The price of everything

Considering the snow

“Sunshine is delicious, rain is refreshing, wind braces up, and snow is exhilarating. There is no such thing as bad weather, only different kinds of good weather.”

-          John Ruskin.

He was born 10 months after the Wall Street Crash. Two weeks before his first birthday, a run began on the local banks. England in subsequent weeks went off the “gold standard”. He became a dollar millionaire at 32, at a time when a million was a big number and a dollar was genuinely worth something. Throughout his long and monumentally successful career – Forbes magazine ranked him as the richest man in the world earlier in 2008 – Warren Buffett has either made financial history, or floated just on its periphery, a player or active observer in some of Wall Street’s most celebrated deals as well as some of its more notorious recent scandals. But as Alice Schroeder makes clear in her substantial biography of Warren Edward Buffett (‘The Snowball’, Bloomsbury 2008), the so-called Oracle or Sage of Omaha, notwithstanding the accumulation of historic levels of wealth, his reputation for honesty and plain-dealing is richly deserved. And this 838-page study fleshes out the humanity behind the Buffett story, handily complementing – for Buffett completists – the free primer on investment comprising his accumulated letters to the shareholders of Berkshire Hathaway.

‘The Snowball’ reinforces some of the essential truths within Malcolm Gladwell’s equally current study of success, ‘The Outliers’: the supposedly “self-made man” also requires being born in the right place at the right time, with a degree of demographic luck, and with a commitment to focus on one’s endeavour (Gladwell suggests a minimum of 10,000 hours’ dedication to the cause). Buffett had all three, and has had the good grace frequently to acknowledge the fact:

“I’ve had it so good in this world, you know. The odds were fifty-to-one against me being born in the United States in 1930. I won the lottery the day I emerged from the womb by being in the United States instead of in some other country where my chances would have been way different.

“Imagine there are two identical twins in the womb, both equally bright and energetic. And the genie says to them, ‘One of you is going to be born in the United States, and one of you is going to be born in Bangladesh. And if you wind up in Bangladesh, you will pay no taxes. What percentage of your income would you bid to be the one that is born in the United States ?’ It says something about the fact that society has something to do with your fate and not just your innate qualities. The people who say, ‘I did it all myself,’ and think of themselves as Horatio Alger – believe me, they’d bid more to be in the United States than in Bangladesh. That’s the Ovarian Lottery.”

But this is not merely a well-sourced hagiography, as even a cursory scan through the index makes clear. Warren Buffett the human being is captured here with all his vulnerabilities, his “attention-seeking”; “avoidance of confrontation”; “clothes and appearance” (sometimes self-deprecation has a place); his “discomfort with illness”; “emotional fragility and unavailability”; “frugality and tightfistedness”; his “immaturity as youth”; his “fears of mortality”.. And perhaps the most intriguing aspect of Buffett’s private life, his unorthodox marital triangle with Susan Buffett (“Big Sooz”) and Astrid Menks, is covered extensively but sympathetically.

Aspirant financiers and entrepreneurs seeking the Value Way to Riches will be well served by the shareholders’ letters alone. ‘The Snowball’ fills in both the private and public history of America’s greatest investor. What strikes the reader of today is the extent to which the current deep crisis has its roots in the behaviour of bankers ten and twenty years ago – the Credit Crunch and Banking Fiasco of 2008 did not come out of a clear blue sky. The full dress rehearsal for the bankruptcy of Lehman Brothers in 2008 – probably the worst decision made by the US Treasury and Federal Reserve so far, in an environment where the swirl of poor decisions has been as thick as autumn leaves – came in 1991 when Salomon Brothers was hours away from bankruptcy following a hushed-up fraud involving rigged auctions for US Treasury bonds. Buffett was parachuted in as chairman to save the firm, and perhaps even the integrity of the US financial system. So “too big to fail” is hardly a contemporary coinage. And the festival of moral hazard that is the current Anglo-Saxon banking culture has its origins in the 1998 collapse of Long-Term Capital Management and its vilely hubristic executives. Buffett was invited to rescue the fund. But its management, in what might be seen as an eerie presentiment of the downfall of Lehman’s CEO Dick Fuld, were determined to retain ownership and control of the business. Alice Schroeder asks the pertinent question of the Fed-orchestrated LTCM bailout:

“It is hard to overstate the significance of a central-bank-led rescue of a private money manager. If a hedge fund, however large, was too big to fail, then what large financial institution would ever be allowed to collapse ? The government risked becoming the margin of safety. No serious consequences had come about in the end from the derivatives near-meltdown. The market afterward seemed to behave as if no serious consequences ever could. This threat, the so-called “moral hazard,” was a chronic worry of regulators..”

Buffett himself candidly explained the second- and third-order impact of failing derivative structures, which again carries huge resonance in our dislocated modern financial arena:

“Derivatives are like sex. It’s not who we’re sleeping with, it’s who they’re sleeping with that’s the problem.”

Much of ‘The Snowball’ has a grim relevance to current events:

“Terrorists have a huge advantage. They pick the time, the place, and the means. It’s very difficult to defend against fanatics.. This [the terrorist attacks of September 11, 2001] is just the start of things. We don’t know who our enemy is. Now, it’s us versus a shadow. There could be many shadows.”

And like the shareholders’ letters, ‘The Snowball’ is a repository of fine quotations, about business and investment success, and much else. But as we crouch in the aftermath of the Crash of 2008, amidst the rubble of the equity and credit markets, there is specific cause to see optimism and a sense of opportunity in Warren Buffett’s words describing a previous panic (in this case, the crisis of confidence in the financial markets post-Enron). As Alice Schroeder puts it,

“Berkshire’s best opportunities always came at times of uncertainty, when others lacked the insight, resources, and fortitude to make the right judgments and commit.”

But Buffett tells it best, and the advice resonates for our time as well as in relation to his previous market coups:

“Cash combined with courage in a crisis is priceless.”

 

‘The Snowball: Warren Buffett and the business of life’ by Alice Schroeder was published in September 2008 by Bloomsbury Publishing. RRP £25.00; available via Amazon from £12.49.

The politics of NAV

“When you’re young it’s fantastically important what sort of car you’re seen to be driving..

 

“Take your BMW, Alex.. it isn’t simply a means of transport, it’s a symbol of your position in society, your manhood..

 

“But when you get to my age and position, things like that appear silly and trifling; a car really ceases to have value as a status symbol..

 

“That’s why I got the helicopter.”

 

-       Rupert to Alex, in ‘Alex’, by Charles Peattie and Russell Taylor.

 

 

Trust economists to suck all the life out of a fascinating debate and reduce it to data. In 1974, Richard Easterlin asked whether economic growth improved human happiness. He found, unsurprisingly, that within individual countries, those with higher incomes were more likely to claim to be happy. Intriguingly, however, when it came to making comparative international analysis, average reported happiness saw little variation relative to national income. And although per capita income within the US rose steadily between 1946 and 1970, average happiness showed no longer term trend.

 

Ruut Veenhoven and Michael Hagerty, in 2003, challenged the Easterlin paradox, indicating that countries did indeed get happier as they got wealthier. And earlier this year, Justin Wolfers and Betsey Stevenson of the University of Pennsylvania re-examined the Easterlin paradox, and also concluded that increases in income tended to match increases in subjective happiness. Their findings, in summary:

 

1)    Rich people are happier than poor people.

2)    Richer countries are happier than poorer countries.

3)    As countries get richer, they tend to get happier.

 

So far, so blindingly obvious. But irrespective of whether Easterlin’s original thesis was correct or not, we seem to have sleepwalked our way into a culture that takes constant growth in GDP as an inalienable human right alongside life, liberty and the pursuit of happiness. As Warwick University economist Andrew Oswald suggested in an interview two years ago,

 

“If you’re poor, and can’t feed your children, theories about the economics of happiness don’t matter. But in America and western Europe, a lot of us don’t need a TV wider than the one we have, or a third car. We’re still stuck with thinking that applied in 1945, when we needed economic growth to supply us with basic things. Today, the case for growth remains much stronger in developing countries..”

 

On a related theme, it has become unchallengeable accepted wisdom that a little inflation (and not too much) has to be a wonderful thing. This is a little like saying that the authorities will operate a policy of carefully managed debauchery of our savings. The Bank of England currently targets an inflation rate of 2%. We can put to one side the degree of manipulation, hedonic or otherwise, inflicted upon that target rate by the west’s central banks.

 

So it is now doubly unfortunate – for the politicians, let alone the real economy – that both the GDP growth genie and the low inflation genie have apparently been let out of the bottle and to all intents and purposes have vanished altogether. It was Ronald Reagan who said that the nine most dangerous words in the English language were “I’m from the government and I’m here to help”. So government “help” (read: taxpayers’ capital) is now working on behalf of the banking system, notwithstanding grisly moral hazard issues, and will soon be working for an indeterminate number of other “special interest” groups that have apparently given up on the free market ideal and are reverting to crisis socialism.

 

A year ago, Slate’s Daniel Gross published his book “Pop !” (HarperCollins 2007) which argued, somewhat counter-intuitively, “Why bubbles are great for the economy”. Gross suggested that a predisposition toward colossal bubbles was “another brief in the case for American Exceptionalism, the notion that the United States has traced a unique path of social, economic, political and cultural development.. The United States wasn’t plagued by the socialism, fascism, or violent revolutions that ravaged the Old World.. precisely because it had no history of feudalism against which the masses could revolt.” Gross also cited psychologist John Gartner’s “The Hypomanic Edge” (Simon & Schuster, 2005) which argues that a neurotic tendency on the part of entrepreneurs is a fundamental aspect of the American character, such that bubbles are reflections of what Gross calls “episodic outbursts of American entrepreneurial id”. And while the US government, through the mechanism of tax credits, patent policies, procurement and legislation, the tax code and direct subsidies has helped incubate and then sustain economic booms deriving from rapid innovation, it has on the whole allowed free marketeers to get on with the business of risking, making and losing vast amounts of capital. Europe, by way of contrast, has invariably allowed heavy government intervention to smooth over the economic blips and bumps triggered by investor mania, in turn moderating the opportunity for Europeans to generate immense wealth out of disruptive technologies.

 

But the supposed boom triggered by the growth of credit was a false boom. Rising property prices do not equate to true wealth creation. And as we now know to our cost, the profits associated with new credit products were largely illusory. Ominously, Gross suggested in “Pop !” that US financial hegemony was built on the infrastructure of “a sound banking system, transparent and lightly regulated capital markets, and a robust home lending system.” In which case, US (and for that matter Anglo-Saxon) financial hegemony is over – an observation reinforced by the National Intelligence Council analysis “Global Trends 2025” which pointed to a long-term decline in US economic and political heft.

 

It was always absurdly foolish of Gordon Brown, or any other politician, to claim a premature or indeed any kind of victory over ‘boom and bust’ – to believe that bureaucrats, rather than markets, are the best allocators of economic capital, or that the business cycle had been vanquished. It remains foolish to believe that unthinkingly pounding that GDP treadmill and hurling any amount of both current and future taxpayers’ money at failed industries will soften the damage and the crisis rather than extend them. Whereas the telegraph, railroad and internet bubbles left lasting value in their wake, there are no obvious signs of prospective benefit in the rubble of the credit boom – other than the forced shrinkage of an overbanked financial system.

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What’s the colour of money ?

“The easiest way for your children to learn about money is for you not to have any.”

-       Katharine Whitehorn.

 

 

Stop the bail-outs, I want to get off. The trouble with flood-gates is that, once opened, they have a tendency to let the floods through. So along with the flotsam and jetsam of the banking industry, Detroit has now joined the queue for “emergency” assistance. The FT’s Lex column recently pointed to the rich irony of this, given that

 

“..less than two months ago, six of eight representatives in the Detroit area voted against the first iteration of Tarp [the Bush administration’s Troubled Assets Relief Programme]. Only too happy to play a game of chicken with the global financial system by scoffing at the concept of “too big to fail”, that is precisely the justification they make for rescuing car manufacturers and the dozens of suppliers and millions of jobs linked to the Big Three, whose “collapse” would be unacceptable.”

 

Economist John Tamny is similarly sceptical, recalling the words of Ludwig Von Mises that the entrepreneur who fails to use his capital to the best possible satisfaction of consumers is “relegated to a place in which his ineptitude no longer hurts people’s well-being”. Detroit’s so-called Big Three are curiously vestigial entities – embarrassing, mismanaged throwbacks to the dawn of car-making. And there can be little doubt that any business (such as General Motors) that has posted $70 billion in losses over the past four years – versus a current market capitalisation of just $1.8 billion – is hardly a success story. President-elect Barack Obama has described US carmakers as “the backbone of American manufacturing”. This particular backbone has advanced osteoporosis.

 

Citigroup’s Hans Kullberg (“Reconstructing America: Why the US Government should turn a blind eye to US automakers.. and invest in the future”) has written an interesting piece in which he details the extent of the problems facing the US auto sector, but also puts forward a strategic alternative simply to shovelling money at them (in the form of investing into energy and alternative energy infrastructure):

 

“Every time I see a commercial on television advertising a “0% APR No-Fees, No-Money Down” loan for a car, I cringe. The average American household currently owns 2.28 cars – how many of these are idle ? The days of “buy now and pay later” are over, meaning there’s no money left to buy cars, meaning there’s no money left to support the auto industry, meaning there’s no sales revenues to pay absurd pension plans, meaning there’s no reason for the US Government to extend a lifeline simply to postpone the inevitable future of a futile auto industry. Although politically appeasing, to do so would be a disservice to the American taxpayer, which is a much larger contingent than the 2 million or so odd jobs that would be saved. It’s readily apparent the “modest” loan would be used simply to renegotiate debt terms which are now trading at 25 cents on the dollar and yielding over 30% a year. To put off the day of reckoning will make the downfall worse when it finally comes.”

 

But then, let he who doesn’t need government money cast the first stone. And the problem with government money is that in most jurisdictions the very term is a misnomer, because governments too are already heavily indebted, so it’s taxpayers’ money we’re really talking about. And this gets us to the heart of the debate: at what tipping point do effectively unlimited guarantees and capital support by governments start to become self-defeating, inasmuch as they start to erode belief in the very instruments (specifically, government bonds, and in due course fiat currency) from which they are constructed ? Or to put it another way, when does money start to eat itself ?

 

It seems to be doing so already. As economist Willem Buiter points out, credit default swap spreads (the price of insuring against a default) have risen for the most seemingly credit-worthy sovereign entities, including the UK (5 year sovereign CDS at 0.46%), the US (0.33%) and Germany (0.27%), well above their post-war historical averages. Bloomberg reported that credit-default swaps on US Treasuries have risen by nearly 40% since TARP was signed into law in early October, “and are now about the same as Mexican and Thai government debt before the credit markets began to seize up in June 2007.”

 

Walter Wriston, former head of Citibank, famously observed that “countries don’t go out of business” – i.e., that countries don’t go bankrupt. That was before all of Latin America effectively did. And as Nassim Taleb pointed out in ‘The Black Swan’, after sovereign defaults in Latin America,

 

“In the summer of 1982, large American banks lost close to all their past earnings (cumulatively), about everything they ever made in the history of American banking – everything.”

 

So systemic banking crises caused by doltish banking management are more frequent than commonly believed. What is more common is for banking crises to metastasise into currency crises – and (in UK Pound Sterling terms alone) we are arguably already there.

 

It seems perverse to be buying the US Dollar as a ‘safe haven’ currency given that the US was the epicentre of the current financial shock. Such is the by-product of being the world’s reserve currency. But can this really last ? If one concludes that it can’t, gold is the natural next hedge.

 

And if the global currency markets end up becoming as dysfunctional and competitively devalued as, say, global equity markets are currently, then another perverse outcome of comparably counter-intuitive inflationary pressure further down the line would be that rational investors would stockpile equities as a natural inflation hedge. But we are getting ahead of ourselves. We are only just entering synchronised global recession. For the immediate future, bracing for further asset deflation and concentrating on capital preservation are the core priorities. But with every announcement of a further government bail-out to be paid for by future tax-payers, sceptics might rightly wonder whether a crisis brought about by easy credit is going to be resolved by more of the same. Never was true portfolio insurance more passionately and urgently sought, nor more difficult to come by.

Facing the music

“There may be trouble ahead
But while there's moonlight and music
And love and romance
Let's face the music and dance.

Before the fiddlers have fled
Before they ask us to pay the bill
And while we still
Have the chance
Let's face the music and dance.

Soon
We'll be without the moon
Humming a diff'rent tune
And then

There may be teardrops to shed
So while there's moonlight and music
And love and romance
Let's face the music and dance
Dance
Let's face the music and dance.”

 

-       Irving Berlin.

 

 

Human beings are good at enduring extreme conditions and surviving in a wide range of habitats. We have mastered tools, speech, fire-making and the wearing of clothing. But our brains are insufficiently evolved to be able to handle financial markets easily. That goes doubly so for bankers. Words are admittedly cheap relative to actions, but the late Sir John Templeton summarised the issue neatly:

 

“To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.”

 

Prepare for rewards. The problem, and it is a critical problem through our inability to handle longer term planning easily, is that those rewards will not accrue overnight, but will take time and patience to be delivered to investors with Sir John’s brand of fortitude. We are hard-wired, sadly, for the short term.

In James Montier’s authoritative ‘Behavioural Investing’ (John Wiley, 2007), the author points to evidence from neuroscience

 

“that real pain and social pain are felt in exactly the same places in the brain. Eisenberger and Lieberman (2004) asked participants to play a computer game. Players think they are playing in a three-way game with two other players, throwing a ball back and forth.

 

“In fact, the two other players are computer controlled. After a period of three-way play, the two other ‘players’ began to exclude the participant by throwing the ball back and forth between themselves. This social exclusion generates brain activity in the anterior cingulate cortex and the insula, both of which are also activated by real physical pain.

 

“Contrarian strategies [such as buying quality stocks now, just as deleveraging investors are tossing them into the waste bin] are the investment equivalent of seeking out social pain. In order to implement such a strategy you will buy the things that everyone else is selling, and sell the stocks that everyone else is buying. [There is not much evidence of the latter at present. This is called an opportunity.] This is social pain. Eisenberger and Lieberman’s results suggest that following such a strategy is really like having your arm broken on a regular basis..”

 

Notwithstanding the huge losses incurred in almost every asset class during 2008, there is good news, of sorts, in the form of comparably huge government intervention. Legg Mason’s Michael Mauboussin suggests that the scale of what he calls global government mobilizations will make this downturn more akin to those of the early 1970s, early 1980s or early 1990s than to the Great Depression. Quite how bad the downturn will be is impossible to say. It is dependent, not least, on the hopes, fears and actions of millions of people currently having the wits scared out of them by media coverage of the markets that is little short of irresponsible.

 

Mauboussin also makes a good case in the income argument for stocks. It is worth recalling some historic data on the topic. Two centuries of investment returns from Anglo-Saxon markets indicate that annualised real returns amount to between 6% and 7%. More than half of that return comes from compounded dividend income. And as Mauboussin points out,

 

“The current dividend yield on the S&P 500 is only about 25 basis points below the yield on the 10 year Treasury note. You have to go back to the early 1960s to find a similar relationship. If you add in share buybacks, the yield is about 400 basis points above the 10 year note yield, and that’s with buybacks down sharply this year. And excluding the financial sector – and that’s a big exclusion – corporate balance sheets remain in decent shape.”

 

Another perspective of Mauboussin’s that seems, at face value, to be bad news but which is almost certainly extremely positive for current investors is the paucity of returns over the recent past. He charts the rolling 10 year returns for large cap stocks:

 

“Over the past century-plus, the market has tended to bottom out around zero percent rolling ten year returns. That happened in the 1930s and 1970s, and that is where we are today. The rolling 10 year figure is worth examining for psychological reasons, too. If the average investor is in a mutual fund, they have lost money after taking fees into consideration. Further, most investors lose an additional 200 basis points due to bad timing. So on a dollar-weighted basis, the average investor has been down substantially in the US stock market in the past decade. That is very psychologically damaging.”

 

Perhaps our most dangerous psychological weakness is the tendency toward extrapolation. When markets are falling sharply and we are invested in them, the natural response is mentally to extrapolate the trend toward extinction. One need only reflect on the market’s tendency towards mean reversion to try and withstand this psychological pressure.

 

But not all of us are interested in tracking the markets, particularly when individual stocks, on a selective basis, are starting to indicate terrific value. And to follow Mauboussin, there are probably worse strategies than treating genuine blue chip stocks (ex-financials) as income-generating instruments – bonds, if you will – and letting fate handle the longer term potential capital growth.

 

We know there is trouble ahead. If the most difficult thing psychologically is to grit one’s teeth, face the music and dance, and reap the prospective benefit of owning quality stocks at throw-away prices into the bargain, then that is probably the right thing to do.

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