The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
JOHN WOODEN is arguably the greatest coach of all time. What made him so good? Coach Wooden admitted that he was not the greatest tactician in basketball. He gave Dean Smith credit for being the best teacher of fundamentals he had ever known. He credited his own success to his attention to detail.
It is as much of a holiday tradition as turkey on Thanksgiving and presents under the tree Christmas morning: New Year’s resolutions. Lose weight, exercise more, read more, be on time for a change, and manage my money more wisely. It is all good stuff, but does it work? According to Psychology Today, resolutions work for about two weeks….
There are two myths regarding policy that I take pleasure in dispelling, the first being that our two political parties are somehow wedded to certain policies that they own. Such as Republicans cut taxes and Democrats raise them; Democrats increase welfare programs and Republicans decrease them; Democrats regulate and Republicans deregulate.
The laws of economics are not just about bean-counting at some fictional company or make-believe nation. They are real and they impact our lives in much the same ways of the laws of physics. Diminishing returns are everywhere, including the ingestion of candy. The first bite is always the best and no matter how good something tastes, eventually your body will say, “no more.”
I have a confession to make. I found myself at the end of the first quarter of 2016 needing to write a newsletter and for the first time in memory I had no idea what to write.
JOHN WOODEN is arguably the greatest coach of all time. Not just the greatest basketball coach, but perhaps the greatest coach of any kind. The man won ten national championships. To put that in perspective, that is twice as many as Mike Krzyzewski. What made him so good?
In his book, “Wooden: A Lifetime of Observations and Reflections On and Off the Court,” Coach Wooden admitted that he was not the greatest tactician in basketball. He gave Dean Smith credit for being the best teacher of fundamentals he had ever known. He credited his own success to his
attention to detail. The most famous example of which was his annual first practice. Many coaches have first practice rituals. Dean Smith made his team run as fast as they could for 12 minutes, a tradition also used by football coach Don Shula. Wooden, however, spent his first practice teaching his players how to correctly put on their socks.
That is right. Wooden would sit his team down and show them the proper method for putting socks on their feet. This might seem silly, but remember Wooden’s prime was in the 1960’s and early 1970’s. Today when I go for a run I put on socks that are made from a manmade material that wicks away sweat. They are contoured to my feet and marked right and left so I know which sock goes where. In Wooden’s day the socks were cotton and they were straight tubes. They would get wet and sag and rub, and most importantly cause blisters. Blisters hurt, and if you have blisters on your feet you are likely to move slower than if you don’t.. Wooden wanted his team to be the faster team on the court, which meant they had better be blister-free, and that required adequate attention to putting socks on properly.
It also sent a message to his team: details matter. I wrote about this back in 2010 when Congress was debating massive new regulations of the healthcare and financial industries. I focused on what I know best, the financial realm. We were recovering from the financial crisis, which was blamed on a lack of regulation. For those of us who have spent our careers in the financial world it was laughable to suggest that there was not enough regulation, yet to the outside world this was a simple, easy explanation for the financial crisis, and therefore it became the unquestionable story.
I argued at the time that most in the financial world would welcome regulatory reform. It should not be about the number of rules, but about getting the rules right. There should be a consolidation of regulators. As it stands now some large financial firms have as many as five different regulators, and they tend to contradict one another. It is a major frustration for ethical firms just trying to comply, but an opportunity for those who wish to shop regulators. This was a problem leading up to the crisis and it was only made worse by the addition of the Consumer Financial Protection Agency. Instead of having fewer regulators, the big banks got one more.
Just as I was writing this, the media announced that Wells Fargo has “clawed back” $75 million in compensation to their former CEO and the former head of community banking Carrie Tolstedt. This was in response to the fact that Wells Fargo, specifically the department run by Ms. Tolstedt,
created fraudulent accounts in order to meet sales goals and receive bonuses.
The outrage over this scandal, which broke into the news last Fall, is understandable. However, I have yet to read a mainstream news article asking the question, Where were the regulators? Let us count them: There is the aforementioned Consumer Financial Protection Agency; the Securities and Exchange Commission; the Office of the Comptroller of Currency; The Federal Reserve; and the state regulators in California and Arizona where most of these activities took place. Which one of these policemen caught Wells Fargo red handed? It was the LA Times.
If adding regulations and regulators worked, then we should be all for it; but it doesn’t. This is a fact that many in America have come to accept. Now there is a different political wind blowing. The desire for a change of course – any change of course – was sounded loud and clear last November.
Leading up to our general election for the office of president, a political outsider with an abrasive style received 45 percent of the Republican primary votes – enough to win in a very crowded field. On the other side a self-described socialist won 43 percent of the Democratic primary votes. In a field of only two, that similar result did not have the same effect. However, put together, a strong majority of voters agreed that the current path was not working.
The day after the election the stock markets rallied, and this strong momentum is just now beginning to slow. We will never know, but I suspect that the rally would have taken place regardless of the victor. The day after the election I believe the markets were mostly excited about the fact that there was no call to count the hanging chads in south Florida; that the election was decisive was enough of a call for celebration in and of itself. I say this because there was a real fear that the election would not be decided on election day, and that outcome would have been taken as the worst possible outcome by a market that dislikes the perception of uncertainty more than anything.
I also say this because the rally actually started in the third quarter, before the election and during a time when most experts were calling for the
opposite outcome. The rally took place because for a few years the market had been so focused on the lack of economic growth and the extraordinary moves of the Federal Reserve that most stocks were priced well below their real value. After all, stock is simply ownership of a company. Ultimately it is the business results of the company that should matter. Politics, interest rates, and the daily news obsessions may have some impact on the business of various companies, but they are not the biggest driver. People buy iPhones is communist China just as they do in democratic America. Eventually the market comes back to business fundamentals and that is what started the rally.
That fact notwithstanding, the outcome of the election has certainly influenced the character of the rally. The stocks of financial companies took off like wildfire, and that probably would not have happened to the same extent. International stocks initially did not participate, although they have gotten back in the game more recently. These occurrences are influenced by the anticipated policies of the new administration. This is an important distinction. Our current political atmosphere is emotional, and it is driven by personality over substance. Financial markets, on the other hand, are not reacting to personality. While there may be some short-term trading on tweets and other out-of-context comments, the real trading is about policy.
I know it is an old-fashioned notion, and perhaps a bit romantic, but at Iron Capital we still believe that actions speak louder than words. There are
three actions that the market is anticipating. First, the market anticipates tax reform, and at the very least, corporate tax reform. Secondly, the market
anticipates de-regulation. Finally, the market is anticipating some restriction in international trade. We see the first two as positives, while the latter would be a huge negative.
Let’s take these in order. Corporate tax reform is one of many issues where just about all experts agree on the need for it to happen. Yet because of our dysfunctional political environment, nothing gets done. Meanwhile the U.S. has lost its competitiveness internationally because we have among the
highest corporate tax rates in the world. Some would argue this is misleading because so many corporations have been given favorable treatment and/or find loopholes. What is not fully understood is that this is precisely the problem. High tax rates always lead to political favors for the well-connected. Again, there is no debate on this in economic circles. Sure, different economists may have different ideas about what an ideal reform would look like, but there really is not anyone who does not agree that reform is necessary.
Similarly, the need for regulatory reform is universally agreed upon. The problem the U.S. has in our regulatory mess is that old regulations never seem to die. We need rules. The rules should be clear, and they should hold people accountable. Take Wells Fargo’s Ms. Tolstedt for example. She fraudulently created accounts to hit sells goals and gain huge bonuses. The Dodd-Frank financial reform is 848 pages long, and that is just the tip of financial regulation. While Wells Fargo itself is going after Ms. Tolstedt, there are no reports of which we are aware that any regulatory body is trying to prosecute her. Compare that to the Eighth Commandment, “Thou shall not steal.” That is just four words, but Ms. Tolstedt would have a difficult time escaping accountability from that regulation.
Trade reform is a trickier issue. While it is understandable that some people see protection from international competition as a good thing, the fact is that international trade is a net positive for all involved. Without trade our lives would be far more difficult. However, some countries have cheated on trade deals with very little ramifications. As with all these issues, we are guilty of speaking in very broad terms. Trade is a positive thing, but are our friends in Canada subsidizing lumber prices to undermine U.S. competition? Senator Ron Wyden of Oregon called this, “the longest running battle since the Trojan War.”
It is easy to say we need tax and regulatory reform. It is easy to say that trade is good. However, the devil is always in the details. The market has rallied a long way since the election largely on the assumption that we would get lower taxes, better regulation and that the trade talk is only talk. No one knows if any of these things will happen. If they do happen, what will they look like?
We are as happy as anyone that the market has rallied over the last three quarters, and all in all we are happy with the results we have been able to deliver. However, we did not make a single decision based on policies that have not happened. We did not “bet” on any outcome of the election, and we have not piled on to hot trades built on assumptions of details to come. If we have said it once we have probably said it a thousand times: Prudent investment decisions are made from the bottom-up: Is this company a good investment? This means that prudent decisions are not made from the top-down: What impact will Trump’s policies have?
Don’t get me wrong. I would love to see thoughtful tax reform. I would love to see simpler regulations that bring actual accountability. I hope we don’t repeat the trade mistakes that contributed to the Great Depression and ultimately to World War II. But, these wishes are not the basis for prudent investing. We will stick to making bottom-up investment decisions and pray that policymakers understand that details still matter.
Chuck Osborne, CFA
~Details Still Matter
It is as much of a holiday tradition as turkey on Thanksgiving and presents under the tree Christmas morning: New Year’s resolutions. Lose weight, exercise more, read more, be on time for a change, and manage my money more wisely. It is all good stuff, but does it work? According to Psychology Today, resolutions work for about two weeks. Most people are backsliding by February and by the end of the year they are right back to making the same old resolutions. This is the year I will save more in my 401(k).
So why do we fail? Part of the reason, according to psychology professor Peter Herman, is that many of us have “false hope syndrome.” We pump ourselves up with unrealistic expectations and then we get depressed when we don’t meet them. So, we quit.
This isn’t just about resolutions. Any goal-setting can often become a trap. Peter Bregman, writing in the Harvard Business Review Blog Network, argues, “When we set goals, we’re taught to make them specific and measurable and time-bound. But it turns out that those characteristics are precisely the reasons goals can backfire. A specific, easurable, time-bound goal drives behavior that’s narrowly focused and often leads to either cheating or myopia. Yes, we often reach the goal, but at what cost?”
For as long as I can remember we have been told that we need to set goals to be successful. Yet more and more, I hear about successful people not setting goals. Two years ago I saw a Ted Talk given by a gentleman named Brett Ledbetter. Ledbetter, who runs a basketball camp, was talking about what drives success on the basketball court. When he started his quest, he interviewed as many successful coaches as he could. He spoke with people like Boston Celtics coach Brad Stevens, Duke coach Mike Krzyzewski, Kansas coach Bill Self, and many others. To his surprise, coach after coach told him that they do not set goals.
Ledbetter defined a goal as a result to which effort is aimed. The problem with goals, as most of the coaches he interviewed saw it, is that the focus is on the result and not the effort. They wanted their players focused on the effort, or what most of them called the process. That is a word that has become closely associated with Nick Saban, the head football coach of the Alabama Crimson Tide.
The Alabama football team has been in the national championship semi-finals or finals in six of the last eight years, winning four championships. The big question the media keeps asking is, how do they stay so consistent? Saban answered as follows, “I think the first thing is the way we approach competition. We don’t talk a lot about winning. We talk a lot about what do you have to do to play your best on a consistent basis…” In other words, he talks about the daily effort, or process, that one needs to be his best. Sure, they want to win – one could say that winning is the goal – but that is not their focus. Their focus is on the effort it takes to win. This may seem like a small difference but it is not. Results-based goals can provide positive (or negative, for that matter) motivation and focus, but eventually one of two things happens: one either achieves the goal, or fails. Then what? The “experts” say at this point we are just supposed to set a new goal. However, in real life the vast majority either get depressed over their failure or complacent with their success.
This is why we marvel at what teams like Alabama, the New England Patriots, the San Antonio Spurs and the Golden State Warriors have accomplished. They seemingly reach their goals but just keep going, and when they do fall short, they just pick themselves up and keep going. This phenomenon is not just in sports. Companies like Google have done away with goal-setting because they believe it dampens creativity and creates false incentives. What is true in sports and in companies like Google is also true when it comes to financial planning. We see this all the time when people make financial goals. It is reinforced by planning programs that project out very detailed visions of the future. It is reinforced by the industry in how they advertise. The company Voya (formerly ING) used to have a commercial that asked if you knew your number? The number they were referencing was the very specific amount of money that one needed to have to retire.
Before I go further, let me be clear: Retirement goals are useful. It is good to have a vision of where one is heading. We run these projections for our clients often. We are careful, however, to make sure the client understands that they are just projections. They give us an idea of what might be, they are not concrete numbers that you can walk around with like the characters in the Voya commercial.
While these projections are helpful in making current decisions, they also have pitfalls that should be known. One of these pitfalls is the illusion of accuracy. Benjamin Graham and David Dodd wrote a book called Security Analysis, which was originally published in 1934. It is like the bible of my industry. In fact, it is thicker than the actual Bible; that is how detailed Graham and Dodd were in their analysis of investment opportunities. Yet the first chapter of this book is basically a warning: No matter how much analysis one does, the future is still uncertain. Graham and Dodd knew that the biggest trap for the professional investor is over-confidence. My model says this is what will happen so I “know” this will happen. Unfortunately no one nows what is unknowable.
One can be as detailed as one wishes in financial planning, but eventually life happens. Jobs that were thought to be secure are not. Health which was taken for granted is no longer certain. Markets surprise us in both directions. No matter what we plan, the odds of our plan working out in exact detail are simply astronomical. In the meantime, over confidence in our plan can lead to significant problems with the effort, or process, that drives the plan. This is especially true for those who have done well until now. They have saved and invested prudently and now the computer says the goal is on track. Then they start to stop doing the things that got them in good shape from the start. They reduce their savings rates or do imprudent things in their investing. They may take undue risk because they figure that they have their goals met or they might get too conservative thinking they no longer need growth from their portfolio. More often than one might believe I have had the conversation with people in this situation and had to convince them that there is no such thing as having too much money to retire.
More frequently we see the problem of the goal being too big. “There is no way I can ever retire so why try?” This is the problem of failing to reach artificially specific goals. I needed to lose 30 pounds and I only lost 15, therefore I’m a failure. That is nonsense of course, but this is the downside of being so focused on the goal. Anything that can be saved for retirement is better than nothing. Sure, one should start as early as possible, but there is no such thing as too late. So many people look at the size of their “number” and just lose confidence. Losing confidence is one step from giving up.
Part of this is unrealistic goals. When the Germans invented the concept of retirement age with the world’s first government-sponsored retirement program, they decided it should be 65. Life expectancy was 62. If we were to invent retirement today, we would be looking at an age near 80. Yet we are programmed to believe that we need to retire at 65, and of course no one wants to be average, so really we all want to retire early. For many people that is not realistic, which isn’t a bad thing. Retirement for many people is not what they thought. This is a topic for another newsletter, but work does not give one just a paycheck. It gives purpose, it gives social interaction, it gives a sense of accomplishment.
One must have a plan for replacing these things. The successful retirees are those who not only saved a lot, but also found ways to stay connected to the world. For many that means going back to work. One may not be able to reach the goal, but if he could get half way, and then cut his work hours in half, that could be a great retirement for many people. However, if the knowledge that the “goal” is out of reach leads to just giving up, then that won’t happen. For some the goal seems bigger than it is. This is especially true among those who are still 20 or so years away from retirement. One of the great mysteries of life is the magic of the compounded return. Today my industry uses computer programs to project the future, but when I started my career we had something called the rule of 72. If one knows the rate of return that she can expect on her retirement portfolio, then she can divide that into the number 72 and the answer tells her how many years it will take for her nest egg to double in size. My first boss had an expression, “It is the last double that gets you there.”
What did he mean? It takes the same amount of time for $1,000 to turn into $2,000 as it does for $500,000 to turn into $1,000,000. Nest eggs do not grow in straight lines. They begin by growing slowly from a dollar perspective, which is how most people view their savings. Then as they grow, the growth becomes faster and faster. An 8 percent return on $10,000 is $800. The same return on $100,000 is $8,000. So people in their 40s who have been saving for several years often look at what they have and say this is just not growing. How could it reach that goal? What they don’t understand is that it is the last double that gets them there.
The variances of life are out of our control. The reason people like Nick Saban focus on the process and not on winning (the goal) is because real winners focus relentlessly on what they can control. If a goal is what Ledbetter says it is – a result at which effort is aimed – then the people who focus solely on what they can control will be focused on the effort. Instead of goal-oriented, they become processoriented. Instead of living and dying with every result, they focus on progress. They don’t ask, “Are we there yet?” Rather they ask, “Are we headed in the right direction?”
This is what we try to do at Iron Capital: Focus on what we can control. Help our clients save as much as they can, not just what a computer says they should. Help them make prudent investment decisions, not drift in and out trying to find the fast lane to some goal. We say it this way: We strive for perfection, we make progress. That is what keeps one humble when goals are met and keeps one going when they are not. Save all you can and invest it prudently – that is the best financial resolution one could ever have.
Charles E. Osborne, CFA
Every four years in our country we have a presidential race, which means every four years we get at least some real discussion on government policy. At least that is the normal course of action; this year most rules don’t seem to apply. But, since the current state of our politics has the vast majority of us disgusted, we will pretend this is a normal year and there are policies to discuss. Iron Capital is honored to serve a diverse group of clients and it is our role to make investment decisions, not to weigh in on politics. Policy, unlike politics, affects the economy, which impacts your investments.
There are two myths regarding policy that I take pleasure in dispelling, the first being that our two political parties are somehow wedded to certain policies that they own. Such as Republicans cut taxes and Democrats raise them; Democrats increase welfare programs and Republicans decrease them; Democrats regulate and Republicans deregulate. These are all myths. John F. Kennedy cut taxes while Richard Nixon expanded welfare programs and George W. Bush created the first new entitlement program since LBJ’s Great Society. Jimmy Carter began the de-regulatory movement of the 1980s and 1990s. I could go on and on. Part of this phenomenon is because economic philosophy and political philosophy are not as tied together as many are led to believe, and part of it is that Congress, not the president, actually controls policy.
The second myth is that different areas of policy are unrelated to one another. This, I believe, is because of the presidential debate system. Granted this year’s version looks more like mud wrestling, but in more normal election cycles we get a debate about this policy, then a separate debate about that policy. The problem is that all policies actually relate to one another in the real world. For example, let’s take two policies we have heard a lot about in this election: international trade and regulation of corporate America.
Let’s begin with trade. Free trade between countries is under attack this year, but before we go into those details we need to understand why trade exists in the first place. To make things simple we will use two countries, both of which make only two products: they grow wheat and raise cattle. Country A is very good at growing wheat and not so good at raising cattle, while Country B is really good at raising cattle but not so good at growing wheat. In Country A they have really good bread, but the meat isn’t very good. In Country B they have great meat but the bread leaves a lot to be desired. They could go on living like this, separate from each other, but then none of the citizens of either country could have a great meal with both great meat and great bread. To do that, the two countries would need to trade with one another. Country A should sell its superior wheat to Country B in return for some of Country B’s superior meat.
In fact, if every person in each country is going to get to enjoy the superior product, then Country A should stop producing cattle altogether and only produce wheat. Country B should do the opposite and concentrate on raising cattle. If both countries did this, then everyone’s lives would be improved. Except for one problem: Half of the people in Country A work to raise cattle, and half of the people in Country B work to grow wheat. Both countries need to keep these people employed.
So what happens if everyone in Country A can now buy the better meat from Country B? Their lives have been improved, but the local cattle industry will be hurt. In a perfect world the cattle ranchers, or at least most of them, in Country A would simply convert to growing wheat. Likewise, the wheat farmers in Country B would start raising cattle. Both countries would concentrate on what they were good at, and everyone would stay employed and enjoy a better life.
However, real life is seldom perfect. Both countries have rules and regulations. The wheat farmers in Country A enjoy the benefit of being able to sell their product to the citizens of Country B. This has greatly increased the demand for their product and as a result profits have increased. They have a vested interest in protecting those profits – profits which would likely disappear if the displaced cattle ranchers start growing wheat. They will lobby their government to create rules which make it harder for cattle ranchers to convert to wheat farms. This will be done as a “protection” for consumers. After all, what do cattle ranchers know about growing wheat?
If the wheat farmers are successful in using their new-found wealth to make it harder for people to compete with them, then Country A will have an employment problem. The cattle ranchers can’t compete with Country B cattle ranchers and now, because of regulation, they can’t convert to producing wheat. Most will go out of business and their employees will be unemployed. Those that survive will likely do so by cutting prices and that will mean they must pay their employees less. Country A will now be separated into two classes – those in the wheat business who are doing wonderfully, and those who have been left behind in the new “global” world. Inequality will grow. The unemployed and under-employed cattle workers will be upset, and the most obvious target will be trade. They want a job and the only job they have known has been in the cattle industry. They will demand protection from the competition of Country B.
Trade barriers will be raised and Country B will retaliate. Before long everyone is back where they started, except now they have hurt feelings (but that is foreign policy, which is another subject entirely, right?). This less-than-ideal reality comes from a misunderstanding of what the original problem was in Country A. Humans have a tendency to focus on symptoms instead of problems. Country A did not like their cattle ranchers going out of business while the wheat farmers got rich; but the real problem is that regulation made it impossible for the cattle ranchers to convert to growing wheat. A policy of free trade does make everyone better off, if it is paired with a regulatory policy that promotes new business instead of preventing it.
Joseph Schumpeter was a midtwentieth century economist who coined the phrase “creative destruction” to describe the process of the death of an old industry making way for the new. In our example the cattle farmers in Country A that were forced out of business, aka destruction, could then start farming wheat, or in a more realistic example with more than two products perhaps grow grapes (after all, what good is good meat and good bread without some wine?). This is what happens in real life as long as the rules allow, or better yet encourage, the creative renewal.
My wife and I recently had a rare evening where we could sit together and just watch a movie. We watched “The Intern,” in which Robert DeNiro plays a retiree who signs up for a senior citizen internship at an online retailer run by a young entrepreneur (Anne Hathaway). DeNiro’s character had produced phone books, and now the business in which he had spent his career was obsolete. In a neat twist, Hathaway’s Internet business occupies the same building in which DeNiro spent his entire career. I can’t imagine a more poignant example of creative destruction. The phone book company was gone, but in its place was a new company the existence of which would be beyond the imagination of DeNiro’s character when he was beginning his career.
This is how free economies are supposed to work. We look a lot like Country A today. Economists know that trade protectionism was a major cause of the Great Depression. This led ultimately to strained international relations and the rise of Nazi Germany and World War II. Because of this knowledge trade relations, until very recently, have been improving to the benefit of many industries. Approximately half of the earnings of the S&P 500 companies, roughly the largest 500 companies in the U.S., come from overseas. Many people have been like the wheat farmers that benefited from free (or at least freer) trade. Others have been left behind as some industries have had trouble competing and factories have shut down.
Our problem is that while trade policies have become increasingly liberal, we have simultaneously been growing the regulatory leviathan which has made it more and more difficult to create the new. This puts us in a place with the worst of both worlds: We have the destruction that can come from free trade, but without the creation that comes from free markets. The Wall Street Journal recently pointed out that the number of initial public offerings (IPOs) on Wall Street is the lowest it has been in 20 years. This means we are not creating new businesses to take over the old. Harvard professor Robert Barro wrote an op-ed published in The Wall Street Journal on September 20, 2016, in which he outlined why the recovery from the 2008 financial crisis has been so slow. He blamed it on a lack of growth in productivity and went on to say, “Variables that encourage economic growth include strong rule of law and property rights, free trade, rolling back inefficient regulations and other constraints on market activity…”. In other words, our problem isn’t trade; our problem is regulation.
This is a policy issue which should not be a political issue. Former Senators Bill Bradley (D-N.J.) and Alan Simpson (R-Wyo.) both sit on the advisory board of an organization called the Common Good, whose mission is to overhaul government and legal systems to allow people to make sensible choices. They speak of restoring common sense. They claim polls show that huge, bipartisan majorities of America’s voters support their initiatives. I believe them.
Wouldn’t be nice to hear two intelligent, thoughtful, maybe even dignified Americans debate the details of restoring our creative economic engine? Instead we get crude sexism and illegal emails. One candidate promises protectionism and the other promises to double down on the regulatory explosion of the last 16 years. Sometimes it looks like the worst of both worlds.
This brings me back to the beginning. One of the reasons that the economic policies of different presidents did not always jive with our perception of party identity is because Congress, not the president, creates policy. One of my personal political pet peeves is that I have to wait in a long line to vote for the president, but two years later get to walk right in to vote for my congressman. Iron Capital has never endorsed a candidate or suggested to our clients how they should vote, but this year I will say this: Please vote. Especially to those clients who are among the majority of Americans who would select “none of the above” were it an option. Vote for your congressman, your senator, all of your local open seats and any ballot initiatives. Vote for all those things that don’t get the national attention of the presidential race, and do it again in two years. It is these things that create the direction of government policy, and policy matters.
Charles E. Osborne, CFA
~Worst of Both Worlds?
The Law of Diminishing Returns
What kid does not like Tootsie Rolls? I know I liked Tootsie Rolls when I was young. In fact, I loved them. I couldn’t get enough of them…until my Mom took me on a trip to visit my oldest sister. She was out on her own and we were going to visit her for a few days. My sister had a candy jar full of Tootsie Rolls. I don’t remember if I asked for permission or if I thought I was being sneaky, but I ate a lot of Tootsie Rolls that day. I ate and I ate and then…well let’s just say I didn’t feel so good.
To this day I can’t stand the thought of ever eating a Tootsie Roll. Even writing this is making my stomach a little queasy. However, I learned a very valuable lesson that day: the economic law of diminishing returns. It was an important lesson.
If one were to look up the law of diminishing returns he would see something boring like an explanation about why incremental productivity gains of adding an employee get smaller with every employee added. If a company has only one employee then adding a second doubles productivity. Adding a third will increase productivity by a third, etc. These types of explanations, while accurate, are probably why so many don’t understand or like economics.
Fortunately for me I had some good teachers who brought these concepts alive. The laws of economics are not just about bean-counting at some fictional company or make-believe nation. They are real and they impact our lives in much the same ways of the laws of physics. Diminishing returns are everywhere, including the ingestion of candy. The first bite is always the best and no matter how good something tastes, eventually your body will say, “no more.”
Kids today don’t even know what a newspaper is, let alone a newspaper vending machine. For those of us that remember these contraptions, there is a reason those machines were structured differently than drink vending machines. The value of some items diminishes faster than others. A second Coke might not be as good as the first, but it is still
pretty good; a second newspaper is worthless. Once one has read it she is done with it. That is why the old newspaper vending machines opened up and allowed anyone who wished to take every single paper for the price of one. Other than the occasional Good Samaritan who would take them all out and place them on top of the machine allowing others to enjoy a free paper, or the unscrupulous entrepreneur who would take them all and re-sell them, most people would take their one paper and leave the stack inside. That would not likely be the case with a drink machine.
This also works with exercise. There have been many studies out recently saying that a short burst of strenuous activity is better than hours and hours on a treadmill. There have been studies showing that excessive exercise can even be harmful to one’s longevity. Of course our culture is full of such warnings: “Too much of a good thing.” “Everything in moderation.” Grandma may not have had a degree in economics, but she understood the law of diminishing returns.
It is really too bad that Grandma is not a central banker. The law of diminishing returns impacts many parts of our lives but it is most obvious with economic decisions. (It is an economic law after all.) Central bankers learned many years ago that they could stimulate economic activity by lowering interest rates. The theory is pretty simple: Interest rates represent the cost of borrowing money. The lower that cost, the more willing one might be to borrow money. That money would be used for many activities from buying houses to starting a new business. If the central bank could lower the cost of borrowing, then all kinds of people might be more willing to borrow and use those funds to produce economic activity.
Why is this important? This realization gave government two tools to use in its ongoing effort to control the direction of the economy: the government could use fiscal policy, which is the ability to tax its citizens and spend that money on various projects; or it could use monetary policy, which is the ability to manipulate the amount of money in the system through interest rates. Both tools are about putting more money into the system. The government could lower taxes, which would allow people to keep more money and therefore spend more. It could increase spending, which would put money directly where the government wanted it. It could also lower interest rates, allowing for more borrowing of money. Through the 20th century governments tried all of the above. They found that the third tool, lowering interest rates, was actually the most effective way to stimulate the economy.
Governments did not, however, count on the law of diminishing returns. The last time any government around the world saw fit to go the other direction – to actually slow the rate of growth in the money supply – was when Paul Volcker was appointed Chairman of the Federal Reserve by President Jimmy Carter. Volcker raised interest rates in an effort to combat inflation. Mortgage rates, which today are around 3.5 percent, topped out at 18.5 percent during Volcker’s tenure.
His war on inflation did two things. One, it worked in defeating inflation and stabilizing the value of the dollar. Two, it set up an interest rate environment where central bankers could constantly lower rates for more than 35 years. Rates have been dropping ever since and today much of the world actually has negative interest rates. Switzerland’s rates actually went negative all the way out to thirty years. People are buying Switzerland’s bonds knowing that they will get less money back should they hold on until maturity. This is simply amazing and is probably the biggest market story of our generation.
How did we get here? So much of it has to do with politics. To claim that central bankers are not influenced by politics would be quite naïve. However, the other control government has, fiscal policy, is governed directly by politicians. There is politics and then there is professional politics. As a result there are lots of politicians who are fans of so-called Keynesian economic policy. John Maynard Keynes was a famous economist in the early part of the 20th Century who theorized that governments could stimulate the economy through running budget deficits, aka spending more money than they have. Politicians love that. The only problem with this is that Keynes also said the budget should balance during normal periods and the government should actually run a surplus during boom times in order to pay for the deficits. The politicians didn’t do so well on those fronts.
In addition, politicians often don’t agree on how such deficit spending should be spent, or even generated. Should the government tax less or spend more? They usually compromised and decided to do both. This has led to an abdication of any reasonable fiscal policy in much of the developed world, which means the government has only one weapon left: monetary policy. For almost a generation this has been possible because rates got so high in the early 1980s that there was a lot of room to lower, and lower, and lower rates. Now those guns are empty as well. Further, as the law of diminishing returns would predict, they do not appear to be working. Once we reached zero interest rates central banks began so called quantitative easing, which is the actual government purchase of its own debt. That didn’t work, again diminishing returns.
Now we have negative rates. This has the potential of ending as badly as my little tootsie roll binge. So what are we to do? What do we do as citizens and what do we do as investors?
As citizens we need to remember that there is another way that government impacts our lives and influences economic growth. Government makes the rules. Often lost in conversations about the economic miracle that was the 1980’s and 1990’s in our country is the role of regulatory reform. This was started by Jimmy Carter and continued by Ronald Reagan and eventually Bill Clinton. How powerful is this force?
When I was young rail roads and the phone company were both heavily regulated. Jimmy Carter freed the phone company but not the rail roads. When I was young everyone had one of two phones. They did not go with you when you left the house and long distance phone calls were incredibly expensive. Today, our phones fit in our pockets, and they run an entire Internet economy which was not even a dream forty years ago. Trains, on the other hand, still look the same. Regulation has an enormous impact on growth.
The problem with reforming regulation is what economists call rent-seeking. Unlike fiscal policy and monetary policy, which impact everyone who either pays taxes or receives
government aid, and everyone who has borrowed any money (in other words, everyone), regulation has a large impact on the industry being regulated but a negligible impact on most. This gives rise to an effort by those impacted to use their resources to influence regulation through lobbying efforts. Economists refer to this as rent-seeking; people on the political right call it cronyism; and those on the left call it rigging the system. Poor regulation slows the economy and moves what rewards still exist increasingly toward those who are skilled at seeking rents. In 1962 Milton Freidman showed that the more regulated a society becomes, the more inequality exists. This is logical. After all, the more regulated a society, the more important it is to be connected and able to influence regulation. In other words, rent-seeking is a vicious cycle which leads to more and more rent-seeking…until an economy grinds to a halt as ours did in the 1970s, and as Europe’s is now, thereby forcing reform.
As investors we must hope for improvements but plan on living in the world as it is. Political risk is alive and well. We must now pay attention to the future of economic alliances such as the European Union. We must pay attention to the political landscape of an industry. We have to think about whether the government will be friendly to this company or not. This may be unfortunate but it is our current reality.
It also makes it that much more important to look at every investment from the bottom-up. We need to know what we own and why we own it. In a world where so much is out of our control we have to focus on getting right that which is in our control. One way or the other, the world will learn (again) the lesson of diminishing returns. Hopefully we learn it the easy way and begin to see real reform, not only here at home but throughout the developed world. Or we might get sick. If we do, it will pass and then perhaps a lesson will be learned. I know I’ll never eat a Tootsie Roll ever again.
Charles E. Osborne, CFA
~Too Many Tootsie Rolls
The following is an imagined dialog with the Roman philosopher Cato. It was written by the orator and statesman Cicero who lived from 106–43 B.C.:
Scipio: “When Gaius Laelius and I are talking, Marcus Cato, we often admire your outstanding and perfect wisdom in general, but more particularly that growing old never seems a burden to you. This is quite different from the complaints of most older men, who claim that aging is a heavier load to bear than Mount Etna.”
Cato: “I think my young friends, that you are admiring me for something that isn’t so difficult. Those who lack within themselves the means for blessed and happy life will find any age painful. But for those who seek good things within themselves, nothing imposed on them by nature will seem troublesome. Growing older is a prime example of this. Everyone hopes to reach old age but when it comes, most of us complain about it. People can be foolish and inconsistent.”
I have a confession to make. I found myself at the end of the first quarter of 2016 needing to write a newsletter and for the first time in memory I had no idea what I was going to write. So instead of writing I read The Wall Street Journal and I fell upon this quote. According to The Journal, the classicist Philip Freeman has published a new translation of this ancient dialog. As I read the short exerpt, inspiration struck.
What could possibly better sum up where we are today in our national discourse than this conversation which took place more than two thousand years ago? In all that time human nature has not changed.
Nowhere is this as clear as in our politics. In both major parties we see a large shift to what economists refer to as populist policies. These are policies that sound good as sound bites, but often have very adverse consequences – con- sequences which the same policy-maker will often rail against. The analogy I have used in the past is like telling a five-year-old that they can eat all the candy they want without ever having to eat their vegetables. Five-year-olds love that idea. They also love the idea of growing big and strong. Of course as adults we recognize that those policies are inconsistent, but try convincing a five-year-old of that.
As I have been writing, one of the leading candidates for president has been on television complaining about Ford Motor Company’s plans to build a plant in Mexico. He finished by saying we can’t allow that to happen. Think about that for a second. We – the United States of America, home of the brave and land of the free – cannot allow a private company to build its plant where it wants to build it? Here is the real kicker: this candidate is running in the party that claims to be for smaller government and more freedom, and he is currently winning among those supposedly freedom-loving people.
Trade has always been one of those issues upon which populists can pounce. Protectionism, the policy of building trade barriers – like a wall, for example – was a major contributor to the Great Depression. This fear of outside compe- tition is nothing new. Trade, however, is a net positive, and for most of our history has been one of our strengths. Prior to our current globalization move- ment, trade within the U.S. was a major advantage to us globally. Civics classes are not what they used to be and many people have forgotten that our nation is a federation of 50 independent states. Our ability to trade freely between the states has long been one of America’s secrets to success. That was a huge incentive to our cousins in Europe to create the European Union, so that Europe as a whole could compete with the U.S.
Why does trade work? Think about it in the micro sense. Let’s say you have a family of four and a long list of weekend chores. The yard has to be mowed, bathrooms cleaned, laundry done and dinner cooked. Does each member of the family mow one fourth of the yard, clean their section of the bathroom, do only their laundry, and then cook four different dinners? Or, are different duties split up among the group? At the micro level it is easy to see how everyone benefits from working as a team. That is really all trade is about.
Trade as a whole is almost always a net job creator, but there is often someone who no longer has a job to do. Trade creates jobs for the trans- portation industry. Goods made in one place and sold in another must be moved. Trade lowers the cost of goods creating more demand and helping the retail industry. But, if something that was made here is now made somewhere else, then those jobs are lost.
From an economic perspective this is not a bad thing. We want to be rid of some jobs. My wife’s family has a cabin in Virginia. It is heated by a stove and a fireplace. Meals can be cooked on the grill outside or on a wood burning stove. Chopping wood is a job that has to be done every day you are there. It is a neat thing to do for a day or so, then you start to realize that losing some jobs may not be a bad thing.
Creativity takes time. We marvel today at the technological advances mankind has made in such a short period of time. My grandmother grew up in a world where cars were a novelty. Her first phone was a “party line,” and anyone could join in to a conversation. Today, ten-year- olds have smart phones and the FBI has to hack into one to get any infor- mation. Why have we come so far in such a short time? Because we lost our jobs on the farm. When it became more effective to trade with a farmer than to be one, people with great ideas were allowed to pursue them. The legendary economist Joseph Schumpeter referred to this process as creative destruction.
Granted it is hard to see. It is as hard to see as it is for the five-year- old to understand why broccoli is better to eat than chocolate. It can also be harsh, and we should do what we can to help those impacted. This is why civilized societies have for the last hundred years or so offered various safety nets. Those nets have varying degrees of success and come with their own issues. This is why policy should be an adult conversation. These issues are real and need to be thoughtfully addressed.
While trade is a bi-partisan move- ment this year – isolation is the one thing both parties seem to agree on now – it is not the only populist issue. Free college is another good example. Really, “free” anything is a good example. My grandmother’s generation understood that free did not exist. The old saying, “There is no free lunch,” exists for a reason. That does not stop some politician from insisting that something needs to be free of cost just about every election cycle. One of those things this year is college.
Like trade, this is an understandable target. The cost of higher education is absurd. Too many young adults have been saddled with questionable degrees and huge student loans. The tuition at Wake Forest University was approximately $12,000 the year I graduated. After graduation I purchased a Toyota Camry, which cost $16,000. Today a similar Camry costs around $23,000. Tuition at Wake Forest is a little more than $44,000 – that is just tuition mind you. Total cost of attendance is approaching $60,000 per year. This brings to mind another legendary economist, Herbert Stein, who has an economic law named after him. Stein’s law states that, “Things that can’t go on forever, don’t.”
Higher education cost must come down, but in the meantime let’s just make it free. We will waive our magic wands and poof – free education. This increasing belief that things can and should be free is horrifying. Cost is precisely the tool free economies use to balance supply with demand. It is what allows for prudent decision-making.
Ironically, this belief centers on the first issue, trade. In a world where everyone had to provide everything for themselves, they understood cost. Only with the benefits of trade do we forget that free doesn’t exist. My children have no idea that water isn’t free. Just the other day they were supposed to be cleaning our deck from the pollen when a water fight broke out, soaking both my children and my neighbor’s kids as well. While they were having a great time lots of water was being wasted. My wife went out and informed them that water is not cheap.
There are still too many places in this world where children spend much of their days having to fetch water from the river and carry it home. They know all too well that it is not free, nor to be wasted. No resource is free. The truth is, what the politicians really want is someone else to pay for it. Of course in the economic history of the world, nothing allows inefficiency and higher cost more than a system where the consumer is not the one paying. In fact, one of the primary elements which has led to the huge rise in the cost of higher education is the ability to have someone else pay for it, at least up front, through the use of student loans.
While this populist movement is cause for concern, it is also understandable. Real people have been hurt by things like trade and the high cost of higher education. There are many other eco- nomic issues we could use as examples. People are angry in many cases, and frankly they don’t know who to direct their anger towards. So one side blames the “one percent” and the other side blames “Washington elite.”
We have not changed. Just like the ancient Romans who wanted to grow old but complained about old age, we want our modern life with easy access to cheap goods, but we complain about free trade. We want higher education for all but we don’t want to pay for it. In the effort to have it both ways we often make things worse. This is the danger. Populism makes easy promises but brings with it economic disaster. It is like promising that one can grow old without any of the concerns of old age. It sounds great but does not work out in real life. A nation cannot fight against the laws of economics any more than an aging person can fight against nature.
Our role at Iron Capital is to manage our clients’ investment portfolios. We don’t like to weigh in on things like politics and frankly we are proud to have a diverse group of clients. But as the late Senator Daniel Patrick Moynihan was fond of saying, “Everyone is entitled to his own opin- ion, but not his own facts.” Regardless of whether our next president approaches the issues of today from the right or the left, we need someone who will approach them as an adult.
Cato finished his conversation thusly, “So if you compliment me on being wise – and I wish I were worthy of that estimate and my name – in this way alone do I deserve it: I follow nature as the best guide and obey her like a god…. Fighting against nature is as pointless as the battles of the giants against the gods.”
Charles E. Osborne, CFA
~Be Careful What You Ask For