he is loved by the LSU faithful because of this trait. For some reason we love the risk-takers. However, that risk-taking just cost LSU a loss in the Chick-fil-A Bowl where all they had to do is run out the clock; instead of playing the odds, they came out throwing the ball, stopping the clock and having to punt to Clemson, who then drove for a winning score.

Contrast that model of decision making with the man Miles replaced at LSU, Nick Saban. Saban’s teams are not exactly known for taking big risks. They play text book, hard-nosed football and they obsess over process. I’m sure Saban has probably “gone for it” at some point in his career but you wouldn’t know it watching his current team, The University of Alabama. Miles has had success, but Saban just won his third National Championship in the last four years, fourth overall. Playing the odds is not endearing – people love to hate Saban – but it works.

This is also true in other endeavors. Take golf for example: crowds adore Phil Mickelson largely because he ignores the odds. We all applaud his boldness when he hits it on the 15th green at Augusta National off the pine straw and behind some trees, but when he fails to pull off a similar shot at Winged Foot causing him to lose the U.S. Open, we call him an idiot. (Actually, he called himself an idiot.) The truth is they were both questionable decisions. In an earlier era Arnold Palmer had a similar outlook and was similarly loved by the crowds. Similarly his go-for-broke, ignore-the-odds style cost him as many heartbreaks as it won him championships.

Contrast these two with their main rivals, Tiger Woods and Jack Nicklaus. They plod around the course, always playing the high percentage shot. They are almost robotic, and while they endeared huge amounts of respect for their talent they have never felt the love like Phil and Arnold. They have, however, won more majors than anyone else and gone down in history as the two greatest of all time. This does not mean that they never lost; they have both felt the pain of defeat, but by keeping the odds in their favor they have won more often than anyone else.

Of course no discussion of probabilities would be complete without discussing gambling. One hears it all the time: investing is really just gambling, Wall Street is just Las Vegas East. There are in fact huge differences between investing and gambling, but they do have one thing in common: probabilities. Like most investors I know, I am not much of a gambler, but I knew a portfolio manager from Boston who liked to play Blackjack. He was what we call a quant, meaning his methodology for investing was based largely on mathematical formulas (mostly statistics). He told me that without counting cards, which Vegas deems as cheating, if one plays Blackjack “perfectly,” that player has a 49 percent chance of winning. Those are the best odds one can get at a Casino unless he heads to the poker tables where he plays against other guests instead of the house. His point was that the casino always has the odds in its favor. This does not ensure always winning – players do win, which of course is what brings them back. However, those big hotels and all those bright lights were not paid for by people winning. The casinos know that as long as the odds stay in their favor they may not win every time, but they will win over time.

As investors, we often get to choose: do we want to act like the players, betting on a hot tip based on price movement, or on a hundred other forms of speculation? Or do we want to act like the casino, always insisting that the odds be in our favor? At its essence this is the difference between speculating and investing. Investors get the odds in their favor by investing in companies that are either a) growing rapidly – the odds are that a fastgrowing company will be worth more tomorrow than it is today; or b) in companies whose stock is selling for less than the company is actually worth – odds are that this disconnect will correct itself over time. This is where we get the growth and value schools of investing. Most legendary investors have had the discipline to demand both, which, is the closest thing one can get to a sure thing.

Even with the odds in one’s favor no one wins all the time. Investors, though, can choose how they lose: they can risk losing more in a down market or making less in the up market. Most prudent investors choose the latter. It isn’t as sexy as going for it all the time like Les Miles, Phil Mickelson or Arnold Palmer, which may bring glory and the adoration of others. It is, however, the way to win most of the time, over time, like Nick Saban, Tiger Woods and Jack Nicklaus.

The tension comes from our human tendency to see not the odds but only the outcome. When a football coach goes for it on fourth and long and makes it, people say he is brilliant. When he goes for it and fails, people say he is an idiot. The truth is that the quality of the decision is not dependent on the outcome; it is dependent on the process by which the decision was made. There have been countless studies saying that investment managers who outperform cannot be identified by their past performance, yet for ten years now Iron Capital has selected winning managers with a more than 76 percent success rate. How is that possible? Looking solely at performance is judging the outcome, but future success is based on making quality decisions that put the odds in your favor. The key to success is having the discipline to judge the quality of the decision-making process divorced from outcomes, especially short-term outcomes.

This will be especially true for investors in the beginning of 2013. 2012 was one of those years that defied the odds. The market was up 16 percent while the average hedge fund according to Bloomberg was up only 2 percent. These are the “smartest guys in the room,” and that amount of divergence seems impossible, but actually it is just improbable. Being prudent, managing risk, and keeping the odds on your side does not guarantee success every time, but it is what it takes to be successful over time.

Charles E. Osborne, CFA, Managing Director

~MISSION: IMPROBABLE

WE’VE ALL HEARD THE WORDS.
At some point in our youth we all have been in the familiar scenario, trying to convince our parents that letting us do something stupid – go to a party or on a trip, get a tattoo, etc. – would actually be a good idea. Our logic was likely that “everyone” (translation: one friend whose parents were “cool”) – was doing it. Then we would get the timeless retort to which there is no response, “If your friends were jumping off of a cliff, would you follow them?”

Now we are the adults. Our friends in Greece, Spain, Italy, and France – you know, all those cool countries that “really know how to live” – have already jumped off of cliffs or will do so soon, and evidently the answer to that age-old question is actually, “Yes.” Yes, Mom and Dad, if all of our friends jump off the cliff, then we will, too.

On January 1, 2013, the United States of America, the great world power with the largest and most sophisticated economy on the planet, is going to be driven over the aptly named fiscal cliff. We have suffered through the worst economic recovery in our history, we are now in a new downturn and we will be facing the largest tax increase in American history with a simultaneous slashing of the federal government’s budget. Even the hyperoptimistic Congressional Budget Office (CBO) says that if something is not done to fix it, the U.S. will experience a recession in 2013. Yet this looming cliff barely garners a mention on the campaign trail.

One of the reasons it is hardly mentioned is that few really believe that our politicians are so reckless that they would actually let us fall off the cliff. The conventional wisdom is that after the election the two parties will sit down and fix this before year-end. I hope that is correct and it probably is, but that still leaves us sitting here in October 2012 with no real clue about what our tax code or government programs will look like in 2013. This isn’t supposed to happen in America, or in any developed country for that matter. This is the kind of thing that happens in “Banana Republics,” smaller former Soviet republics, and Middle Eastern dictatorships. This should be the great scandal of our time.

This whole situation was set up when the administration and Congress could not agree on a lasting fix to the debt ceiling debate in the summer of 2011. That embarrassing episode led to Standard and Poor’s downgrading our credit rating and forced our politicians in Washington to punt the decision until after the election. It is dangerous to bring up economic subjects like this, because it ultimately gets political. To avoid that trap let’s pay attention to the old adage, “Great minds discuss ideas, average minds discuss events, and small minds discuss people.” The famous investigative reporter and author Bob Woodward has published a book about the events and the cable news networks have already villainized all the people involved, so we will take the high road and discuss the ideas of what this means to us as investors and how we as a country might get out of it.

To some degree the fiscal cliff is the perfect representation of what has gone wrong in this anemic economic recovery. It represents uncertainty. The numberone concern of business leaders today is a lack of confidence and uncertainty about the future. This argument has been made many times. Some refute it, arguing that life is always uncertain. Business, economics, and investing are by their nature uncertain. Investors and business leaders always make decisions today not really knowing what will happen tomorrow. This is true, but it misses the point.

Let me use a recent analogy. Football is an uncertain game, as are all games. There is always a favorite going into a game. We know the coaches and the players, we know their tendencies. We may think we know what will happen, but as the old football saying goes, “There is a reason they play the game.” You see, upsets happen. Underdogs surprise us and stars disappoint, that is what makes us watch. We enjoy that uncertainty. It is exciting, in the same way business leaders enjoy the marketing game and professional investors enjoy the action of the market. This is the normal uncertainty in which business gets done and economies grow.

When fans pile into stadiums or turn on their televisions they may not know who will win the game, but they do know the rules. The rules are not uncertain. They are known ahead of time and there is an expectation that the rules will be enforced evenly and fairly by professional referees. When the National Football League (NFL) recently fielded replacement referees, it was a disaster. All of a sudden it was not just the game that became uncertain, but the enforcement of the rules. Ultimately it cost at least one team a game, and one game in the NFL can make the difference between making the playoffs and potentially winning the Super Bowl and not making the playoffs and watching the Super Bowl at home with the rest of America.

Similarly, the uncertainty businesses and investors face today is not regarding the usual uncertainty about the outcome of certain decisions; the uncertainty is about the rules themselves. Embarrassingly bad calls are not supposed to happen in the world’s premier football league, just as not knowing what government will do two months from now is not supposed to happen in the world’s premier democracy. It is an embarrassment, and the result is that economic activity has seemingly ground to a halt.

Of the approximately 30 companies in the S&P that have changed their earnings guidance before the release of third quarter results, 28 have lowered their estimates. A few have lowered guidance more than once. Our fear is that the third quarter results will be very ugly and we are remaining defensively positioned because of this.

We will get beyond this, and just like the NFL finally had to deal with their referees, the U.S. will have to deal with the fiscal cliff. One of our political parties suggests that we can get there by raising taxes on the wealthy. That would be laughable if they were not so serious. It won’t work for multiple reasons but mainly it won’t work because it ignores the problem. Think about your own experiences: we all know someone, a child, sibling, friend or spouse, who simply can’t seem to control their spending. We know it doesn’t matter how much money they are given, they will always find ways to spend more than they have. More income may ultimately be needed, but you must first get spending under control. You can start with small items, cut out the lunches and the Starbucks, but when the situation is severe you then must address the big items. A smaller house, a less expensive car, fewer trips, etc. Likewise, our government is no different than our friends; it has a spending problem, and it must deal with it. Its problem is severe and we are going to have to look at the big items. Social Security and Medicare must be reformed or they will drive us over the cliff just as they have our friends in Greece, Spain, Italy, and soon France.

We have another political party that refuses to raise revenues at all. This is also unrealistic. While spending does need to be controlled that cannot solve the entire problem. Just as we would advise an individual with a budgeting problem, you get spending under control first and then look for ways to increase income. The second part cannot be avoided. There are smart ways to increase revenue to government and not-so-smart ways. The not-so-smart way would be to raise income tax rates on a few rich guys.

Let me explain why this is not smart. It is just math: there isn’t enough money there. We could raise marginal rates to 100 percent on incomes over $1 million and, assuming no one changed their behavior, the money still would not make a significant dent in our debt. People talk about the evil one percent, but to be in that notorious group takes a combined household income of approximately $400,000. Those making more than $1 million are a fraction of a percent of all Americans. The idea that there are millions of billionaires out there that can pay for government for the rest of us is a fantasy. On top of that, in the real world taxes do cause changes in behavior. France just raised its top tax rate to 75 percent. Practically the next day, Bernard Arnault, the wealthiest man in France, applied for Belgian citizenship. Another example closer to home: I live 0.5 miles from my office. Over the last several months my commute has doubled as I have had to detour around multiple movie sets to get home. Why are they filming movies in Atlanta and not Hollywood? Rich people and rich industries have choices, and if one location offers a better tax environment than another they will exercise those choices.

Even if that were not the case and a government could get all it needed from the very rich, there is a danger in having a tax code that is too progressive. It does become an inhibiter of growth, but not for the reasons usually mentioned. Economic growth does not trickle down from the rich. Economic growth happens when a man like Steve Jobs starts a business in a garage. He starts it in a garage because he can’t afford to start it anywhere else. You see, Steve Jobs was not rich when he started Apple, but Apple made him rich, and that is economic growth. Growth occurs when people who are not rich today build something real that makes them rich tomorrow, along with their partners and the hundreds and eventually thousands who get jobs, hopefully with stock options, in the companies they create. When tax rates rise with incomes it does not hurt those who are already on top – they can afford it; it hurts those who are not on top today but wish to be there tomorrow. It puts a barrier in their way, and those are the people who make our economy work.

The smart way to raise revenue is to reform the tax code. Lower rates and eliminate tax breaks that are overwhelmingly skewed to the wealthy. The lower rates create less friction for the entrepreneurs who actually create economic growth, while the closing of loopholes means higher actual taxes for those who are already rich. This is how Ronald Reagan and Tip O’Neal did it in 1986, it is the basic framework of the bi-partisan Simpson Boyles plan, and it is the basic framework that just about every expert who isn’t running for office supports. Reform, however, must be designed to raise revenue if we are going to be serious about fixing our fiscal mess.

Are we going to go over the cliff? Everyone else is doing it, but we have never been everyone else. From our birth as a nation we have been a leader; a trend setter; as Reagan put it, “a shining city upon the hill.” The single biggest obstacle to American growth and future investing success is that fiscal cliff and the continued uncertainty that it represents. We need a president who is prepared to make the tough decisions to get spending under control, reform our social safety net and give us a fair tax system that reasonable people can support. As with most things in life knowing what needs to be done is rather simple, but doing it will be hard. But then, that is why they call it the highest office in the land.

Charles E. Osborne, CFA, Managing Director

~Everyone’s Doing It!

GROWING UP, I’m sure my father’s car had a radio in it, but I don’t know why – he never listened to the radio as he drove us around town because it would interrupt his singing. My father is not a good singer – Mom has the musical talent in our family – and he seemed to know only two songs, but that didn’t stop him. The first song was the bluegrass classic, “Mountain Dew,” and the other was “Sixteen Tons,” originally recorded by Merle Travis and later made popular by Tennessee Ernie Ford.

I don’t know that there are any financial lessons in “Mountain Dew,” although leaving your money in an old hollow tree is probably not the wisest investment in the world, even if it is mysteriously replaced with a jug of “mountain dew” (aka moonshine for those not versed in Bluegrass tradition). “Sixteen Tons”, on the other hand, seems very appropriate for our times.

We are awash with debt, and no one seems to have a really good plan to deal with it. As Lacy Hunt, Ph.D., of Hoisington Investment Management puts it, we have not only too much debt, but also too much unproductive debt, and too much counterproductive debt. Hunt should know, since he is a disciple of Yale economist Irving Fisher, who argued that the Great Depression was caused not by a lack of demand as John Maynard Keynes theorized, or by poor monetary policy as Milton Freidman theorized, but by excessive debt. Consensus leans towards Friedman being the one who was correct about the Depression, but Hunt may be on to something now. After all Anna Swartz, Friedman’s co-author, famously criticized policy makers in 2008 for responding to the wrong crisis. This was surprising because they were basically following the play book she and Friedman wrote. Swartz argued that the 2008 crisis was different because in the 1930s banks faced cash crunches but were otherwise in good shape, while this time they had made numerous bad loans.

This fits nicely into Hunt’s theory. He argues that there are three types of debt. First there is productive debt, which is good. Productive debt pays for itself and then some. For example an entrepreneur may borrow money to start a business. This is debt, but this debt has the potential to not only be paid back to the lender but also add to society in terms of jobs, new products and services, etc.

Productive debt does not have to be private sector debt. If a government borrows money to build a bridge, that can be very productive. Toll revenue and/or taxes can pay the loan back, and the new bridge may create new economic opportunities.

The next level is unproductive debt, which is debt that will be paid back but does not add anything else to society. Refinancing is the best example. It works out for the lender and the borrower but nothing new is being built. No other economic activity is created.

Finally there is counterproductive debt, which not only does not produce economic benefit beyond its cost, but also has a high probability of not being paid back. Sub-prime mortgages come to mind, as do student loans. Richard Vedder, an Ohio University economist, writes in the Chronicle of Higher Education that as many people and perhaps more have student loans as have college degrees. In 2010 the New York Times reported on Cortney Munna, then 26, a New York University graduate with almost $100,000 in debt. If her repayments were not then being deferred because she was enrolled in night school, she would have been paying $700 monthly from her $2,300 per month after-tax income as a photographer’s assistant. She says she is toiling “to pay for an education I got for four years and would happily give back.” Her degree is in religious and women’s studies.

There is nothing wrong with getting a degree in religious and women’s studies or with buying a house. There is something wrong with borrowing money that you have no real way to pay back. There is also something wrong with lending money to people when it is almost certain that they will not be able to pay it back. This behavior is, as Hunt puts it, counterproductive, and weighs our economy down.

Unfortunately in most economic circles – the very circles tapped to help guide us out of this mess – debt is completely ignored. Hunt points out that debt is simply not in their models. It is not part of Keynes’ model or those of any of the post-Keynes improvements from his followers. It is also not in Friedman’s models. Traditional policy tools, both fiscal and monetary, simply are not having an impact because of the debt overhang.

This certainly seems to fit our current situation: Large fiscal stimulus packages that are completely ineffective. Interest rates near zero and two rounds of quantitative easing, and the economy is still not going anywhere. It would also explain the awful recent record of some of the most notable economists. For example, in January 11, 2010 – just a few months before Greece imploded and the European debt crisis began – Paul Krugman published a glowing op-ed in the New York Times where he wrote, “Europe is an economic success, and that success shows that social democracy works.” This was very unfortunate timing for the Nobel laureate which, quite honestly, makes him look foolish.

Paul Krugman may be a lot of things and many people, including myself, disagree with him most of the time. However, he is not foolish; he is a very bright man and a respected economist. Obviously, in his analysis Krugman was and still is ignoring the debt. Why would one ignore the debt?

Krugman is not alone. Ben Bernanke, in his Essays on the Great Depression, makes the following statement that is indicative of mainstream economists of all political hues: “Beginning with Irving Fisher (1933) and A. G. Hart (1938), there is literature on the macroeconomic role of inside debt. Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system, but in doing so have had to depart from the assumption of rational economic behavior. Footnote: I do not deny the possible importance of irrationality in economic life; however, it seems that the best research strategy is to push the rationality postulate as far as it will go.”

In plain English this means that economic models from just about every school of thought rely on the assumption that people behave rationally, or at least rationally as defined by economists. In the case of debt loads, this economically rational person would not change his behavior because of debt until the market began to demand higher interest payments. From a classic economics standpoint, if one can continue to borrow at low interest rates than one does not have a debt problem.

Recent studies have shown that this theory does not work out so well in real life. In a paper published in the National Bureau of Economic Research, Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff studied the effect on GDP growth of excessive public debt. They defined these public debt overhangs as periods of time where all public debt equaled 90 percent or more of GDP for at least five years. They found 26 such episodes globally post-1800. Their research indicates that public debt overhang episodes are associated with growth over one percent lower than during normal periods. In addition, the “…duration of the average debt overhang episode across all 26 episodes lasted an average of 23 years… Growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low interest rates.” They go on to say, “Contrary to popular perception, we find that in 11 of 26 debt overhang cases, real interest rates were either lower or about the same as during the lower debt/GDP years. Those waiting for the financial markets to send the warning signal through higher interest rates that government policy will be detrimental to economic performance may be waiting a long time.”

Again, in English this means people do not wait for high interest rates to change behavior and reduce economic activity. Once debt levels reach 90 percent of GDP the debt turns cancerous, to use Hunt’s term, and begins to deteriorate economic growth. In the U.S. today total government debt (Federal, state and local) is 99 percent of GDP, according to data from the McKinsey Global Institute. This concurs with our sluggish recovery.

So how do we get out of it? Hunt points out that there are only four ways out: first, belt-tightening, or austerity; second, inflation; third, massive default; and the final way is to grow out of it. The second and third methods have only occurred in relatively small, emerging economies. The final method only occurred once, and that was the U.S. post-World War II. The circumstances that led to that recovery – the U.S. being the only industrial power in the world not in ashes – are not likely to recur. Hunt makes another interesting point: During World War II the U.S. economy experienced an export boom, because our industrial capabilities were not being bombed. At the same time those who were still at home were under-consuming due to war time rationing. The savings rate spiked to more than 26 percent. That is some pretty severe austerity and may cast a little doubt on the theory of the U.S. simply growing out of its debt post- World War II.

The bottom line is that we are going to have to learn to live within our means, not just as individuals, but as a nation. Debt can be a double-edged sword. It can be productive and finance businesses, roads, schools, etc.; but in excess it becomes ruinous. Debt is like the main character in Merle Travis’ famous song:

“If you see me coming better step aside/ A lotta men didn’t, a lotta men died/ One fist of iron, the other of steel/If the right one don’t get you/The left one will. We load sixteen tons, what do we get/ Another day older and deeper in debt/ Saint Peter don’t you call us ‘cause we can’t go/We owe our soul to the company store.”

Charles E. Osborne, CFA, Managing Director

~Sixteen Tons

Can you tell us how you really feel about your former employer, Mr. Smith? For those who may have missed it, Greg Smith was an employee at Goldman Sachs until this past March when he resigned and had his stinging resignation letter published in The New York Times. He claimed that Goldman Sachs has become a toxic environment where the firm thinks only about its own profits and cares little for its clients. He relayed stories in which senior-level executives referred to clients as “muppets” and the most common question asked about an investment is, “How much money did we make off the client?”

His letter quickly went viral, posted and shared throughout the internet and various social media sites. If his fifteen minutes of fame was what Smith had in mind he succeeded, perhaps at the cost of his career. His letter was one-sided and perhaps a bit extreme, but it did sound very familiar to me.

I saw similar things in my previous career, which motivated me to start Iron Capital. Too many people see stories like this and go immediately to the easy conclusion that “those people are just greedy,” or “they are bad people.” That is too simple, and not realistic. The problem is much bigger, and it is about the entire structure of Wall Street. Interestingly, Jamie Dimon of JP Morgan commanded his people not to take advantage of Mr. Smith’s story. Perhaps he was just taking the high road, but it seems more likely to me that he understood that that letter could have easily been written by one of his employees, or by anyone from any other Wall Street firm.

The problem with Wall Street today boils down to the simple truth that one cannot serve two masters. I started my investment career 20 years ago, and back then stock brokers were stock brokers. They were drilled on the fact that they could not and would not provide advice. They could guide their customers, just like any good sales clerk, but they absolutely did not provide advice. Today, just 20 years later, they call themselves financial advisers. Smith is pointing out the problem with this dual identity. He even states in his letter that he had “the privilege of advising two of the largest hedge funds on the planet.” I am sure he really believes this, but that is complete nonsense. The two largest hedge funds on the planet are not seeking the investment advice of a mid-level derivatives broker at Goldman Sachs. They may buy derivatives from him, but they are doing their own research and when they pick up the phone to call a Wall Street firm they are looking for someone to fulfill an order. They want a broker, not an adviser.

This is the conflict that Smith has going through his mind. He is trying to reconcile his job as a seller of a product with his self image of being an adviser, and he can’t do it. He can’t do it at Goldman and he won’t be able to do it anywhere else, because it cannot be done. One simply cannot serve two masters: one cannot ethically be on both sides of the table.

We have been preaching this message since our founding in 2003, but I think it is hard for many people to fully underWe have been preaching this message since our founding in 2003, but I think it is hard for many people to fully understand. In a relatively short period of time Wall Street and its marketing machine have convinced a generation that they are there to give advice, which is a huge conflict of interest and a fundamental flaw in the business model.

In 2004 the SEC and the Department of Labor (DOL) teamed up to investigate the advice given to retirement plans. They came out with a list of ten questions that retirement plan sponsors should ask their advisers to ensure that they were receiving objective advice. We use this list in our institutional business, and in reading Smith’s letter I realized that it would be good to share it with private clients as well. After all, a large retirement plan may be more complicated, but fundamentally it is still just an investor seeking investment advice. If the SEC and DOL guidance is good for retirement plan sponsors, it should be good for individual investors as well. Here are the questions:

1. Are you registered with the SEC or a state securities regulator as an investment adviser? If so, have you provided me with all the disclosures required under those laws (including Part II of Form ADV)?
Note that they do not ask if you are registered or “licensed” with a brokerdealer, which is the bad advice often given to individuals. In the investment world we often use the terms buy-side and sell-side. The sell-side is what most think of as Wall Street – they create and sell products. The buy-side is the investors and fiduciaries acting on behalf of investors. Traditionally, sell-side firms are registered as broker-dealers and their employees as representatives of the broker-dealer. Buy-side firms register with the SEC as investment advisers.

Objective advice is a buy-side function. Unfortunately this line has blurred as many firms have become dually registered. That simply sounds confusing to most people, but if instead of saying dually registered one used plain English and said they represent both the buyer and the seller, the conflict of interest becomes clearer.

2. Do you or a related company have relationships with money managers that you recommend, consider for recommendation, or otherwise mention to the plan for our consideration? If so, describe those relationships?
Immediately they ask about conflicts of interest. One cannot give objective advice while being paid by the product they are selling.

3. Do you or a related company receive any payments from money managers you recommend, consider for recommendation, or otherwise mention to the plan for our consideration? If so, what is the extent of these payments in relation to your other income (revenue)?
Here they basically repeat the last question in a slightly different manner, emphasizing the importance of independence.

4. Do you have any policies or procedures to address conflicts of interest or to prevent these payments or relationships from being considered when you provide advice to your clients?
We do not believe conflicts can be overcome, but because the vast majority of firms do have serious conflicts woven into their very business models, this question has to be asked.

5. If you allow plans to pay your consulting fees using the plan’s brokerage commissions, do you monitor the amount of commissions paid and alert plans when consulting fees have been paid in full? If not, how can a plan make sure it does not over-pay its consulting fees?
This question may not sound relevant to individuals, however: If you are paying your adviser through commissions, how do you know how much you have paid?

6. If you allow plans to pay your consulting fees using the plan’s brokerage commissions, what steps do you take to ensure that the plan receives best execution for its securities trades?
If you are getting advice from a traditional broker, the expenses you pay are actually revenue to them and to their firm. There is no way you are getting best execution.

7. Do you have any arrangements with broker-dealers under which you or a related company will benefit if money managers place trades for their clients with such broker-dealers?
This is huge for individual investors. A critical point: The SEC and DOL are suggesting that investors should be leery of anyone that has any “arrangement” with a broker-dealer. Again, a broker-dealer is the sell-side, or what one might think of as a Wall Street firm; Goldman Sachs, Merrill Lynch, Morgan Stanley, Charles Schwab, and E-trade are all brokerdealers. They are the firms that custody assets, sell products and execute trades on behalf of their customers. This is exactly where the vast majority of individual investors get their “advice,” and the SEC and DOL are telling institutional investors that they should be concerned if there is any business connection, let alone the adviser being an actual employee of the broker-dealer.

I have been preaching this message for years. I think some of our clients and readers get it, but others probably just hear this as me promoting our business model. This is not coming from me; it comes from two government agencies tasked with protecting retirement plan investors, and the implication is clear: Do not take advice from an employee of a broker-dealer.

8. If you are hired, will you acknowledge in writing that you have a fiduciary obligation as an investment adviser to the plan while providing the consulting services we are seeking?
Broker-dealers and their employees do not have a fiduciary responsibility to their customers. This does not mean that they have no responsibility. Like any merchant selling a product, they should stand by their product and they should not sell anything that is not suitable. But, being a fiduciary is a much higher standard.

9. Do you consider yourself a fiduciary under ERISA with respect to the recommendations you provide the plan?
The highest standard for fiduciaries is provided by the Employee Retirement Income Security Act (ERISA). Under ERISA a fiduciary must act solely in the interest of the plan and plan participants. When we started Iron Capital we were among a very small group that accepted this level of responsibility; today I am glad to say that we have many more competitors. Some have been dragged kicking and screaming by client demands, but several firms share our belief that this is the way an advisory firm should operate.

10. What percentage of your plan clients utilize money managers, investment funds, brokerage services or other service providers from whom you receive fees?
I can’t say it enough: One cannot serve two masters. When you are getting paid to sell a product you are not able to also provide objective advice, period.

That does not mean that salespeople are bad people. They are by nature competitive people. They want to win, and winning means selling the customer their product. When the customer does not cooperate they may get frustrated and say things in the privacy of their offices out of emotion, such as calling a customer a “muppet.” They are and always have been rewarded by their employer by bringing in revenue. They legitimately want to know how much money the firm made from their sales efforts. There is nothing wrong with this. We expect this from a salesperson. I’m sure the clerk at Brooks Brothers thinks I am crazy for not liking the ties he suggests. We all laugh when Julia Roberts, in the famous scene from “Pretty Woman,” goes into the store that had refused to help her the day before with her arms full of packages and asks if the clerk works on commission. Holding out her packages she says, “Big mistake. Big. Huge!”

There is nothing wrong with being a salesperson, as long as one is honest about it. The problem with Wall Street today is that its salespeople have been convinced through training and marketing spin that they are, in fact, advisers. Smith’s letter is the result of this identity conflict. He believes that he was supposed to be a trusted adviser, but he lived in a sales culture.

Many investors today believe they are working with a trusted adviser, but in reality are simply buying products from a nice salesperson. This may be what one wants. Brokers did very well before the culture of Wall Street started to deceive people about their role. However, if advice is what you seek, then take some from the SEC and DOL and ask your adviser the ten questions. You may be surprised about what you learn.

Charles E. Osborne, CFA, Managing Director

~Mr. Smith Goes to Wall Street.