Sunday, July 25, 2010

The Danger of Too Much Capital

Some women have been told they can be never too rich or too thin. In the financial regulatory world some say “you can never have too much capital.” After most market crashes, regulators call for more capital. In regulators' analyses, the firms that failed were under-capitalized. A careful examination of the failed firms showed that most had assets in excess of liabilities. They had merely made a misallocation of capital, often in relatively new areas that proved to be more illiquid than thought. Both Lehman Brothers and Bear Stearns had more assets than liabilities if their mortgages and real estate were properly marked.

What is of more concern to me is that often after a new surge in capital, firms, governments, and individuals make large new investments in areas “beyond their circle of competence,” to use Warren Buffett's phrase. As Wall Street firms moved from partnerships to corporations, regulators expressed a desire for permanent capital. This led to some firms going public, being acquired, or obtaining large strategic investors. Both Goldman Sachs and Morgan Stanley followed this route and built up capital businesses beyond their historical bases. Lehman and Bear Stearns were less successful in generating excess capital and were prone to using leverage. All of these firms were among the leaders in the arbitrage business which allowed them to take momentary advantage of unequal prices within markets. These skills were critical in the development of other proprietary trading activities using leverage. Because part of these trades involved being short certain securities, a culture of concern about counter parties evolved.

One of the lessons from both the arbitrage and the proprietary trading desks is when traders have too large a line of capital they take on more risk to earn a return on the enlarged capital base. This has often led to large losses. Governments also generate augmented capital. In ancient times this capital was from defeated countries. In modern days the augmented capital comes from the captive taxpayers. The results are the same, to allow the rulers to undertake new adventures or programs. In a similar way, when a family becomes rich beyond its legitimate needs it also takes on new initiatives. Understandably, this is one of the problems we deal with advising ultra high net worth families. However, it is more difficult with average net worth families, smaller companies and governments. More capital without more discipline is dangerous.

Applying this lesson to the selection of stocks, I would suggest that one should be wary of companies that have a great deal of excess capital. Disciplined investors should invest in disciplined companies.

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