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.
Have you ever taken something back to a store and all the store will give you is a store credit? It is aggravating, isn’t it? You may not wish to buy anything else in that store. What you really want is your money back so you can go anywhere. With international trade, this is the way local currency works. China takes dollars. Dollars are like store credits, they eventually have to be used here if you want your value.
My wife loves flowers. Her Mom and Dad both liked digging in the dirt, as they say, and they grew lots of things. This was a little different for me when we first got together; my Mom baked, and she was (still is – though she does it much less now) fantastic at it. While I did not grow up in a home that had lots of flowers, I do understand their value.
The need to produce profits also promotes sustainability, which is a very popular notion in our culture today. Most of the time, people who use this word today are speaking of environmental sustainability…I am speaking of economic sustainability.
One did not need a college education to understand that nothing is free. Everything has a cost. Why? Because everything is scarce. Scarcity is the primary issue of the study of economics: how people, corporations, governments, and societies as a whole deal with the fact that “money doesn’t grow on trees.” Even if it did, it would be in limited supply – like Georgia peaches, for example.
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.
Have you seen what children and dogs do to furniture? My family moved into our home in 2010. Our previous house had no formal living room; the entire downstairs was three big rooms – a big kitchen, a big dining room, and a great room. Our new house had a more traditional living room and a cozy den, and when we moved in my wife was excited to finally use some of the living room furniture she had inherited from her parents. We later added two chairs from my parents.
I love our living room. Most of the furniture is antique and all of it has meaning to us. There is something cool about that, which we have largely lost in a society that now buys entire rooms of new furniture, all at once. It does, however, have one downside: nothing matches. We could fix that, as it is simply a matter of getting chairs and sofas reupholstered. We almost did it once, but a wiser, more experienced soul stopped us. She said, “You have small children and dogs, you can’t have nice things.”
I was reminded of that sage advice earlier this year. A colleague and I were enjoying a very nice dinner in Mobile, AL. If you like seafood and are ever in Mobile, you have to go to Felix’s Fish Camp Grill. We were discussing the state of the union, as it were, and the unusual turn our politics had taken. Congress had passed tax reform and the stock market was at all-time highs. We came to the conclusion that if he desired, President Trump could cruise through the rest of his term and then walk away being remembered as a successful one-term president. Vice President Pence could run for office and no matter your politics, at least we would be back to more usual candidates.
I will admit to being one of those who is still not convinced that Donald Trump ever really wanted to be president. I could be wrong, but I wonder if this all just started as a publicity stunt and then suddenly he started winning. But back to our point. You can have whatever political views you wish, but the U.S. presidency is won and lost based on the economy. Ronald Reagan did not win 49 states in 1984 because California and New York used to be “Red” states. Most people – the ones who don’t talk about politics – vote based on how they feel, and how they feel is largely based on how they are doing economically. The tax reform which had just passed is going to stimulate the economy. If Trump could avoid any disasters, things should be going well in 2020. That could give him a graceful exit, if he wants it, and set the stage for more traditional candidates to run a more traditional presidential election.
Then things ran off the rails because of tariffs and a war on international trade. This brings to the forefront important questions which many of us thought we had long since passed having to answer: Why is trade so important? Why shouldn’t we “protect” our industries by using tariffs?
The instinct to build walls against foreign products is understandable. There are few things harder on humans than change. It was hard when fewer and fewer workers were needed on the farm and many people were forced to leave their small communities to get work in the big manufacturing centers. Romanticizing the old days of rural life was an American pastime long before those manufacturing jobs started giving way to the service and information economies. Change is tough, and when it seems to be forced upon us by nameless faceless “foreigners,” it is easy to think that we can just stop it from happening by putting up barriers to trade.
Of course, hiding behind barriers is no way to face life’s challenges. We know that personally, but this is true nationally as well. We may be nostalgic for old cars, but do we really want to live in Castro’s Cuba? That is what a society who builds walls against the outside world looks like.
Those who support trade barriers often argue that we have such a large trade deficit. They fret that the trade deficit is a horrible thing – after all it is called a deficit, and deficits are by definition bad, right? Usually that is true, and in my opinion this unfortunate label causes a great deal of confusion. In fact, during the presidential campaign Trump often referred to the trade deficit in terms of us losing.
Is that really true? Having a trade deficit means that we export less than we import. In other words, we are sending the rest of the world a relatively small amount of stuff, and for that stuff they are sending us back a large amount of stuff. We are giving a little and getting a lot. Who’s winning this game again?
It is at moments like this that we mourn the loss of people like Milton Friedman, who could accurately describe economic issues in a way most everyone could understand. In 1978 he spoke on this issue. At that time, it was Japan who was the foreign disruptor instead of China. This is what Friedman had to say, “Let’s suppose, for a moment, that the Japanese flood us with steel. That will reduce employment in the American steel industry, no doubt. However, it will increase employment elsewhere in America. We will pay for that steel with dollars. What will the Japanese do with the dollars they get for the steel? They aren’t going to burn them. They aren’t going to tear them up. If they would, that would be best of all, because there’s nothing we can produce more cheaply than green pieces of paper, and if they were willing to send us steel, and just take back green pieces of paper, I can’t imagine a better deal!”
Talking about the art of the deal. If we could get steel, aluminum and everything else we need for nothing more than green pieces of paper, that would be awesome. Economists know, of course, that currency is just a convenient store of value. In truth, what we are doing is bartering. We provide the world today with most of its technology, and in return, we get the products we desire. If they take fewer things from us than we get in return, then they get to hold dollars. What are they going to do with dollars?
Have you ever taken something back to a store and all the store will give you is a store credit? It is aggravating, isn’t it? You may not wish to buy anything else in that store. What you really want is your money back so you can go anywhere. With international trade, this is the way local currency works. China takes dollars. Dollars are like store credits, they eventually have to be used here if you want your value.
Today the U.S. is the largest, most trusted “store” in all of the world. That means our store credits can be traded, because there really isn’t anyone who wouldn’t want to take them, but even if China uses those dollars to buy stuff from Brazil, what is Brazil going to do with them? Ultimately there are only two things that can be done with dollars: they are either used to purchase U.S. goods, or they are used to invest in the U.S. If we have a trade deficit, then we have a matching investment surplus. That is good for our economy.
There is a reason why trade deficits peak during economic booms and bottom during economic downturns. Of course, all we have discussed thus far is what a trade deficit is and how it really is not a bad thing. We have not mentioned the benefit of low-cost steel. Yes, this hurts the steel industry, but it helps every industry that uses steal and most importantly, it helps the consumer through lower prices. I believe this gets lost on many people, usually because of the very arguments one may have heard from the steel industry regarding these latest tariffs. “We are only adding a small amount to every car.” It is just a small amount, after the small amount that was added for the passenger air bag, and the small amount that was added for the emissions standards, etc.
Lots of government-mandated items on cars are individually desirable, and all of them add just a little cost. But, when added up, the average car now costs more than half of the average family’s total income. This is what economists call rent-seeking, and it is one of the biggest dangers of an intrusive government. Every tariff brings large benefits to a few, in our example the steel industry, and brings small injury to the many. This creates a passive majority and a very active minority, which wins the day at the expense of the majority.
In our case steel workers win and consumers lose. Who are the consumers? Everyone. That means everyone, including (ironically) the steel workers. Of course, it is noble to defend steel workers – we all love the iconic image of blue-collar, middle class America. So, let’s change our example, and instead of tariffs on steel, let’s say we are talking about bailing out banks. Suddenly this begins to look totally different. Let’s say we want to protect Wall Street bankers from the Chinese at the expense of everyone else in America. That doesn’t have the same political appeal, does it?
Benefiting a sympathetic group over the rest of us seems very different from benefiting an unsympathetic group, but in fact it is not. Our founders understood that. It wasn’t about replacing a bad king with a good one. It was about not having a king at all. It is about creating a system of checks and balances where hopefully the greater good can win out over selfish interests.
What is the greater good? Politicians like to see everyone as part of some definable group. They wish to silo us, divide and concur as it were. If they do group us together it is often as workers. This seems to be Trump’s vision; he is for the workers. Economists, on the other hand, see everyone as consumers. After all, the primary reason individuals go to work is to be able to consume. Most would choose not to work if consumption was possible without it, hence the retirement planning industry of which I am a part. If this were not the case, I would not have a job.
The irony is that most of us are workers and all of us are consumers, yet workers’ interests and consumer interests are not always aligned. When in doubt, I say do what is right for the consumer. Do what is right for everyone. The healthier the consumer, the more they will consume, and the more good jobs there will be for all of us workers. They might be in the steel industry or they might not. That should be up to the consumer to decide.
This is what we have always done at Iron Capital. Our clients are our primary concern, and the more we successfully focus on our clients (the consumers), the more we (the workers) benefit. A few years ago we changed our business model to become strictly referral-only. We do not spend an ounce of energy marketing our firm or selling our services. We focus entirely on taking care of our current client base. Once we did that, we ended up doing more new business than we had ever done in the past, because our clients are far better at selling our services than we ever were. This works for many other great businesses, and it can work for our nation as it has in the past.
Until we grow up and learn that lesson as a nation, our economy will be a lot like my living room: a place where we just can’t have nice things.
CFA Managing Director
~This is Why We Can’t Have Nice Things
My wife loves flowers. Her Mom and Dad both liked digging in the dirt, as they say, and they grew lots of things. This was a little different for me when we first got together; my Mom baked, and she was (still is – though she does it much less now) fantastic at it. My father dug in the dirt, but only with his wedges…golf wedges that is, not any type of garden tool.
My mother-in-law particularly liked orchids. The care it takes to keep them happy, so that they will bloom, is amazing. She had a gift for it and she passed that onto my wife. Unfortunately, my mother-in-law is no longer with us, but some of her orchids still are, and my wife would not trade them for all the tea in China.
While I did not grow up in a home that had lots of flowers, I do understand their value. Like all self-respecting security analysts, I am familiar with what many people think is the world’s first investment bubble. It probably is not, but we don’t know a whole lot about the investing world prior to
seventeenth century Europe. This was the Dutch Golden Age; the Netherlands were the center of the civilized world, leading the way in trade, science, art, and of course military might. In 1602, the Amsterdam Stock Exchange was established by the Dutch East India Company. Investing in stocks was born.
The problem with markets and the speculators that are attracted to them is that they are never satisfied with simply investing in companies. They always want something more exciting, and it doesn’t take long for them to find something, anything. In the 1630s they found tulips. The then-rare and
exotic flower was all the rage. As their popularity grew speculators started to want in on the action, and the already-rising prices headed for the sky.
The mania peaked in February 1637. One tulip type known as the “Viceroy” sold for 3,000 to 4,200 guilders depending on size. For perspective, the annual income of a skilled craftsman was about 300 guilders. In his classic 1841 book, Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackey records one transaction where twelve acres of land were traded for one tulip. Then, as suddenly as it had started, on February 3, 1637, the prices of tulips began to fall. On February 5 they dropped like a rock, and by May of that year their prices had dropped 99.999 percent.
This episode in history has been discussed by economists ever since. Of course, like anything that happened so long ago, there are varying explanations and debates about how accurate the facts really are, but there is no doubt that the prices of tulips rose sharply and then collapsed in February 1637. Lesson learned, right?
Of course not. There have been other bubbles in history, but why don’t we just fast forward to our lifetime, or at least mine. I remember vividly sitting with my boss in his boss’s office sometime in 1999. “The market is wrong, it is just plain wrong.” That was the statement from the elder statesman. My boss respectfully but firmly said, “The market is never wrong.” I remember being torn. I was too young to disagree with my immediate supervisor, but the wisdom of the more seasoned veteran seemed more correct than not. Six months later I was in my former boss’s job and my lesson was learned. The market may not be wrong often, but it certainly can be wrong, and when it is, it is usually by a large margin.
That brings us to bitcoin. So how many presents under your Christmas tree were purchased with the digital currency or so-called cryptocurrency? Really? Same here, my answer is also zero. That may be because it isn’t actually a currency, at least not one that can be used to do stuff like buy something. So, what is it?
The truth is, I’m not really sure. That is not what worries me about the cryptocurrency, however. There have been many good investments that I did not understand the first time they were explained to me. I didn’t understand Google’s business model when they first went public. It did not take me long to figure it out. We now own shares in Alphabet, Google’s parent company. I didn’t fully appreciate the wonder that was the iPhone in 2007, but we made a good deal of money on Apple’s stock, which we no longer own. There are many things I don’t understand, but in my world, I have the good
fortune of being connected to lots of smart people who can help explain complicated investments to me. This is what worries me about bitcoin and the rest of the crypto stuff: Not only do I not understand it, but no one who I have ever talked to or read does either. Let me explain.
Here is how the usual bitcoin conversation goes:
Me: What is it?
Expert: It isn’t the currency, you can’t think of it that way. It is this technology called blockchain.
Me: What is blockchain?
Expert: It is like a giant ledger where you can record trades. It can allow you to transact wherever you want in the world.
Me: But I can do that now.
Expert: But this cuts out the middleman.
Me: The middleman is there to verify the transaction.
Expert: The ledger does that.
Me: So we just say we did something and everyone believes us?
Expert: Well no, there are these “miners” who must unlock the ledger for you. It takes a ton of computation and enough energy to light a small town.
Me: So, there is a middleman?
Expert: You just don’t get it, it’s complicated but trust me, everything will be blockchain within five years.
That is how it goes. Sometimes the “expert” will be ruder than others. Some have actually called me, heaven forbid, old. When I was young, “old” often went with “wise,” but I don’t think millennials know that. There is a man who understood far more than me about the science of our physical world. His name was Albert Einstein, and he famously said, “If you can’t explain it to a six-year-old, you don’t understand it yourself.” I have yet to meet the person who can explain bitcoin to a six-year-old.
This is not unique. There is something about human nature and it starts at a young age. I love the Tom Hanks movie, “Big.” If you don’t remember, this is a movie where a young boy made a wish to be big and he woke up as a 30-year-old man. While trying to find a way to turn himself back, he had to get a job. In his first meeting, a superior was introducing a new product that made no sense, and the 30-year-old boy rose his hand and said, “I don’t get it.” It turns out none of the adults got it either, but they were not brave enough to admit it.
I use this all the time. I call it having a Tom Hanks moment. Every analyst who has ever worked here and had to present an investment idea absolutely hates it when I have a Tom Hanks moment.
The problem with the movie is that it implies that when we were young we were more honest with ourselves, and as we grew older we lost that ability. My son is 10. He is two years younger than Tom Hanks’ character in that movie. At least four times a week I’ll ask him if he knows what something, anything, is. “Yes, of course I do Dad.” So, what is it? “Well, aaaa… I can’t really explain it.” So, every time I try to tell him the same thing: There is no shame it not knowing something, it is only dangerous if you will not admit that you don’t know something.
Just for the record, my son is not unique in this. As most of our readers know, I coach youth basketball. I will explain a drill to a group of 10-year-old boys and then ask, “Do you understand?” “Yes, Coach, we understand.” Then, two seconds later they are doing exactly what I told them not to do. One of these days I’ll learn to just stop asking the question, because I know the real answer. But this is human nature, and that nature often forces us to do crazy things. We are hard-wired to want to go with the crowd. There is safety in numbers. We want to know what others are doing, even when deep down we know that most others do it wrong. We have this desire to compare and contrast. We don’t want to miss out. Or, we are the exact opposite: We love being the naysayer, the contrarian, the one who always disagrees with popular opinion, Mr. or Ms. Let Me Tell You Why You’re Wrong. Neither of these natural tendencies are helpful when making investment decisions.
The famous investor and Warren Buffett mentor, Benjamin Graham, put it best when he said, “You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right – and that is the only thing that makes you right.” So here are my facts and reasoning regarding bitcoin.
I don’t know why we need it. No one has sufficiently convinced me that the world needs another form of currency. In fact, most of the backers don’t even bother attempting to explain this. Many say you buy bitcoin not because of the currency but because you wish to invest in the technology. However, a purchase of bitcoin is not an investment in the technology any more than buying an iPhone is an investment in technology. Buying shares of Apple would be investing in iPhone technology, but no such opportunity exists with bitcoin. These are the facts.
In terms of reasoning, the future is always uncertain, but we can reason possible futures so let’s think about that. One possibility is that bitcoin does become the currency of the entire world. So what? That would mean that my house and my investment portfolio would simply be translated to bitcoin. I still don’t want to invest in the currency any more than I would in dollars or euros, etc. Another possibility with a greater likelihood of happening is that bitcoin goes away, but we find some use for the underlying technology, blockchain. Buying a bitcoin is not an investment in blockchain, so that doesn’t help. Regulators could also step in and shut it all down. Try buying something with a Confederate dollar.
So, even if all the hype comes true one may not benefit from buying bitcoin today, but there are multiple scenarios where it becomes worthless. The investment conclusion is, we don’t fully understand what it is, and even if one thinks he does, there is no useful reason for owning it.
Know what you own and why you own it. This is a cardinal rule in investing. Why would anyone buy bitcoins? Why did they buy tulips? We have seen this story before and it does not end well. At Iron Capital we will stick to prudent investing. If you wish to gamble on some technology still in search of a useful purpose then by all means do so, but know what you are doing. That is gambling and that is not what we do here.
Chuck Osborne, CFA
~This is Crazy: Tulips, Dot-coms and Bitcoin
I have a daughter who just turned seven years old. Approximately 18 months ago she finally got over the phenomenon which will partially define children of her generation: Yes, I am speaking of the Disney movie Frozen. Much like earlier generations are defined by Bambi, The Jungle Book, The Little Mermaid or The Lion King, my daughter’s time is marked by Frozen.
My parents are lucky. Once the movie was out of the theaters there was no way for my generation to keep watching. My wife and I, on the other hand, have seen or usually just overheard Frozen at least 30 times. Fortunately for us, Disney is very good at throwing the parents some entertaining bones
that go right over our children’s heads. One such scene in Frozen is when Princess Anna is going after her sister, Princess Elsa, aka the Snow Queen in the original fairy tale, who had inadvertently turned summer into winter. Just before she freezes to death, Anna comes upon a small store which is largely stocked with summertime goods, except in one small corner. The store owner charges her an outrageous amount for her winter supplies because, “These are from our winter stock, where supply and demand have a big problem.”
This is when my confused daughter would look at me and wonder why I was laughing. She did not understand the humor of a price-gouging capitalist being plopped in the middle of a movie inspired by an old Hans Christain Andersen fairy tale. This is, however, many people’s view of what it means to be in a for-profit business: the cliché goes that it is all about gouging people, getting the most one can out of every sucker.
Last quarter I wrote about healthcare. I courageously predicted that Congress would end up doing nothing. While it is always somewhat gratifying to be correct, I admit that was not my boldest of predictions. The reason I felt so comfortable in that prediction is because healthcare requires tough decisions, and politicians don’t do tough decisions. We need statesmen for that, but this term is so far removed from our current reality that it hasn’t even been degenderfied.
One of our readers responded asking why I did not bring up insurance company profit margins as major driver of costs in our system. So, let’s bring it up.
A few years back I was on the board of an industry group now known as the Atlanta Society of Financial and Investment Professionals. They provided new board members with an orientation/training session. The material finally got around to the finances of the organization, and the first slide simply read: Not-For-Profit is an Income Tax Designation, NOT a Business Plan. What did they mean?
To understand what they meant one must understand the definition of profit. Investopedia.com defines it as follows: Profit is a financial benefit that is realized when the amount of revenue gained from a business activity exceeds the expenses, costs and taxes needed to sustain the activity. Any profit that is gained goes to the business owners, who may or may not decide to spend it on the business.
To put it another way, to be profitable an organization must spend less money than it generates. Where have we heard this before? The number one goal for individuals in financial planning is to spend less than they make. It is the only way to be financially stable. If one spends more than he makes, it will not take long for him to go bankrupt. If one even spends exactly what she makes, she still is living paycheck to paycheck and is one bump in the road away from financial ruin. Why would an organization be any different?
In fact, they are not. I have spent most of my career in for-profit businesses, but I also worked for the Life Office Management Association (LOMA) at one time. LOMA is an industry educational association and a not-for-profit organization. When I was there we had two cost-cutting reorganizations, and the second time the president was replaced with someone who could focus on the bottom line. Not-for-profit is a tax designation, not a business plan.
Organizations, just like individuals, must spend less money than they make or they will eventually go bankrupt. But, this does not directly answer the question of whether the need for profit raises prices. Let’s think on this for a while. What organizations do you associate with the term “low prices”?
My guess is that you came up with names like Amazon, Walmart, or maybe Dollar General. These organizations operate as for-profit entities. They are corporations, you know those evil things that provide people with everything they want, including jobs. Amazon recently purchased the grocery chain Whole Foods. Did you hear anyone saying, “Now that Whole Foods is owned by a business they are going to raise all their prices?” No, it was exactly the opposite.
It is shocking to me how so many people who live in a world blessed by the freedom of capitalism do not understand it and even claim to despise it. Capitalism is driven by what Harvard Business School professor Clayton Christensen calls disruptive innovation. Disruptive innovation is not invention; it is not coming up with some grand new technology. That isn’t what innovative capitalists do. What they do is take technology that already exists and make it cheaper and more available to the masses. The profit motive does not drive prices up; in reality, it does the opposite.
The motive for profits drives efficiency. It drives the quest to make one’s products available to more and more people. The only way to do that is to be better at what you do so that more people want what it is you offer, and to be able to give it to them at a price they find reasonable. Henry Ford did not invent the automobile, no matter how many times you may have been told otherwise; he invented the production line, which was a way to produce cars so cheaply that everyone could afford one. He became a very rich man by selling cars at a price his own employees could afford. Today Amazon makes reading less expensive and Netflix brings entertainment to us less expensively. This is what capitalism’s profit motive does.
If one wishes to criticize capitalism it would be much more accurate to mourn the demise of the local bookstore. Grocery stores replaced the local market and now grocery stores face off against Walmart on one side and Amazon on the other. One also could accurately point to situations where individuals cut corners to cut costs. These are far more accurate criticisms.
What about high costs? In what areas of your life do you run into outrageous prices? My guess is the first two thoughts that came to your mind were healthcare and education – both industries dominated by not-for-profit organizations. I graduated from Wake Forest University is 1992. The last year of my college experience, the full cost of attending Wake Forest was $12,000. Upon graduation I purchased the first car I ever paid for myself: a Toyota Camry, which cost approximately $16,000. Today the manufacturer’s suggested retail price for a Toyota Camry is $23,070, while today total cost at Wake Forest University is $66,512. Toyota is a for-profit corporation, while Wake Forest University would never stoop to such levels.
The need to produce profits also does something else: It promotes sustainability, which is a very popular notion in our culture today. Most of the time, the people who use this word today are speaking of environmental sustainability (which is also possible only in a capitalistic society, but that is another topic). I am speaking of economic sustainability. The need for profit drives efficiency and innovation, and without these things organizations eventually collapse. We are beginning to see this already within education. Just a few years ago Sweet Briar College in Virginia shut its doors. Dedicated alumni bailed them out, but the college is still far from out of the woods. Moody’s has predicted that college closures will triple in 2017.
When a for-profit organization suddenly becomes unprofitable, the reaction most of the time is to look for ways to cut costs. Leadership makes hard decisions which may sometimes mean cutting jobs. It is hard and unpopular, but often it is the only way to survive. On the other hand, at not-for-profits, the answer too often is to raise prices. Universities for too long have just raised tuition. This building isn’t working, let’s build a new one. Finance professors don’t like being part of the larger Economics or Business schools; fine, they can be their own department. We’ll just get a gift from an alum, or once again raise tuition. It is not sustainable.
This is also true when making investments. I would be naive to believe that no lazy executive hasn’t looked at their bottom line shrinking and decided to raise prices. It does happen. Some companies can do it more easily than others; we call it having pricing power. It is the kiss of death. Show me a company that is growing earnings primarily through raising prices, and I will show you a stock that should be sold immediately. The days of this company are numbered. When high prices exist in a world where others are free to compete, then competition is not far behind and that competition will deliver justice to price-hikers. If you don’t believe me, then ask Borders Books or Blockbuster or the hundreds of other companies who no longer exist today because they failed to compete.
Another misconception is that all profits go to the owners. This is not true in most businesses and certainly not true in the best businesses. When profits are paid out to owners they come in the form of a dividend. It is true that at one point in our history the vast majority of profits were paid out to the owners. According the Wikipedia the average payout ratio – the percentage of profits given back to the owners – for the S&P 500 was 90 percent in the 1940s. Today that rate is 30 percent. The amounts not paid out to the owners are reinvested in growing the business. The better the business, the more money is usually reinvested. Amazon does not pay out any of its profits, nor does Netflix, Alphabet (Google’s parent company), or Facebook. That reinvestment leads to new products, new departments, new jobs and usually higher wages.
So, does the insurance industry’s for-profit structure lead to higher cost in healthcare? The simple answer is no, it does not. I want to be clear that this does not mean that health insurance companies don’t share blame in the total mess that is our healthcare industry. They certainly do. I am simply saying that being for-profit is not the problem. When we think about our daily lives in terms of the things that bring us joy and bring us stress, this truth becomes self-evident. Would you rather order something from Amazon or wait in line at the post office? What is more fun, buying a new car or getting a new driver’s license?
Granted, Disney films can bring joy and stress…joy to the child, stress to the parent who must listen to that song one more time…but our kids do eventually grow out of it. Fortunately, Disney is a profitable enterprise so our children will be able to take their kids to whatever hit they come up with at that time…and we can enjoy what is commonly known as grandparents’ revenge. Now that is a profitable and sustainable concept.
Chuck Osborne, CFA
~Profitability & Sustainability
Where have all the good clichés gone? Long before an entire generation was weighed down by student loans bigger than their parents’ first mortgages there was a collective wisdom which was passed down from generation to generation through worn out clichés. We all knew things like, “There is no such thing as a free lunch.” “A bird in the hand is worth two in the bush.” “The early bird gets the worm.” And, my personal favorite, “Waste not, want not.”
One did not need a college education to understand that nothing is free. Everything has a cost. Why? Because everything is scarce. Scarcity is the primary issue of the study of economics: how people, corporations, governments, and societies as a whole deal with the fact that “money doesn’t grow on trees.” Even if it did, it would be in limited supply – like Georgia peaches, for example. The crop would be impacted by the weather. So when the first part of winter is very mild, almost like spring, and the trees start to bud only to be rudely greeted by a late freeze, then there will be a much smaller than normal crop. What is one to do? It is summertime and Georgia peaches are in scarce supply.
This is the basis of economics. How do we deal with scarcity? In the history of mankind there are really only two systems that have ever been created to answer this problem. The system we live under is based on the freedom of individuals to own their own property and make their own choices. In our system, Georgia peaches are owned by Georgia peach farmers. They are dealing with a much smaller than normal harvest.
Georgia farmers sell their peaches, eventually, to me and people like me who cannot imagine going through the summer without raw peaches, peaches and cream, peach cobbler, and of course homemade peach ice cream. I remember hand-cranking it at my cousin’s house when we were children. Once it started to harden one of us would sit on top of the ice cream maker so we could really crank it and see if we could get it as hard as the stuff you buy in the store. My parents were always on the cutting edge of technology so we had a fancy electric ice cream maker. I had one Uncle who embraced the best of both worlds – he would use the electric motor until it stopped and then put the hand crank on for a few more minutes.
Probably more than you needed to know, but suffice it to say there is a demand for Georgia peaches every summer. That demand may vary slightly year to year, but for the most part it is consistent. The supply, on the other hand, is not. Some years farmers have bumper crops and there are tons of peaches, and some years are like this year. Our system of economics deals with this by allowing individuals to make their own decisions in a free
marketplace. If the supply is low, then farmers may demand higher prices. Some consumers may not be willing to pay those prices. If one does not know the difference between a Georgia peach and, say, a California peach, then one might buy those instead. “Ignorance is bliss” after all. (I, for one, will pay.) If the supply is high, then farmers can afford to sell for less and more people will buy peaches. If the prices get too low, then farmers won’t sell. This is how we deal with scarcity, allowing the supply and demand for an item to determine the price of that item and people voluntarily deciding to use that item or not.
There is another way. In the alternative system no one owns anything. A central authority would ration peaches. Everyone gets a certain number of
peaches based on how many peaches are available. People who like peaches and who would be willing to pay more for them would get the same number as people who do not like peaches. The farmers would get paid the same, regardless of crop size, so there would be no incentive to maximize yields. This would work fine in good years, but eventually we would have a year like 2017 where the crop is too small. Then we would have something that is similar to scarcity but far worse: a shortage.
Never mind the fact that such a system requires that there be someone in charge. That person has a great deal of power, and in the real world, power has the unfortunate effect of corrupting. This power only grows when there is a shortage, and in most real-world situations we find that those who are friendly with the authority end up getting peaches and those who are not get none.
In his book, “The End of Doom,” Ronald Bailey points out that in the economic history of the world, no shortage has ever occurred when free individuals willingly participating in a market have been allowed to do what they do. The laws of supply and demand may be inconvenient at times, but they do work. Rationing, on the other hand, does not have a very good track record. I’m old enough to remember what price fixing – a form of rationing – did to gas lines in the late 1970s. I had to go with my older sister to get gas in case someone was needed to push the pea green-colored Pontiac Ventura the last block. We would turn off the air conditioner to conserve gas…which, incidentally, is why vinyl seats no longer exist. It is no longer the ’70s, which is thankfully why pea greencolored cars no longer exist.
Yet, rationing still has its fans and free exchange has its enemies. One of the questions that I have struggled with most of my adult life is, how could anyone be against freedom? I have always assumed either bad motives – if one gets to be the authority in charge, then the alternative system is pretty good – or ignorance. The Soviet Union’s collapse made ignorance hard to come by for a generation. Unfortunately that was a generation ago,
and here we are again.
Our current environment encouraged me to re-read F.A. Hayek’s “The Road to Serfdom.” Hayek answered my question. He explains that what people hate about the system of freedom I have described – which the world calls capitalism – is scarcity itself. In other words, people want free lunch, or at least “free” contraception. They want to have their cake and eat it too. They want high-paying jobs with a great work-life balance. They revolt against scarcity itself, which they believe is caused not by nature but by the system under which they live.
Nowhere is this dislike of scarcity more evident than in our current debate over healthcare. Healthcare is just like every other good or service in that it is scarce. There are only so many doctors, nurses etc. They each have the same 24-hour day that we do. There is only so much care to go around. That is true in America and in China. It is true in Canada and Russia as well. Scarcity is reality, but we don’t like it, and we certainly do not wish to admit it.
This is why eight years ago our government promised that everyone could keep their doctors and premiums would not go up, even though they knew that was impossible. This is why, even with eight years to dream about repeal and replace, the current Congress cannot come up with an agreement on health care reform. Because no one wants to admit that scarcity exists in an item as important and as personal as health care. No one wants to admit that health care must either be distributed via the market’s pricing mechanism or through rationing. Either way, someone is not going to get to see the doctor of his choice and that person, and all of his family and friends, is going to be mad. They are going to feel hurt and will blame the system. The only answer that partially makes sense is to say that health care is complicated. But it is not, really. It may be more complicated than selling peaches, but what does it mean to be complicated?
Something is complicated if it takes more than one simple step to accomplish. Selling peach cobbler is more complicated than selling peaches. Peaches have one ingredient: peaches. Peach cobbler has several ingredients, including but not limited to peaches, sugar, butter and flour. There is a market for each one of those ingredients, and then there is the baker’s time to consider, and finally a market for peach cobbler. Outside influences can also play a role. For example, if one is selling peach cobbler in a restaurant and the restaurant does not sell vanilla ice cream, then the demand for peach cobbler will be far lower than it will be in a restaurant that can put a scoop of ice cream on top. Who would even eat cobbler if it’s not a-la mode?
In the same way, health care is complicated because there are so many moving parts, and if one really gets sick it gets even more complicated. You have multiple doctors, multiple facilities, and then all the extras. When one starts to think about it, it will make you just want to sit down and bury your concerns in a comforting bowl of peach cobbler. However, just like peach cobbler, the complexity is really made up of many simple parts, each of which could be divided up using market choices or central rationing.
In America we have gone the middle path. We didn’t really make that decision, we just let it evolve. We used to pay doctors directly for everything, getting reimbursed for large unexpected costs through insurance. Then managed care came around and insurance paid for more and more. Insurance payments used to go to the consumer after they had paid the doctor directly, but then the insurance company started paying doctors directly. Over time the insurance companies started looking more and more like government planners rationing out care rather than true insurance companies reimbursing claims. They started telling us which doctors we could see and which brand of drugs we could take. At the same time most doctors were private business people running their own practices. Those who cannot get private insurance get insurance through one or more government programs. It is a mix of both systems, a middle path.
Hayek discusses the middle path. He describes it as the worst of the three options. This is where one sees the worst of both worlds – the sometimes high prices found in capitalism combined with the uncaring rationing of socialism. Just this past six weeks, I tried to get my father in to see a specialized doctor. His primary care physician recommended a doctor that by chance I had seen, so we felt good about that. He could have seen my
father in six weeks if we wanted to wait, but we were able to get in to see one of his partners after two weeks so settled for him. He ran some very expensive tests which were only partially covered by insurance, and that took us four trips to his office to complete. Fortunately my father is in good
health. No further treatment was needed, but this is the middle road: luxury costs with economy-level service.
To really solve health care we need to pick a path. This is why finding consensus is impossible. I’m not here to make policy recommendations, but we could try something with health care which is logical when one looks at our country’s full name. The United States of America is one nation organized as a federation of fifty states. Why are we fighting over a one-size-fits-all disaster when each of those states could be experimenting with their own, more manageable systems?
Regardless, we need Washington to move one way or the other so we can move on to things we care about as investors: tax and regulatory reform. Meanwhile, it is still summer. “Live for the moment” and enjoy a Georgia peach if you can find one.
Chuck Osborne, CFA
Managing Director, Peach Aficionado
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