There has been a great deal of volatility in the market over the last quarter, and I believe much of it is driven by pure ignorance.

I came up with this theory when I saw an article written by Daniel Klein, professor of economics at George Mason University and editor of Econ Journal Watch. Klein’s article was about a survey done by Zogby International Measuring basic economic understanding.

Of the eight questions, people who identified themselves as “progressive/very liberal” were correct about basic economic questions only 34% of the time. A third of them did not understand what it meant to have a monopoly.  people who described themselves as “very conservative” did best, scoring an 83% on the test, followed by libertarians, who scored 82.75%.

When one sees these survey results from an organization as widely respected as Zogby, it should make one ask, Does this have anything to do with Europe falling apart? Could the crisis in Greece be a byproduct of the far left being blind to economic consequences? Throughout the world today we see a strange confluence of events: leftward-leaning economies collapsing and a backlash against private enterprise.

I know it is always dangerous to bring up politics, and we certainly do not mean to offend, but as I have said before on these pages, there are plenty of things about which Democrats and Republicans, liberals and conservatives can legitimately disagree, but the general direction of economic policy is not one of them.

I think Bryan Caplan explains it magnificently in The Myth of the Rational Voter. Caplan points out that the vast majority of voters are economically illiterate, which explains why American “politics” so frequently devolves into divisive social issues like abortion or gay marriage. How many times in the last twenty years has Congress voted on abortion legislation or a gay rights bill or any other social issue that takes up so much of our political air? Compare that to the daily decisions being made that impact economic policy. Industry regulation, appropriations, taxation – these are the daily business of government, and unfortunately they are ignored until we end up at the place we are today.

Political scientists and economists have traditionally believed that the average voter had no real idea of the economic consequences of his vote, but that these errors were random. So while the economically educated were a small minority of the voters, the belief was that their view would win the day because the economically illiterate voters cancelled each other out. Caplan argues, convincingly, that this is not true because the erroneous views of the masses are in fact not random, but systematic. Most people do not just have random misconceptions about economics that cancel each other out at the election box, but in fact they have the same misconceptions that end up swaying elections in favor of sometimes very damaging economic policy.

Caplan identifies four basic biases that the vast majority of people share, all of which lead to undesirable policies. Those biases are:
1) anti-market, 2) anti-foreign, 3) make-work, and 4) pessimism.

Let’s start with the anti-market bias. Most people simply do not understand the “invisible hand” of the market and its ability to harmonize private greed and the public interest. This has certainlybeen true over the last few years during the financial crisis. There has been much blame placed on the market, even though the facts of the case clearly show failures of government policy and regulation. We speak of these failures often as the “unintended consequences” of well-meaning policies.

Greece, for example, paid its public employees 14 months salary for every 12 months worked. They provided full retirement benefits at age 50, and covered all medical expenses. When all is well, the vast majority of voters would be in favor of such bountiful benefits. Unfortunately, these generous gifts come with an unintended consequence: Greece is now broke.

It is important to see that while these results may have been unintended, that does not mean they were unforeseeable. Governments do a far worse job of making economic decisions than does the mysterious power of the market. History if full of such examples.

Twenty years ago the greatest example of all presented itself. The collapse of the Soviet Union, combined with the economic success of the pro-market reforms in the US and the UK, put an end to what had been a debate about how to best run an economy. Bill Clinton declared the days of big government to be over. Yet somehow this poisonous idea that government regulation is superior to free market forces survived only to resurface today.

I want to be clear here. I am not saying – nor was Caplan – that conservative economists or economists from the ‘Chicago School’ have more faith in the market than the average lay person; I am saying that the consensus view of all economists is more favorable to the market. John Maynard Keynes himself was a true believer in the free market and did not believe in socialistic government regulation or control of the economy. In his own words, “Marxian Socialism must always remain a portent to the historians of Opinion — how a doctrine so illogical and so dull can have exercised so powerful and enduring an influence over the minds of men, and, through them, the events of history.”

There are differences of opinion among economists, and some views are closer to being what Caplan calls ‘market fundamentalist’ than others, but these differences are far smaller than the general public realizes. In his book, Caplan tells a humorous anecdote from the Carter White House. Even in the Carter administration, the economic advisors were economists first and liberals second. A policy adviser asked the economic team to prepare the best economic arguments for a particular policy, and the response was that there is no economic argument for this policy. The policy staffer shot back that he understood that the economic advisor may not completely agree with the direction of the administration, but he needed to be a team player and give him the best known economic arguments. The economists
replied he was not trying to be difficult, but there really are not any economic arguments in favor of the policy in question.

This kind of thing is still happening today. The Brookings Institute issued a white paper a few years ago about the problems in our health care system and what policies should be adopted to solve them. One of their conclusions was that patients do not bare enough of the cost of their care, which causes two issues. First, there is greater demand for health care services because the patient is not the one paying. Secondly, the patient gets worse service because the health care provider is actually getting paid by – therefore works for – the insurance company. The solution suggested was more old-fashioned reimbursement-type insurance plans, greater use of health savings plans, etc. Some of the authors of this paper have consulted the Obama administration, but the actual legislation went in the opposite direction. There is near unanimity among economists that the unintended consequence of this legislation is that health care costs will skyrocket.

With financial reform regulation, it has been the administration’s own economic advisers pushing back harder on the left’s proposals than even the republican opposition. As I am writing this, there are warnings that some of the requirements of this bill will do away with the free checking that almost everyone in today’s banking system enjoys, and potentially an entire class of people will not be able to obtain a bank account. This is another unintended
consequence, but it is not unforeseeable.

Now for the anti-foreign bias: there is an unexplainable bias against free trade among other nations and a fear of immigration. People tend to see other nations as competitors instead of partners in a global economy. In his book Pop Internationalism, Paul Krugman states, “The growing obsession in the most advanced nations with international competitiveness should be seen not as a well-founded concern, but as a view held in the face of overwhelming contrary evidence. And yet it is clearly a view that people very much want to hold – a desire to believe that is reflected in the remarkable tendency of those who preach the doctrine of competitiveness to support their cases with carless, flawed arithmetic.”

The fact is free trade is an economic win-win for all nations, and legal immigration is desirable as immigrants usually take jobs that, for whatever reason, native workers do not want. Immigrants also can bring with them skills and knowledge that the native workforce may not posses. No country is a greater example of this power than the United States, yet the majority still believes trade and immigration to be harmful, and populist politicians, mainly on the right, take advantage of this fear. The protectionist actions of the Obama and Bush administrations have led to many unintended consequences, including doubledigit unemployment. It has also contributed to part of our health care issues.

International travelers may have wondered why a Coke in Great Britain tastes so much better than a Coke in Atlanta, the home of Coke. In Great Britain that Coke is sweetened with real sugar, as opposed to high-fructose corn syrup in the U.S.. Experts have argued that the use of high-fructose corn syrup in the US is contributing the obesity epidemic. So why do U.S. International travelers may have wondered why a Coke in Great Britain tastes so much better than a Coke in Atlanta, the home of Coke. In Great Britain that Coke is sweetened with real sugar, as opposed to high-fructose corn syrup in the U.S.. Experts have argued that the use of high-fructose corn syrup in the US is contributing the obesity epidemic. So why do U.S.

The public also has a bias towards make-work programs. As we talked about in length in previous newsletters, economic growth brings much better jobs, but that is not the belief of the masses. Politicians promise job programs, and even brag about the jobs they have created while the unemployment rate is held below 10% only by the hordes of workers who have given up hope and dropped off the rolls.

Finally, people also are more pessimistic about the economic future than are trained economists. Maybe here is the silver lining. My first micro-economics professor in college opened class the first day by making a bold statement: The economy is more powerful than any President or any Congress. I’m not sure I believed him at the time, but I do now. Our current administration has seemingly done everything in their power to harm the U.S. economy, yet it still grows. We are growing far slower than we have in any other recovery, and far slower than we would be in more competent hands, but even so, the economy is coming back. This too shall pass, the pendulum will swing back, and we will see economic prosperity again in the U.S..

Ignorance is supposed to be bliss, but if Mr. Caplan’s data is correct, it looks like the knowledgeable are actually far more optimistic. That isn’t a bad thing.

Charles E. Osborne, CFA, Managing Director

~Ignorance Is Bliss. Or Is It?

When I was in college, I got involved in a long-distance relationship. I met a girl over the summer and we continued dating when I went back to school at Wake Forest. Her birthday was coming up and we were going to be apart. With the advantage of several more years and hopefully a little more wisdom this seems like no big deal, but at the time I was young, in love, and stupid. The thought of not being with my girlfriend on her birthday was just too painful.

I scraped together all the money I could, flew to her town, and surprised her with champagne, roses and a reservation at her favorite restaurant. She was beside herself with excitement when she opened the door and saw me standing there. I gave her the gifts and told her about our dinner plans, and her response was, “Where is my card?” Card? What card? Webroke up shortly after that expensive trip, but I had learned a valuable lesson: details matter.

Last quarter we began a conversation about the big structural changes that the United States must go through to remain relevant in the 21st century. I promised I would get back with specifics throughout the year, so I will start with the topic about which we know most here at Iron Capital, regulation of the financial industry. I will begin with an assertion that most likely will surprise you: I believe the vast majority of people within the financial world today would welcome intelligent regulatory reform. I base that first on my own opinion as the owner of an investment counseling firm, and secondly on 19 years of experience and relationships in this business. I can honestly say that I do not know anyone in our industry who does not believe we need reform.

That is probably a surprise because it seemingly contradicts what you hear from the mass media who report how Wall  Street is standing in the way of the administration’s efforts to pass financial reform. I believe Jamie Dimon of JP Morgan said it best after being summoned to the White House along with his fellow big-bank CEO’s. Dimon told reporters that he was in favor of reform, but details matter. You simply cannot succeed in business like he has succeeded without understanding that details matter.

One of the primary problems we face in today’s effort to fix the financial regulatory framework is a lack of understanding of what actually went wrong during the financial crisis. The reason for this is that it is human nature to operate with a closed mind. Most humans make up their mind before any facts are known and then look only for facts that support their views. Today that is made easier than ever, as depending on your particular political persuasion you just turn on MSNBC or FOX News. One might read the New York Times and refuse to read the Wall Street Journal or vice-versa. Online one can swim in crazy extreme ideas until they start sounding sane.

Having an open mind is extremely difficult, and not natural. John Maynard Keynes said it best when he commented that, “the difficulty lies not so much in developing new ideas but in escaping from old ones.” In his book Socrates’ Way, Ronald Gross describes the effort the ancient Greek philosopher went to be open-minded. He suggests an exercise where you purposely seek out sources written from a view with which you disagree, and not just read them but really consider their arguments and “grade them” on whether they have actually proved their case. This exercise has proven very useful for us at Iron Capital. Before we make any investment decision, we seek out contrary views and truly consider them. It is not easy because it goes against human nature, but I would like us all to try it now.

There are two popular explanations for the financial crisis: first, the whole thing was created by bankers, all of whom are simply evil greedy people. The second view is that the entire crisis was caused by government regulators who want to crush the free market and create in America a communist utopia.

I have purposely positioned these arguments as so extreme that hopefully no reasonable person would agree with either one, but while I state them in the extreme, the fact remains that almost everyone falls into one of those perceptions. If they were being honest, most people would admit that they thought this way before the crisis. If they disliked free markets, then the crisis just proved that free markets don’t work, and if they disliked government regulation, the crisis simply proves it causes more harm than good.

Both sides can point to facts that support their case. There are certainly cases of what seems like hubris and greed in several large financial institutions, and these undoubtedly played roles in the crisis. This is a detail which is largely ignored and/or brushed aside by many who defend capitalism.

However, there is also no doubt that banks were pushed to make loans to certain groups of people for political reasons regardless of credit worthiness. Without the strong public support for home ownership regardless of cost, the sub-prime market never would have existed. In addition, the financial firms never would have acted so recklessly if there had not been a record of the government bailing them out every time they got into trouble. These are details that just don’t fit the world view of the pro-regulation crowd, so they must simply be ignored.

Unfortunately, details do matter and cannot be ignored, particularly when they challenge one’s view of the world. The problem with all the details is that they paint a different picture of what happened in the financial crisis than what either view wants to see. First, there is no one thing that caused the crisis. People want a villain, someone to blame. Greedy bankers did it. No, it was the Federal Reserve. Banks became “too big to fail.” Regulators pushed sub-prime mortgages and subsidized the entire mortgage market.

The problem is that all of these statements are half-truths. The whole truth is that this crisis was a perfect storm. No one of these issues independently could have caused a crisis of this magnitude.

Once one understands that, one starts to see regulatory reform through a different lens. Reform needs to be more comprehensive and address all the various contributors to the crisis and at the same time needs to be more restrained since nothing is completely broken. In other words, what is needed is lots of little tweaks not one big new initiative.

There are two areas that need tweaking that I want to address specifically: accounting standards and the shear number of regulators. These are little details that matter dramatically. University of Virginia economics professor Edwin Burton has written one of the best and most thought-provoking papers on how accounting practices helped lead to the crisis. At the heart of the crisis, he says, was the valuation of assets on the balance sheets of banks and other financial organizations. Balance sheets of non-financial companies are relatively simple to understand – on one side you have assets, and on the other side you have liabilities. If a company owns a building out right on their balance sheet and the building burns down, they now have fewer assets. However, the fact that this company has fewer assets does not impact any other company.

Financial firms don’t work this way. Financial firms exist largely to loan money. Their assets are mostly loans to others. While that loan is an asset to the financial firm, it is also a liability to someone else. Increasingly in our interconnected world those loans are being made to other financial firms. If the ability of the borrower to pay back the loan for some reason becomes in doubt, then the firm’s accountant might say this asset must be written down, or recorded at a lower value than it was before. This leads to the much-talked about “mark to market account-ing.” Mark to market means you write the loan down because of doubt about the borrower’s future, not because of an actual default. Furthermore – and this is the interesting insight added by Professor Burton – if the borrower has not actually defaulted, then that firm is still carrying the liability at its full value. This is what Burton calls an asymmetric write-down – the asset has been reduced in value, but the matching liability has not. Because financial firms are so interconnected, making countless loan transactions with each other, financial firms begin to look weaker and weaker on paper as assets are written down but corresponding liabilities are not. This leads to a panic and a run on the bank.

Professor Burton’s ideas need further exploration. The flaw in accounting methods for financial firms could be fixed with a small tweak, but it would have huge consequences. One other accounting rule that has not gotten as much attention on the reform front is the ability of financial firms to hold assets and liabilities “off-balance sheet.” In my opinion there should be no such thing as off-balance sheet. These two seemingly simple fixes would eliminate the entire too-big-to-fail myth. It was the opaque and asymmetrical nature of accounting, not size, that led to panic, which could have brought down not just poorly run companies but the entire system.

The other problem that was discussed initially by the adminis-tration but has faded is the fact that the financial world has far too many regulators. As former Merrill Lynch head John Thain stated in a speech at Wharton last fall, the numerous regulators gave some firms an ability to shop for the regulation they liked the most. For example, AIG could have put their now-infamous financial products group under one of their insurance operations, but they would have been more heavily regulated. Instead they were able to move it to the parent holding company and avoid almost all regulation. In my own career I have been subject to multiple regulators at once and have been given conflicting guidance. This allows less scrupulous firms to play regulators off one another much like a manipulative child who knows whether to ask mommy or daddy depending on the desired answer.

The current proposals in Washington only make this worse, by adding yet another regulator, the new Consumer Protection Agency. This may sound politically appealing – who would possibly be against protecting the consumer? But, isn’t that what every regulator is really supposed to be doing? In the meantime the real issues that led to this crisis are being ignored and business as usual is back on Wall Street.

Why does all this matter to our clients? Regulation is real, and it costs money. Regulation done correctly can help ensure that everyone is playing by the rules, which makes it easier to make investment decisions and therefore have investment success. Regulation done poorly will increase costs, reduce investment opportunities, and have a negative impact on your portfolio. You have a vested interest in what happens with financial reform, so please pay attention, keep your mind open and remember that details matter.

Charles E. Osborne, CFA, Managing Director

~Details Matter

I have heard the story attributed to Milton Friedman and a vacation in China, and I also have heard it attributed to a nameless economist doing mission work for his church. Personally I doubt it ever occurred, but as with many legends and myths, the fact it didn’t really happen does not make it any less true.

It goes like this: An economist travels to a far-off land to help the native people build a dam to provide power and a source of clean water for their village. Before leaving for his trip, he gathers donations to pay for the heavy equipment they will need to build a modern dam in this remote area. Upon arriving he notices that the heavy equipment has arrived safely. He also notices that the natives have already begun work; however, they are not using the modern machinery. What he sees looks like a scene out of movie about the building of the pyramids of Egypt – he witnesses a mass of humanity battling the force of a river with nothing but shovels. It looks awful to the modern eye.

Our economist hero immediately demands to see who is in charge. The foreman comes forward – our hero half expected him to be carrying a whip – and greets the new visitor with enthusiasm. “We are glad you are here, thank you for your financial support and the help you are giving us,” he says. “No problem, glad to do it,” the economist responds, “but I have to ask. What is going on here? Why isn’t the equipment we paid for being used?”

“If we use this heavy equipment we would eliminate many of these jobs and we simply cannot do that,” explained the foreman.

“Oh,” responded the economist. “I think there has been a misunderstanding. My organization was under the impression you were trying to build a dam. But you are trying to create jobs. If that is the case, you should take away the shovels and give the workers spoons.”

The moral to the story is that it is important to distinguish from a symptom of a problem versus the problem itself. If the leaders of this mythical community really wanted to create jobs they should focus instead on economic growth. The faster they finished the dam, the faster they could generate energy and better control the water supply, which could bring industry and/or agriculture to their community, which would create much better jobs than shoveling mud. These jobs would also last beyond the length of the dambuilding project, and the jobs themselves may create needs for other jobs in services such as childcare; they may even need a local bank…oh no, there goes my make-believe town, now it will be destroyed by the ‘evil banker.’

Those future jobs are hard to see in the present moment. It all makes sense in my mythical village, as it does when we look back in history. In 1800 America was a nation of farmers, with roughly three-quarters of the labor force working in agriculture. By the eve of the Civil War, only half worked in agriculture; by 1900, one-third; and today, less than three percent of our labor force is in agriculture. This does not mean that food production has gone away – U.S. agriculture has maintained a positive trade surplus for decades, producing more food than even our overweight society can consume.

The industrial economy has seen the same phenomenon over the last 60 years. There is a firmly held belief that America has lost its manufacturing edge to competitors overseas, mainly to China. Like most conventional wisdoms, this belief is not true. In 1947, a little less than 15% of the total gross domestic product (GDP) came from manufacturing. Today that percentage is roughly the same and it has been stable throughout that 60-year period, meaning American manufacturing has grown in line with the economy as a whole. However, in 1947 manufacturing represented over a third of total employment in the U.S. There were lots of relatively low-skill, high-paying union jobs. Today that is no longer the case. Manufacturing represents less than a tenth of our total workforce, but the vast majority of those jobs were lost not to competitors but to technological advances. This is important to understand because jobs lost to competitors could be won back, while jobs made obsolete by technology are gone forever.

This reality is hard to hear and it is painful to go through, but this is a necessary process which the famous economist Joseph Schumpeter called ‘creative destruction’ – the old must be destroyed so the new can take its place. American history is full of these episodes and we owe much of our global success to the fact that, for the most part, throughout our history we have allowed this economic cycle of innovation, boom, decline, destruction and new innovation to keep on cycling. Most notably, in the last 100 years we faced two times when unemployment reached the levels we are near today. The reaction to those two periods could not have been any different and the lessons learned are important for us.

The first such period was the Great Depression. In 1933, the unemployment rate hit 24.9%, and the government reacted by passing a slew of new regulations on industry, increasing spending, and creating new entitlement programs and ‘make-work’ jobs programs. All of this was very popular as it made the government look like they were ’doing something.’ Yet in 1939, the unemployment rate was still 17.2%. Things got better, but not by much.

The second time the unemployment rate got up to near double digits was in 1982. At the end of 1982 the unemployment rate was 9.7%, and the government reacted by reducing regulation, reducing the size of government, and lowering taxes. The public response at first was not positive, since it appeared that government ‘didn’t care.’ By 1989 unemployment was down to 5.3%. Government continued to downsize through the 1990s and in 1999 unemployment stood at 4.2%.

One approach didn’t work and the other did. But, there were some side effects to the second approach. Most notably, there has been a disturbingly increasing gap between the haves and the have-nots.

Today we sit between a rock and a hard place. To produce jobs, we must encourage innovation by providing economic freedom, but we must also do something about the growing bifurcation of our society. This dilemma is spelled out very well in Jim Manzi’s essay for National Affairs, “Keeping America’s Edge.” Unfortunately what Manzi describes – correctly, in my opinion – as a “dysfunctional political dynamic” is preventing us from actually facing this challenge and has instead “given us the worst of both worlds: a ballooning welfare state that threatens future growth, along with growing socioeconomic disparities.”

Liberals are correct when they point out the disparity of the rich versus the poor in our country today, but they are blind to the reality that their attempts to control economic activity centrally are counterproductive and actually make things worse. Conservatives are correct when they argue for the power of the free market, but they are blind to increasing inequality. We live in a world where increasingly people are able to avoid any bit of information that does not fit with their world view. They increase their closed-mindedness by digesting only views with which they know they will agree. This serves only to grow our respective blind spots and our political dysfunction.

There are solutions, and I will discuss some during the course of this year. But they are going to require a mature facing of facts – all the facts. Big government does not work. We need to do something about the economic disparity in our society – starting with reforming education. We need a state-of-the-art regulatory system to govern the financial markets. If we do these things, jobs will come. In the meantime, beware of politicians promising jobs programs – they might just be handing out spoons.

Charles E. Osborne, CFA, Managing Director

~JOBS

This fall, we commemorate the one-year anniversary of the financial meltdown of 2008. What a crazy ride it has been. In many ways this crisis actually has been good for our business in that we have gained several new clients, I – like most of us – still wish it had never happened. Life seems to be getting back to a new normal, and seven months of positive returns have calmed nerves and somewhat restored portfolios. This calm has given me time to reflect on the past year.

For most of the past year it has been our role to calm our clients’ anger and fears. We have tried to rise above and to bring rational thought to what was an emotional rollercoaster. We feel privileged to have helped our clients through this process and to have been the grateful recipients of unsolicited gratitude as well as the sounding boards to whom some of our clients have vented. I am proud of the Iron Capital team and the fact that we have performed far better for our clients than most in the industry, and yet I wish we had done better still. Now that some calm is here, it’s my turn to vent a little.

There are many things that stand out in my mind over the last year, but none irritate me as much as the media coverage. Much to my dismay, somehow in 2008, I and everyone else who works in the financial industry became a “banker.” I’m not sure how this happened, but it did. Almost every story about the crisis describes all kinds of people as “bankers.” I have read about the bankers at Merrill Lynch, the bankers at Goldman Sachs, even the bankers at AIG.

I’m not sure if the average lay person can understand how distressing this is to those of us in the financial sector who are not, in fact, bankers. With all due respect to my banking friends (and I do have several), most of the rest of the financial world thinks of bankers in the same way novelist Tom Wolf describes them in A Man in Full – bankers are the people who finished last in their class at business school.

Of course the media are trying to simplify things by using a somewhat generic term. They don’t want to explain the difference between a retail banker, a commercial banker, an investment banker, an analyst, a trader, and a portfolio manager. Let’s just call them all bankers. What is the problem with this?

The problem is that it was the non-bank financial firms that got us into this mess. The epi-center of the financial crisis was Freddie Mac and Fannie Mae – government agencies, not banks. Bear Sterns was the first victim – not a bank. Lehman Brothers and AIG were the biggest problems – guess what, not banks. Yet over the last several weeks there has been much talk about the new regulations finally coming out of this. The grand total of these new moves is the consolidation of some of the various banking regulators and the creation of a Consumer Protection Agency to police bank products. These proposals may or may not be good, but they certainly do not address any of the issues exposed in the crisis.

This is not the only area where media coverage has let us down. As John Maynard Keynes once pointed out, “Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be.” Our modern media has certainly taken this to heart. The Nightly News should be renamed The Nightly Polls and Pundits, as this is about all we get. My favorite example is from a report I heard on CNN early one morning as I was about to board a plane. This was shortly before the ’08 presidential election and CNN was breaking a story about how most Americans blamed the Republicans for the crisis.

What ever happened to true experts? I could be wrong, but I believe we are living at the height of the uninformed strongly held opinion. I guess to prove that I would actually have to conduct a poll. Instead of experts, today we have opinion polls and political pundits. Benjamin Graham once said, “You are neither right nor wrong because the crowd disagrees with you. You are right (or wrong) because your data and your reasoning are right (or wrong).” Just because the poll said Americans think the Republicans created the crisis does not mean that is true – or false. It has no bearing whatsoever on solving anything.

I do realize experts are boring, and they typically do not present well. They tend to offer a long, detailed, often complicated analysis of the issues, and we no longer have the attention span to deal with such. After all, who needs to study books when you can simply find all the answers in a one-paragraph entry on Wikipedia.com?

This phenomenon is not directly related to the financial crisis, but it sure has impacted the aftermath. Barely one year from the apex of this crisis and revisionist histories are already being written. The problem is that the true causes of this crisis are very complicated, and our modern media doesn’t do complicated. They do pundits and polls.

One of the issues coming out of this era of the uninformed strongly held opinion is that pundits don’t just pick their point of view; they actually get to pick the facts. I have read several articles that will have a sentence beginning something this one from a recent issue of The Wall Street Journal: “The fact that our current troubles are the consequence of government’s withdrawal from the economy…” This is not, in fact, a fact. The person who wrote this obviously has never worked in our economy. Government is everywhere in our economy. The author may believe we have too little regulation, and he is certainly entitled to that point of view, but that is his opinion, it is not a fact. This is, in my opinion, the primary reason our politics have become so hateful: people with differing points of view can intelligently debate each other and remain respectful, but people who choose to make up facts cannot be reasoned with.

Unfortunately, this particular fiction is fast becoming consensus in government circles. The danger of this avoidance of the truth is that we will end up not addressing the actual causes of the financial crisis. If we don’t address all the causes we will be doomed to repeat this chapter of our history. It won’t be exactly the same, but we’ll face these issues again. To paraphrase Mark Twain, history doesn’t exactly repeat itself, but it sure does rhyme.

One year after the apex of this crisis, not only has government gotten off clean in the media consensus view, but the real attack is on capitalism itself. Michael Moore has a new movie out entitled “Capitalism: A Love Story”. I have not seen the movie but I have read interviews with Moore about it. In one interview Moore states, “Capitalism is evil and you can’t regulate evil.”

He goes on to argue that capitalism is a big scam that was devised by the rich to convince the regular folks that if they worked hard, they too could be rich one day. Moore says this is a big fat lie. I’m curious how Moore, the child of a secretary and a factory worker who has become a multi-millionaire movie producer, explains his own life story under this “big fat lie” theory.

Ayn Rand once said, “The hardest thing to explain is the glaringly evident which everybody had decided not to see.” The overwhelming superiority of capitalism over every other economic system is so glaringly evident that it is indeed difficult to explain. Yet people like Michael Moore condemn the very system that makes their material existence possible. Moore is a poster child for capitalism, yet he condemns it.

Perhaps the best way to explain it is to go to the dictionary and define it. Dictionary.com defines it as follows: an economic system in which investment in and ownership of the means of production, distribution, and exchange of wealth is made and maintained chiefly by private individuals or corporations, esp. as contrasted to cooperatively or state-owned means of wealth. In other words, capitalism is simply a system of private property. When we think of property we tend to think in big wealthy terms, but property begins with a much smaller radius. It begins with your ownership of yourself. Capitalism is freedom, and to call it evil is the mother of all uninformed strongly-held opinions.

In The Seven Habits of Highly Effective People, Steven Covey points out that effective people focus on what they can control. In this article I have taken my turn to vent about what I think is wrong, however I have no control over the media, or public perception, or the overall direction of our nation. I and the rest of the staff at Iron Capital can control only how we react to these forces and how we allocate our clients’ money. The current attacks on capitalism and the resulting growth of government will have the same negative impact it has always had. In the 1930s and the 1970s, these same forces brought us economic stagnation, high unemployment and markets that were volatile but went nowhere. On the bright side, these decades also gave us investment greats like Benjamin Graham and Warren Buffett. There will be positive investment opportunities and we will find them for our clients. That is my pledge to you. This too shall pass, and the pendulum will swing back. Truth has a way of coming out in the end. We may be heading into a dark chapter, but the American story isn’t over yet.

Charles E. Osborne, CFA, Managing Director

~My Turn

“YET EACH OF US DEFINES THE LONG RUN WITH A DIFFERENT TIME SPAN IN MIND, WHICH MEANS THAT YOURS WILL BE APPROPRIATE FOR ME ONLY BY COINCIDENCE. NO MATTER HOW WE FIGURE IT, THE LONG RUN MEANS MORE THAN SHUTTING YOUR EYES AND HOPING THAT SOME GREAT TIDAL FORCE WILL BRING YOUR SHIPS HOME SAFE, SOUND, AND LADEN WITH JUST THE RIGHT MERCHANDISE FOR THE OCCASION.”  ~ Peter L. Bernstein

The investment world lost one if its shining stars this quarter with the passing of Peter Bernstein in June at the age of 90. The author of numerous books on economics and investing, most notably Against the Gods: The Remarkable Story of Risk, and founder of The Journal of Portfolio Management, Bernstein certainly belongs in the investing hall of fame. He spoke often about the misunderstood concept of long-term investing. He wrote: “The long run smooths the data by averaging out the wild volatility we experience in the short run. Therein lies its fascination. But therein also lies a mass of wishful thinking and oversimplification.”

Wall Street is broken – I believe we have made that point clear in our last two newsletters – but, what now? How do we get back to where we were and then on from there?

The first step is to understand the wisdom of Michael Price, legendary investor and founder of the Mutual Shares family of mutual funds, who said, “Wall Street is in the business of generating fees for Wall Street. Period. It is not in the business of getting good investment results. You have to separate from Wall Street to do that.” Wall Street also has dominated the communication to and education of the average investor over the last twenty years or more. That education is primarily marketing and while not un-true, it is filled with a mass of wishful thinking and oversimplification. Let’s debunk some of those oversimplifications.

I HAVE NOT ACTUALLY LOST MONEY UNTIL I SELL. This idea has become so ingrained in investor  behavior that psychologists have created a name for it: the ‘break-even effect.’ People hate to admit a mistake, and holding onto losers until the value comes back makes one feel as if nothing was ever lost. We saw this in our clients last year and earlier this year as many questioned why we were reallocating their accounts, causing them to realize losses. We hear this from prospective clients, who wish they had been with us last year but don’t want to move until they have regained at least some of their losses.

This doesn’t impact just the lay person; many professionals fall into the same trap. In his book Your Money and Your Brain, Jason Zweig cites a study of mutual funds that got new managers. Researchers ranked the funds’ holdings from the best to worst return. On average, the new manager sold 100% of the worst-ranked securities, which implies the old manager was paralyzed by his own mistakes. The funds that cling most desperately to their losers underperform by up to five percentage points annually.

When Warren Buffett was a young man he spent a lot of time at the race track. On one particular day he lost money in the first race, so he decided to double down on the second race. He lost again. The trend continued all day until he had lost all of his money. The lesson he learned, which he says he still uses to this day, is that you don’t have to make it back the same way you lost it.

This does not mean you should simply sell out any time a price goes down – that would be another oversimplification. Sometimes a price drop is an opportunity, while other times it simply means what you own is not worth what you thought. The wise investor must be able to discern the difference.

ONE SHOULD SIMPLY “BUY AND HOLD.” This is the fallacy that Bernstein was debunking in the quotes cited earlier. Investing for the long term is, in our opinion, the correct way to invest. In the history of the market there is not one credible account of anyone who has been successful at rapidly trading in and out of positions for any prolonged period of time. That is not from a lack of data. Countless people fall for the allure of thinking they can beat the market by various timing strategies, but this is a loser’s game. It is wiser to invest for the long term. Warren Buffett once said, “Don’t own a stock for ten minutes if you don’t intend to own it for ten years.” This is a principle that we adhere to at Iron Capital.

Nevertheless, just because you intend to own a stock for ten years when you first buy it does not mean you should bury it in the back yard and forget it. I will bet my home that Warren Buffett would sell a stock two days after he bought it if someone came along and offered far more than Buffett thought it was worth, or if some new information came out that forced him to question the original decision. There does come a time to sell.

ASSET ALLOCATION DETERMINES RETURNS is another favorite oversimplification. People who promote this idea often quote a study by Brinson, Hood and Beebower, published in 1986, which examined 91 pension plans and concluded that asset allocation decisions determine more than 90% of the variability of returns. Financial advisers love this study and oversimplify it to the point that they will tell clients that it really doesn’t matter what funds you use… therefore those C-class shares that pay them handsomely are just as good as lower-cost, better-performing options.

Asset allocation, or more broadly portfolio construction, is indeed hugely important. The level of importance,  however, is dependent on how you invest in the various assets. As David Sewensen, chief investment officer of Yale’s endowment, states in Pioneering Portfolio Management, asset allocation is the most important factor in the performance of large institutional portfolios largely because they have chosen to make it so. Most institutions use several managers per asset class and they prefer managers who don’t stray too far from their index. Those constraints greatly limit any value an active manager could add, therefore any value added must come from asset allocation. The smaller and therefore more concentrated your portfolio, the more important security selection becomes.

With all the talk in the investment world about portfolio construction, it is shocking to me how few practitioners actually understand how to build a portfolio. This is without a doubt the number-one flaw we see in portfolios we inherit from other advisers. I can only recall one prospective client who has ever come to us with a portfolio that had a coherent strategy evident in its construction. Although the strategy was different than ours at the time, I told the prospective client that he had an adviser who obviously knew what he was doing and that he should stay with him.

Usually what we see is a hodge podge of funds, stocks and ETFs, with no coherent theme whatsoever. It is what a former colleague of mine used to call ‘the front page Wall Street Journal approach,’ because it looks like the investor got up every morning and put money in whatever happened to be on the front page of the paper that day.

So how do you construct a portfolio? The basic premise is simple. At any given time you want to have the most money in the area of the market that has the highest probability of performing well going forward. You must, however, balance that with the risk that you could be wrong, so diversify with investments that all have promise but are unrelated to one another.

So what does that mean for today? We must understand the world we are in, and realize that this is most probably not the world that we wish it to be. Focus on quality, as this economy is a long way from recovery and many weak companies are yet to fail. Realize that government intervention is here to stay for the foreseeable future. Vote how you will, but do not fight Washington with your portfolio – you cannot win that battle. Also understand that Washington’s backing may guarantee survival, but it does not guarantee success. Be wary of unproven industries propped up by their political popularity, since such popularity can change quickly. Realize that the world does not revolve around the U.S. and that while the last century was certainly ours, the odds are that this one will not be.

This is a time for active management. It is a time when it is critical to understand what we own, and what is happening to those businesses. We must be able to recognize the difference between short-term market volatility and actual deterioration of a security’s real value.

We are entering a period where the broad market may go nowhere as the broader economy goes nowhere, yet there will be clear winners and losers. We are entering a period where portfolio construction will really matter, and those who understand that should do well, but those who simply close their eyes and hope that some great tidal force will bring their ship home safe, sound, and laden with just the right merchandise for the occasion will most likely be very disappointed.

CHUCK OSBORNE, CFA, Managing Director

~Where Do We Go From Here?