Sunday, March 29, 2009


As a result of training, part of my pleasurable weekend routine is the reading of Barron’s. This week’s issue devotes a half-page to a summary of a forthcoming 17-page piece by the respected investment authority Robert D. Arnott. A longer review of the same piece is covered by John Mauldin’s weekly letter. Both articles focus on the “myth” of a 5% equity premium of stocks over bond returns, and include Arnott’s chart of bond and stock indexes. (This not the time or place to discuss the fact that there are flaws built into indexes which can lead to faulty decisions.) Arnott’s conclusions do not take into consideration either transaction costs nor the tax impacts of capital gains. These deficiencies are understandable because they are not major concerns of the large tax-deferred or tax-exempt institutions who are Arnott’s main customers. Nevertheless, the data is somewhat startling.

In the 68 years from 1803 to 1871, bond returns beat stocks. The period includes three land wars, either within our country or on its borders. Significantly, the period ended before the credit and liquidity collapse of 1873. That period has many more similarities to the present conditions than those of 1929-1933. In the 20 years between 1929 and 1949, including World War II, bonds again outperformed. Many believed that WWII was caused by the worldwide Great Depression. Almost all data is “end point determined,” i.e. if 2006 was used as an end point, a much different result would have occurred.

I come from a bias in favor of equity, and almost disregard high quality bonds in the real world as did Franz Pick, who called them “certificates of confiscation” due to their decline in purchasing power when principal is returned with less-valuable purchasing power than when it was lent. Despite my bias, I do recognize that bonds perform better than stocks in some periods. One can clearly identify with that occurrence in periods of declining equity prices, which probably happens in one in four years, often tied to the U.S. presidential election cycle. That explanation would not count for a little more than half of the period cited, 129 out of 206 years. The superiority of bonds also must include long periods of flat or trendless markets.

How should we apply this research? Arnott believes that equities are more attractive today than they have been due to their higher-than-normal yields. I would suggest one of the reasons for the higher yield is the uncertainty of many dividends. And, I may add, the long period of equity underperformance would make stocks attractive at some point.

The stock “bulls” focus on the recent stock purchases by Warren Buffet, Ken Heebner, and Jeremy Grantham. (Three disclosure points: First, I have owned Berkshire Hathaway for a number of years both personally and in a financial services hedge fund that, after fees, produced the same a less-than-stellar -32% in 2008. In addition, Ken Heebner’s CGM Focus is in a number of our managed accounts, as well as some pro bono accounts that I influence. Finally, I have known and respected Jeremy Grantham for many years.)

The appropriate term to be used is fixed income now, not bonds as we are dealing with loans, mortgages, derivatives and similar instruments. Three institutions which I serve on a pro bono basis are in the process of building up their fixed income investments. In each case, well-respected investment managers are leading the charge. They are seeking good credit managers to advise whether or not to go directly into the PPIP (the Public-Private Investment Program unveiled by the Treasury Department last Monday), or some other beneficiary of the process of supplying liquidity to an illiquid part of the market. All of these participants believe that they have at least one year to catch the built-in inflation that has been baked into the global economy by the various governments.

From my vantage point, I recognize the potential capital appreciation of fixed income. In the past, most of the institutional portfolios which I have managed or influenced have used bonds as a strategic reserve to reduce the impact of potential equity declines. Until very recently, I have favored the use of the highest possible quality money market vehicles. However, due to the protracted low interest rate environment, I have not counted on high-quality bonds to produce meaningful income.

I now am coming to the belief that we should devote some portion of our portfolio to the capital appreciation of fixed income opportunities when and if skilled managers can be found. That is now my search. Both suggestions and comments are most welcome.

Sunday, March 22, 2009


Last week my blog post was entitled “In the Land of Re.” Dr. Philip Neches, my distinguished scientific adviser and student of history who sits with me as a trustee of the California Institute of Technology, emailed me the thoughtful response below.

I expect Phil to play a role on a new hedge fund I will manage.


Interesting blog post! I see an echo of our conversation on Friday in the part about looking behind the increase in reported lending.

I also note that, at least on the surface, the US savings rate has increased in the last few months. Economists note that while this builds the kind of investment capacity you discuss at the end of your blog post, money just saved does not have an immediate stimulative effect.

Standard accounting does not make a good distinction between spending and investing. Some spending is purely consumed in a way that does not expand economic capacity. Examples include military supplies and spa treatments: once used, they never get back into the economy. On the other hand, spending on things like product development and public infrastructure create things that directly or indirectly produce new economic value for months or years to come. In this sense, such spending is investment.

Conversely, if increased savings result in increases of debt or equity -- which must be done to generate the return -- the savings are spent, either as investments or as consumption. It just means that someone other than the saver does the spending.

My point is that investment can be enabled by saving or by spending. To better measure the long-term prospects for the economy, we should be measuring and trying to increase the investment rate, not the savings rate or spending rate. If the economic crisis gets people to shift their spending and savings to do less consumption and more investing, we will be better off in the long run, and perhaps even in the short run.

Finally, I think that the automation and mechanization of labor is still accelerating, not decelerating. The percentage of the work force involved in agriculture is still declining, as it has been since the early 1800s. The percentage of the work force involved in manufacturing is still declining, as it has been since the 1950s.

I think we have seen the peak in percentage of the work force employed in information technology. I have been writing for several years now that IT as a percent of the work force will decline. I mean this world wide: outsourcing just moves the jobs and temporarily makes it possible for workers who are less productive to be competitive due to currency and standard-of-living arbitrage.

As the arbitrage declines, those workers are even more vulnerable to technological obsolescence than their US-based counterparts. Call center workers can be replaced by voice response systems. Low level application programmers can be replaced by new software development tools.

Agriculture, manufacturing, and now IT are characterized by continuing technology innovation that increases productivity: more output from fewer hours of labor. For the first 50 years of the IT industry, demand increase so much faster than productivity that employment increased. Demand is still increasing, but at a slower rate as the industry finally has enough capacity to meet the demand and is no longer growing into unfulfilled demand. Productivity growth remains high, and the balance is now such that the need for workers is growing slower than the population, or the economy as a whole.

As costs and living standards increase in other countries, off-shoring will make less sense. In manufacturing, as people count in the real costs of transportation, a lot of off shore manufacturing now looks less advantageous. While a lot of manufacturing can "come home," I do not foresee manufacturing employment ever returning to the levels of prior decades.

So the result is that the workers who a decade ago were in great demand and short supply now find their circumstances radically altered. Ex-investment bankers and ex-programmers are driving taxis and limos while they figure out what's next.


Philip Neches received his BS, MS and PhD from CalTech

Sunday, March 15, 2009


My text today focuses on “RE.” One might think of this prefix as returning to past times of glory or relearning past lessons. With all due respect to various writers of imaginary kingdoms and a number of sermons, my thoughts are on the return of capital (employed) and the return on investment.

Starting with the most controversial application of “RE,” the biggest long-term risk is reflation. (Some may use the term re-inflation.) Many governments around the world are incurring debts at current levels of interest to cover their deficit spending, as well as the new manipulation entitled “stimulus spending.” In either case by inflating the value of the currency they will be paying back the debt with devalued currency. Further, higher prices for goods and services will increase the level of taxes paid. With some exceptions (e.g. social security payments and the value of some deductions), income taxes will rise. Prices for property, whether real estate or other forms of equity, will rise to offset the decline in the value of the currency. Part of the danger coming from inflation is that the increase is built into the cost structure of tradable goods and services as well as various forms of property. Eventually after prices rise above their real value based on their utility function, prices will decline, often rapidly, which can lead to various stresses including bankruptcies. For these and other reasons, I believe governments, including our own, will reflate by putting too much credit and money into the system.

Out of the fear of such future occurrences of inflation, in many accounts I use Treasury Inflation Protected Securities (TIPS). I recommend at least some TIPS in every balanced account of stocks and bonds. If interest income provides most of the living expenses and charitable gifts, the portion invested long-term in TIPS should approach the level of interest income generated from high quality bonds. Even in the case of a large commitment to stocks, some holdings in TIPS may act as the “canary in the mine,” a very sensitive indicator of future perceived inflation. There is one major drawback to the use of TIPS in a tax-paying account: the calculated incremental rise in the value of the debt (which is how inflation is accounted for at maturity) will be taxed each year even though the investor did not receive the income in the year charged. While the risk of rising inflation is very real over time, the tax-related issues are such that investors should consult with their investment manager and their tax accountant.

The second “RE” is “releveraging” or the opposite of the more popularly-used term deleveraging. On an overall global basis, incomes can not grow faster than the sales of products and services unless the commodity is in permanent short supply, (which doesn’t often last long), or when leverage is applied. There are two types of leverage, operating and financial. These are detailed in my book MONEY WISE. Operating leverage occurs when sales grow at a faster rate than costs. Often operating leverage occurs when there is a high break-even point due to capital employed. This desired attribute is called a rising operating margin. Often “growth” stock investors look for increasing operating margins with the hope that this growth will be sustained. Until sales and distribution costs, as well as prices, turn unfavorable, growth is a winner. Very few companies can actually maintain rising operating margins for long periods of time in a competitive world.

The second form of leveraging is financial leveraging; buying additional productive capacity through the use of debt. For this to work the interest rate paid on the debt needs to be below the operating margin. Debt also needs to be repaid or refinanced, so the ability to generate sufficient cash to repay the debt is very important. “Value” investors often focus on stocks and bonds of a company that can pay off their debt quickly and substitute operating earnings in place of interest payments. Often this focus leads to only looking at companies that the markets perceive as being distressed. “Value” investors see productive use of financial leverage as looking at free cash flow, net of the interest and principal of debt service. In other words, they are saying, “To get us out of the hole, we will add back in debt service spending that they believe will be declining.”

The next “RE” is reviewing the facts beneath the surface. Let me suggest two very different examples of facts, that when reviewed will suggest a difference from the popular view. The first is the report that a number of large commercial banks are both profitable in the first two months of the year and that they are increasing their loans. Many potential borrowers from banks, such as corporations, tax-free institutions, and some individuals, have obtained lines of credit for future borrowings. In a period where cash is becoming king, some are now tapping into these lines because they are fearful that the money will not be available when they have a real need for capital. These loans are being taken down by the borrower while the lender records an increase in lending. In some cases the borrowers have no immediate need for the money and turn around and invest it in short-term, high-quality paper (e.g. US Agency or commercial paper). From a macro viewpoint, this is not a stimulus-oriented use of capital. I do not know what proportion of the increase in lending and bank profits are due to this type of activity, but this is an example of looking underneath the headlines in press releases.

The second area to review is more difficult to identify. I am beginning to sense that the long- term trend of substituting machinery for human labor may be decelerating. With new capital equipment costs high, and the abundance of highly motivated, intelligent people who will work at much lower wages and fringes than in the past, we can see changes. One is already seeing former business people driving cars, trucks and buses which in the past sat idle for the lack of drivers. A number of unemployed people have entered the market for services, either as part-time employees of established businesses or franchises, or are becoming entrepreneurs. I am told that there are many commission-only jobs available, some will be filled by enthusiastic people who never in the past were directly involved with sales. I am not privy to whether these people are listed as unemployed or underemployed. Government statistics are always behind in measuring changes in the structure of the economy and that may be why I don’t have statistics to back up my view.

The final “Re” for this session is relearning. As children, many of us were required to save a portion of our meager allowance each week. Some of us tried to install this concept with our own children. Many families from other parts of the world, particularly Asia, are prodigious savers. From an overall economic standpoint, our government is trying very hard to get people to spend now and even incur more debt. This “logic” holds that with consumption in the neighborhood of 70% of GDP, this spending will jump-start the economy. As often the case with politicians facing elections, this is very short-sighted. Consumption spending without saving is like treading water: surviving for now, but not leading to a rescue. In pure economic terms savings leads to a much higher multiplier effect than consuming. As savings grow, it will build up in the financial system, though whether that will be in the formal banking system is another question. Eventually the small savings will filter into the investment stream, which over time, will direct it to a high return on investment (with risk of loss very much in mind). If we can get the savings rate in this country up to 10%, which produces (after the current “delay”) annual returns anywhere from 6-12%, we will be giving our next generation the financial means, and more important the discipline, to deal with the huge debt needed to cover the excessive spending done while we were, theoretically, in the driver’s seat.

Sunday, March 8, 2009


As we approach the 85th birthday of mutual funds in the US, the thought occurred to me that in our sound bite world there may be numerous misperceptions about mutual funds. Some of these misperceptions could lead to legislators not fully understanding mutual funds, even though many of them use funds themselves to avoid the potential conflicts-of-interest of owning individual securities. The same could be true for the members of the Fourth Estate. (The term Fourth Estate term comes from the French Revolution, where the press was going to be recognized in the new perfect government after the revolution. I will let others determine whether this is an appropriate term in the US today.)

My concern is that individual investors’ misperceptions, either directly or through the influence of the Fourth Estate, could be depriving them of useful investment instruments to fulfill their needs, particularly those fortunate enough to fit into a category called Ultra High Net Worth (over $25 million to invest).

The fund business can take pride that in 1924 some professional fiduciaries came up with funds that had redeemable features. Prior to that time all funds here and in Europe were closed to redemptions. The first fund organized as an investment company began in Belgium in the 19th Century, and the movement quickly found acceptance in the UK. However, the principle of gathering assets from (usually wealthy) individuals, to be directed by one or a small group of leaders, predates organized funds by a couple hundred years. They were called by their legal name as a joint stock company. The great exploration companies, such as the Dutch East India Company that developed New York City and other places within our country, as well as various locations in Asia, were joint stock companies.

The principle of banding together in perilous journeys was seen in the development of our West, as well as the camel caravans of biblical times, where the members paid to be led and followed the orders of the leader. The main lesson from this history is that it is common to seek a manager to guide you through dangerous times and places. Becoming part of a group creates an asset base large enough to attract some of the best leaders available.

One of the major misperceptions about mutual funds today is how big they are. Even after substantial market declines and a lot of redemptions, the open end fund business has total net assets in excess of $9 trillion dollars. This amount is larger than the US deficit, as well as all of the goods and services of most countries. This total excludes the kissing cousins of closed end funds, variable annuities and commingled vehicles of various institutions that follow many of the same practices of open end mutual funds. On a world-wide basis, the amount of money invested in redeemable funds is in the neighborhood of $20 trillion. Who are the holders of mutual fund shares? In the UK, some of the misinformed press believe that funds are for those families headed by a man wearing a soft cap rather than a top hat. As with many British notions, this is a class-oriented comment that is probably statistically out-of-date, and way outdated in the US. The penetration of mutual funds into American households is close to 50%, where it has been for some time. Many of the owners of funds are women, and serve as the investment decision-makers for their households. As an investment advisor to individuals and families that are within the top 1% of our country’s wealth, I can testify that many very rich people own mutual funds. Because of my work with various non-profits, I can state quite a number of billionaires are very knowledgeable about mutual funds, and therefore probably use mutual funds.

Often one hears from various “talking heads” that mutual funds are doing this or that. While some funds may well be doing whatever the commentator is bashing, the plain truth is that the fund business is much broader than any single investment objective or practice. Of the $9 trillion assets, $3.2 trillion is invested in various types of Money Market funds. Another $1 trillion is invested in Long-term, Taxable Fixed Income funds, and at last count $832 billion in Tax-exempt securities. The last figure suggests that a number of wealthy households own mutual funds. Many other wealthy investors use Money Market funds (with a much better record of safety) as alternatives to banks. Thus, over half of today’s funds are fixed income funds. This total excludes the $789 billion in Hybrid funds that own both stocks and bonds.

Stock or Equity funds are quite diverse in their choices of securities and techniques; such as mutual funds that mimic some hedge funds by shorting stocks, to others that are designed to meet court-designated legal lists of high-quality common stocks. If one looks at the nine investment objective classifications that are pure equity, each totaling over $100 billion dollars in assets, six of them of them have a conservative or middle of the road orientation. The largest single investment objective is Large Market Capitalization/Value-Oriented portfolios, with $296 billion in assets. The second largest investment objective category is the $288 billion in funds who attempt to track the S&P 500 index. This is an interesting group, often the subject of not particularly accurate media reporting about the group not beating the market. They are designed to replicate the S&P500, not surpass it. Representing only 8.8% of equity-oriented funds, I believe a disproportionate share of these assets is owned by various types of fiduciary institutions and members of academia.

The largest category that fits the traditional view of mutual funds is the large cap, growth-oriented equity funds who seek large-scale growth of earnings and valuations. The next two investment objective classifications are ones that do not accept that the market moves within specific capitalization bands; large, midcap, or small. Multi-cap Core Equity with $270 billion is as middle of the road as one can get, without an overabundance in size categories as well as growth or value oriented stocks. Slightly more aggressive is the Multi-cap Growth oriented portfolios, which is a bit more venturesome. The four other remaining investment objectives with over $100 billion in assets are, in size order, (1) Large Cap Core Equity, (2) International Multi-Cap Growth, (3) Small Cap Core Equity and (4) International Multi-cap Core Equity. All in all, investors are pretty conservative, especially as many have significant market related assets outside of their fund investment.

The preference for active management is easily understood: the average S&P 500 fund in the last ten years (ending in February) is down -3.88%. Of the twenty US diversified investment objectives, 15 of them beat the S&P500 index funds; 8 by going up and 7 by losing less. The same thing could be said by the twenty Sector-Oriented funds; 11 gained and 2 declined less. A caveat should be noted that the fund data base used by my old firm, Lipper Inc., has a survivorship bias. Funds that are no longer available are dropped from the calculations. Thus, the clunkers drop out. Nevertheless, I believe that the general observations made here are valuable.

I believe it was Yogi Berra who said that one can see a lot by observing. When looking at the leaders and laggards for the first two months of 2009, I see widely-held fund types that are in contradiction to the bulk of the way most investors have their assets. As a contrarian, I think it is likely that the leaders and laggards will be reversing positions in the future.

For the first two months of 2009, dedicated Short Biased funds, (the mutual fund business’s answer to the growth of retail oriented hedge funds) took the first twenty-five places as the leading fixed income funds. The laggards were a more diverse group with Financial Service funds getting the four worst performances, and 6 of the twenty-five largest decliners. On the fixed income side the leaders for the first two months were the Loan Participation funds. These are funds that buy loans typically from banks on a non-recourse basis, at a substantial discount from their face value. Another type of leader later in the period was the High Current Yield funds, if you will “junk” bonds. What is significant about these two is that they are attracting risk-assuming equity types of managers and investors.

My, only somewhat biased, conclusion is that mutual funds are often misperceived, can teach us about the markets, and are an appropriate vehicle for all types of investors.

Sunday, March 1, 2009


Many investors, including me, spent Saturday and Sunday of this weekend reading Warren Buffett’s latest letter to the shareholders of Berkshire Hathaway. I was interested in his comments about the company and its quite poor 2008 investments. I have been a shareholder for many years and the stock is in the portfolio of the hedge fund that I help manage. However, my principal focus was on the implications I could draw from the 22 page letter to apply to our other investments and to share with you in this blog.

What follows are items that Mr. Buffett commented in the order of his comments and my reactions to the comments. As usual in most things that I write, my mission is to provoke tangential thinking on your part rather than the laying down dictum “according to Mike Lipper.”

Throughout the letter Buffett focuses on the financial and political abuses of our trust carried out on both the national and local levels. I agree with him that the after-inflation value in various governments’ paper is more questionable now than ever. In addition, Buffett also expects rising unemployment in 2009, and perhaps beyond. Despite those dour views, he intones that the best days for America lie ahead. Part of his optimism is probably based on his assumption that Americans are focused on saving money as never before. (With our oversized position in financial service securities that is good news in the long term.)

Turning to investing in securities, Buffett has a number of observations that may seem to be logically inconsistent, but actually recognize the complexities of investing. “When investing, pessimism is your friend, euphoria the enemy,” Buffett reminds us. Nevertheless, he points out that the S&P500 has gone up about 75% of the time in the last 44 years that he has been managing the company. The historic upward slant to the market has not prevented him from either buying securities or companies. However, his pricing decisions are different and insightful. He says, “We like buying underpriced securities, but we like buying fairly priced operating businesses even more.” I suspect this apparent dichotomy is based on the reality that good, privately-owned businesses managed by owner/operators instinctively know both their present and future values, and want their price.

It is my belief that in the public securities market, future prices are not primarily dictated by the operating results, but by the co-ventures in the security. When will they sell and what will prompt the sale? Thus, one needs to apply a discount from value for the irrational behavior of one’s co-ventures. Given the choice between the two; securities or operating businesses with management attached, Berkshire has a decided bias in favor of buying operating companies at fair prices over securities at a discount. A number of ultra high net worth investors have a similar bias.

Buffett issues some cautions regarding the future. He is suspicious of relying on past financial data, particularly price data in its many derivative forms. Two of his quotes are instructive. First, “Investors should be skeptical of history-based models. Beware of geeks bearing formulas.” Second: “If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.” Having really learned about security investing at the local race tracks, I have a more than skeptical view of those who have a “system” that can beat the odds repeatedly. Despite these cautions, I agree with Mr. Buffett in believing that after many years of under-pricing risk, we are now over-pricing risk. His major financial warning deals with derivatives, which he appropriately labels as dangerous, having spent $400 million to unwind the derivatives he bought at a very wrong price when he purchased General Re.

Despite these feelings, he has entered the market for credit default swaps (CDS). These securities are somewhat like the reinsurance policies that Berkshire manages brilliantly in most instances. On the other hand, in some cases these securities settle many years in the future, and it is the final price that matters, not any of the intervening prices. What makes this much more risky is that the counterparty can, and does change without the permission, or in some cases knowledge, of the other party to the trade. I believe Buffett is correct that until effective clearing houses and exchanges are established, the bulk of this business will rest with a concentrated group of dealers. In this case a handful or less of major banks will be dealers, which add to both risk and opportunity to those in and around the concentrated circle.

Finishing his securities insights, Buffett provides details of his sale of part of his positions in Johnson & Johnson, Procter & Gamble and Conoco, which I assume were largely at a profit. He did this to fund his high yield with equity kickers in Wrigley, Goldman Sachs and General Electric. I am much more confident in the return of all of his capital than I am of the value of the GE kicker. What is significant about these trades is that while Berkshire still had significant cash and debt-carrying capacity, Buffett felt that he should maintain these reserves and accepted the discipline of having to sell some favored positions to fund purchases of better bargains. I am particularly focused on the Conoco sale, made after adding to this position earlier this year. Yet in his letter he states he still believes oil will sell for higher prices in the future to which I concur.

As is appropriate, Mr. Buffett states his views on the current housing credit crisis. Though the letter doesn’t volunteer the information that he is betting on both sides, publicly he urges home buyers to look to their purchase for enjoyment and utility, not for profit and the opportunity to refinance. Less publicly stated, but in the innards of the letter, is the disclosure that the company owns the second largest real estate broker in the country, and that Berkshire will continue to buy local real estate agents at reasonable prices.

No summation of Warren Buffett, his letter, or his work would be complete without a recognition of how great a showman he is, and a genius at cleverly manipulating public opinion through skilled conversations with the press. His PR acumen will be demonstrated at this year’s annual meeting of Berkshire Hathaway, where he has invited three high profile journalists to pose questions to himself and vice chairman Charlie Munger. Included are Carol Loomis of Fortune (who has written more great insightful pieces than any author that I have read), Becky Quick of CNBC (which guarantees electronic media coverage), and Andrew Ross Sorkin of The New York Times (which fits Mr. Buffett’s political tendencies).

Bottom line: One can learn much from Mr. Buffett, but don’t try to copy him, you don’t have the same equipment. He and Berkshire Hathaway will survive. The economic outlook over the next couple years may be challenging, but as the structure of the new world departs from the old, the opportunities for investment bargains will be great.