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 15, 2009
Sunday, March 8, 2009
WHAT WE CAN LEARN FROM MUTUAL FUNDS
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.
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
LESSONS TO ALL INVESTORS FROM WARREN BUFFETT’S LETTER
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.
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.
Sunday, February 22, 2009
Washington & the Necessary, But Insufficient, Signs of a Market Bottom
Feeding the optimist can be a long and frustrating task, but a necessary one. I am taking on this task to help others as well as to reinforce my upside bias. This bias is based on the old US Marine Corps belief that the best defense is an offense. Like most analysts, I am a reviewer of history; and I believe that even in history’s darkest moments, the human condition has been on the rise.
In the midst of our deep financial problems, we may be in the best position ever to deal with solutions. The current mood of investors is shifting to the view that the light at the end of the tunnel is not a way out, but rather an oncoming train. Historically this feeling of hopelessness is a required backdrop for the scene at the bottom. With that thought in mind, I was thrilled to see a story entitled “Bear Market’s Bite Could Go Deeper” in the online version of The Washington Post. “It is unlikely the market has hit bottom,” the article begins, continuing with the opinion of a chief technical analyst at S&P, “The current market environment is showing few signs that have characterized previous lows—high price volatility, high volume of trading and even higher levels of fear.” “Bear market bottoms tend to be violent affairs.”
Why am I thrilled with this article? First, the Washington Post is the single most respected source of perceived wisdom, therefore it must be politically correct in the Washington Beltway. Second, based on the high regard the American investing public has for the media in general, people now search for truth in the opposite direction of media pronouncements. Third, the S & P analyst is accurate only if one is dealing with a cyclical bear market where the search is for a violent bottom to wipe out the weak holders as a precursor to a sharp rise. This kind of bottom is not logical if one believes, as I do, that this bottom is the terminal set of points at the close of one era. The most logical type of bottom after the damage of the corrective phase is a dull exhaustion bottom, created by the absence of buyers at any price. The pessimists are exhausted and possibly sold out; and the optimists, like me, feel the prices are fine, but the time may not be quite right.
One of the many signs of a tectonic shift in the structure of our investment markets crossed my desk late this week, driving home the impact on our conservative and senior population. I received a notice from the American Funds Group announcing that their Balanced Fund was reducing the dividend to its fund holders. The explanation for the cut was the curtailment of dividends from the high quality stocks they own, as well as the current low interest rates on high quality fixed income securities in their portfolio. As many of you know, the American Funds are managed by Capital Research one of the largest investment management groups, with a long history of distinguished results.
A word about the origins of Balanced funds. This type of fund was an extension of the trust accounts used in both the UK and the US, comprised of both stocks and bonds. In Boston, these were the types of accounts that Clipper Ship Captains left with their lawyers to manage while they were away. The income off the trust was to provide for the current needs of the family, and the stocks for growth of assets. In many ways balanced funds act more like fiduciary accounts than the single asset class type funds.
There are a number of important observations from this action to reduce the dividend:
In some ways we may be in a Revolutionary period similar to the French or scientific revolutions or even closer to home, the American Revolution. I am writing this blog on February 22nd, George Washington’s birthday. As my wife Ruth serves as a “Lifeguard,” a group devoted to fund-raising and introductions to the wonders of Mount Vernon, we often go there to celebrate the memory of our first President, the only one not to serve in the city named after him. For the moment I want to focus on this man, often called “the indispensible Washington.”
If we are truly in a revolutionary period, where are our leaders like Washington, Hamilton and the others? The politicians and most of the patriots turned to General Washington for the leadership of what could be laughingly called our army. It was a bold step to choose a military leader who had been defeated in the last war, but he was possibly the richest man in the colonies. His fortune was earned by brilliant land speculation in many of the thirteen colonies and other nearby regions. During the Revolution we had better tactical generals, but none better on a strategic level. Interestingly, Washington was constantly out of sorts with Congress, and threatened to resign on numerous occasions if provision was not made for the meager funds to pay his troops.
The war was won largely due to the quality of Washington’s leadership, a fortunate break in the weather and the threatened presence of the French fleet. Washington’s leadership created trust on the part of his soldiers and perhaps the one-third of the population that supported the cause. At the moment what we are missing is faith, or if you will, trust in our institutions, media, economy and markets. Each day many of us start the day with low trust in that list, and the actions of the day lowers the trust even further. What we need now during what appears to be a revolutionary period, is faith that things will get better. Let us hope so. History suggests that eventually the optimists win.
In the midst of our deep financial problems, we may be in the best position ever to deal with solutions. The current mood of investors is shifting to the view that the light at the end of the tunnel is not a way out, but rather an oncoming train. Historically this feeling of hopelessness is a required backdrop for the scene at the bottom. With that thought in mind, I was thrilled to see a story entitled “Bear Market’s Bite Could Go Deeper” in the online version of The Washington Post. “It is unlikely the market has hit bottom,” the article begins, continuing with the opinion of a chief technical analyst at S&P, “The current market environment is showing few signs that have characterized previous lows—high price volatility, high volume of trading and even higher levels of fear.” “Bear market bottoms tend to be violent affairs.”
Why am I thrilled with this article? First, the Washington Post is the single most respected source of perceived wisdom, therefore it must be politically correct in the Washington Beltway. Second, based on the high regard the American investing public has for the media in general, people now search for truth in the opposite direction of media pronouncements. Third, the S & P analyst is accurate only if one is dealing with a cyclical bear market where the search is for a violent bottom to wipe out the weak holders as a precursor to a sharp rise. This kind of bottom is not logical if one believes, as I do, that this bottom is the terminal set of points at the close of one era. The most logical type of bottom after the damage of the corrective phase is a dull exhaustion bottom, created by the absence of buyers at any price. The pessimists are exhausted and possibly sold out; and the optimists, like me, feel the prices are fine, but the time may not be quite right.
One of the many signs of a tectonic shift in the structure of our investment markets crossed my desk late this week, driving home the impact on our conservative and senior population. I received a notice from the American Funds Group announcing that their Balanced Fund was reducing the dividend to its fund holders. The explanation for the cut was the curtailment of dividends from the high quality stocks they own, as well as the current low interest rates on high quality fixed income securities in their portfolio. As many of you know, the American Funds are managed by Capital Research one of the largest investment management groups, with a long history of distinguished results.
A word about the origins of Balanced funds. This type of fund was an extension of the trust accounts used in both the UK and the US, comprised of both stocks and bonds. In Boston, these were the types of accounts that Clipper Ship Captains left with their lawyers to manage while they were away. The income off the trust was to provide for the current needs of the family, and the stocks for growth of assets. In many ways balanced funds act more like fiduciary accounts than the single asset class type funds.
There are a number of important observations from this action to reduce the dividend:
- The current market decline is now going to be felt by those who can least afford a change to their income level.
- Many high quality stocks have cut or omitted their dividends. These are the very same corporations that were considered among the most reliable of our corporate citizens as recently as one year ago. Something fundamental has changed for the worse among our best.
- The original investment concept of a Balanced fund was that stocks and bond prices would move inverse to each other. Bond prices would rise when stocks declined. Currently in the high quality corporate bond market this is not happening in a significant way. This is another example of the tectonic shifts in our marketplaces. The term tectonic is an apt geological term that that defines when the great plates that make up the earths’ crust move, which happens extremely rarely. We are now into something new and maybe for the first time in our investment lifetimes, something “completely different.”
In some ways we may be in a Revolutionary period similar to the French or scientific revolutions or even closer to home, the American Revolution. I am writing this blog on February 22nd, George Washington’s birthday. As my wife Ruth serves as a “Lifeguard,” a group devoted to fund-raising and introductions to the wonders of Mount Vernon, we often go there to celebrate the memory of our first President, the only one not to serve in the city named after him. For the moment I want to focus on this man, often called “the indispensible Washington.”
If we are truly in a revolutionary period, where are our leaders like Washington, Hamilton and the others? The politicians and most of the patriots turned to General Washington for the leadership of what could be laughingly called our army. It was a bold step to choose a military leader who had been defeated in the last war, but he was possibly the richest man in the colonies. His fortune was earned by brilliant land speculation in many of the thirteen colonies and other nearby regions. During the Revolution we had better tactical generals, but none better on a strategic level. Interestingly, Washington was constantly out of sorts with Congress, and threatened to resign on numerous occasions if provision was not made for the meager funds to pay his troops.
The war was won largely due to the quality of Washington’s leadership, a fortunate break in the weather and the threatened presence of the French fleet. Washington’s leadership created trust on the part of his soldiers and perhaps the one-third of the population that supported the cause. At the moment what we are missing is faith, or if you will, trust in our institutions, media, economy and markets. Each day many of us start the day with low trust in that list, and the actions of the day lowers the trust even further. What we need now during what appears to be a revolutionary period, is faith that things will get better. Let us hope so. History suggests that eventually the optimists win.
Monday, February 16, 2009
For the Greater Good: Frugality vs. Stimulus, T.A.R.P. and Foreclosure Relief
In this Sunday’s New York Times, Cornell Professor Robert H. Frank wrote an article entitled “Go Ahead and Save. Let The Government Spend,” in which he discussed whether taxpayers should resist spending their last dollar and let the government spend through the stimulus package, TARP and similar programs including the expected foreclosure relief package. In the article, Professor Frank referred to the John Maynard Keynes essay, the “Paradox of Thrift,” which argued that increasing individuals’ savings rates has the effect of reducing aggregate demand, and because of the negative multiplier effect, actually reduces personal income. Over the past seventy years many academics and politicians have used this analysis to conclude that government should stimulate a declining economy with grants. Keynes would individually have us spend our last dollar to lift the economy. In the Times article, Prof. Frank disagrees, “Taxpayers shouldn’t feel bad for putting their own savings first.” He stresses that personal savings find their way into the financial system, usually through some form of deposits. These deposits will force banks to compete for good loans by lowering interest rates which helps some existing borrowers as well as new borrowers.
I agree with the thesis that we should let the Government spend our money first, whether it provides optimum benefit to the economy or not. However, there are two stronger arguments that Professor Frank could have made. The first has to do with the contrast between the multiplier on consumer goods and services purchases as opposed to the multiplier on capital goods purchases. The largest part of consumer spending is for immediate or near-term consumption, which pays for the human labor already expended. Compare this impact to spending on capital-producing investments, such as mining or manufacturing, which may produce much larger revenues and earnings in the future. Those who favor immediate satisfaction by spending today are following the same pattern of over-spending and under-saving that is one of the causes of our current calamity. In effect, this is a consumption based philosophy that does not look to the needs of the future. In contrast, savings that support capital production does grow the size of the pie.
In order to make wise capital expenditures, business people assume various contingencies when building their calculations for cost of capital and expected returns on their capital, including sweat equity. I believe that from an economic measure, the return on private capital spending is materially higher than consumption expenditures. Thus, we should all be increasing our savings for the long-term benefit of the economy.
The second reason we should encourage savings is that frugality has its own reward. In my recent book Money Wise, I suggest that the second most important way to convert riches into wealth is by controlling expenditures. If your goal is to increase your savings from the current 5% to 9%, you will need to find the other 4%. You will do this by either expanding your gross income or finding some expenses you can do without, or can delay. In other words you will become a much more efficient purchaser. This more efficient mind set will stay with you for a much longer period of time than will the pleasure of consumption, and thus will have a more lasting benefit to you, yours and your charitable endeavors.
I agree with the thesis that we should let the Government spend our money first, whether it provides optimum benefit to the economy or not. However, there are two stronger arguments that Professor Frank could have made. The first has to do with the contrast between the multiplier on consumer goods and services purchases as opposed to the multiplier on capital goods purchases. The largest part of consumer spending is for immediate or near-term consumption, which pays for the human labor already expended. Compare this impact to spending on capital-producing investments, such as mining or manufacturing, which may produce much larger revenues and earnings in the future. Those who favor immediate satisfaction by spending today are following the same pattern of over-spending and under-saving that is one of the causes of our current calamity. In effect, this is a consumption based philosophy that does not look to the needs of the future. In contrast, savings that support capital production does grow the size of the pie.
In order to make wise capital expenditures, business people assume various contingencies when building their calculations for cost of capital and expected returns on their capital, including sweat equity. I believe that from an economic measure, the return on private capital spending is materially higher than consumption expenditures. Thus, we should all be increasing our savings for the long-term benefit of the economy.
The second reason we should encourage savings is that frugality has its own reward. In my recent book Money Wise, I suggest that the second most important way to convert riches into wealth is by controlling expenditures. If your goal is to increase your savings from the current 5% to 9%, you will need to find the other 4%. You will do this by either expanding your gross income or finding some expenses you can do without, or can delay. In other words you will become a much more efficient purchaser. This more efficient mind set will stay with you for a much longer period of time than will the pleasure of consumption, and thus will have a more lasting benefit to you, yours and your charitable endeavors.
Sunday, February 8, 2009
Financial Community Restructures
For close to fifty years I have participated in the financial community as a worker and/or investor; in the U.S. markets and as an investor overseas. I see our financial world undergoing massive changes, both as a unit and through its interactions with organizations and individuals. Amidst these changes, I have been formulating a course of action for the money I have been, or will be, entrusted to invest. Some of my ideas are starting to congeal into view. These thoughts were reinforced by Jason Zweig, the always thoughtful and well-researched author of “The Intelligent Investor” column in the weekend edition of The Wall Street Journal. A friend for many years, this weekend Jason points out the hopelessness of trying to control the level of bonuses on Wall Street. He recognizes that the large firms inflicted by the TARP will out-source most of their high compensation work to firms in which they have some ownership.
My thought pattern is more encompassing, and to some extent a throw-back to a Nineteenth or early Twentieth Century model. My basic concept might be called the “Single Capacity Approach.” First, an entrepreneur or group of entrepreneurs would find a banker (most likely a merchant banker or venture capitalist) to provide the next level of capital and to offset risk from its own resources. Once additional capital was needed, then an investment banker would be sought. In the old days, this firm would be called a buying firm, somewhat analogous to the role often played by the old First Boston. Up to this point, as all of the participants would be using their own, relatively small amounts of private capital, one would think they would exert a reasonably high level of prudence in their risk aversion. There would not be much systemic risk if any participants failed.
In this model, the buying firm would have no direct customers and would turn to a selling firm who has commissioned brokers to sell the new merchandise. As the selling firm would only have investors as clients, they would research the prospects of their underwritings very carefully. Because of the need to underwrite these issues, some public ownership would be desirable. If the selling firm would go bust, it would not create a major failure. The ownership of selling organizations has always been problematic for the marketplace because of the over-zealousness of commissioned sales people, or the risks of the selling organization pushing its own proprietary products. (The latter event can create a major risk). Recently, there have been press reports that Bank of America turned to its newly-owned Merrill Lynch to sell Bank of America’s own capital-raising issue. Similar lapses in judgment are ill-advised and may quickly bring the reversal of the repeal of the two sections of the Glass-Steagall Act that prohibit commercial and investment banking from cohabitating. When properly supervised, the selling firms, as well as commercial banks could provide custodian services, including margin lending and securities lending to their clients.
To protect the public investor in these underwritten and publicly traded securities, there should be a bunch of intermediaries/fiduciaries independent of the commercial bankers, investment bankers, venture capital firms and most important of all, the selling organization firms; they could be independent advisers, mutual funds and hedge funds with enhanced disclosure. While the need for substantial capital for these intermediaries is not enormous, they could be publicly traded to facilitate internal transfers of ownership and the settlement of estates.
The structure that I outline is far from perfect, but it has the advantage of keeping the required capital relatively small and reduces the need for TARP-like intervention in the capital base and compensation tables.
I look forward to hearing your views, please comment.
My thought pattern is more encompassing, and to some extent a throw-back to a Nineteenth or early Twentieth Century model. My basic concept might be called the “Single Capacity Approach.” First, an entrepreneur or group of entrepreneurs would find a banker (most likely a merchant banker or venture capitalist) to provide the next level of capital and to offset risk from its own resources. Once additional capital was needed, then an investment banker would be sought. In the old days, this firm would be called a buying firm, somewhat analogous to the role often played by the old First Boston. Up to this point, as all of the participants would be using their own, relatively small amounts of private capital, one would think they would exert a reasonably high level of prudence in their risk aversion. There would not be much systemic risk if any participants failed.
In this model, the buying firm would have no direct customers and would turn to a selling firm who has commissioned brokers to sell the new merchandise. As the selling firm would only have investors as clients, they would research the prospects of their underwritings very carefully. Because of the need to underwrite these issues, some public ownership would be desirable. If the selling firm would go bust, it would not create a major failure. The ownership of selling organizations has always been problematic for the marketplace because of the over-zealousness of commissioned sales people, or the risks of the selling organization pushing its own proprietary products. (The latter event can create a major risk). Recently, there have been press reports that Bank of America turned to its newly-owned Merrill Lynch to sell Bank of America’s own capital-raising issue. Similar lapses in judgment are ill-advised and may quickly bring the reversal of the repeal of the two sections of the Glass-Steagall Act that prohibit commercial and investment banking from cohabitating. When properly supervised, the selling firms, as well as commercial banks could provide custodian services, including margin lending and securities lending to their clients.
To protect the public investor in these underwritten and publicly traded securities, there should be a bunch of intermediaries/fiduciaries independent of the commercial bankers, investment bankers, venture capital firms and most important of all, the selling organization firms; they could be independent advisers, mutual funds and hedge funds with enhanced disclosure. While the need for substantial capital for these intermediaries is not enormous, they could be publicly traded to facilitate internal transfers of ownership and the settlement of estates.
The structure that I outline is far from perfect, but it has the advantage of keeping the required capital relatively small and reduces the need for TARP-like intervention in the capital base and compensation tables.
I look forward to hearing your views, please comment.
Sunday, February 1, 2009
The Next Big One - FX
The Madoff scandal and other similar grand thefts come as a complete surprise to people, but they shouldn’t. Why? Bad behavior is part of the human condition. Large scandals happen because they can happen. Investors believe first in people, and second in their own understanding of the perpetrator’s personality. In the back of these investors’ minds is a belief that there are effective, long-established controls that would prevent any large frauds to take place. Often the mind of an outright criminal, or more likely someone who “temporarily borrows money” from the unsuspecting, is smarter than the best of the designers of financial/trading controls. Most of the large losses experienced over the last ten years grew because the perpetrator(s) understood “the back office” systems better than those in charge of various compliance functions. Some may have actually been motivated by the battle of man vs. machine, where the lone mind can beat the machines and their watchdogs. I will let the lawyers and the forensic accountants supply the blueprints to the Madoff scandal, if they can. I am attempting to spot the next big, unexpected fraud.
One of the attributes of securities fraud is that the ultimate size of the transfer of wealth is usually large. In most cases of embezzlement, the initial transfer is small and is designed to cover an error or unauthorized trading loss. However, once the person learns how easy it is to cover the tracks, the need to fill an ever larger hole or desire often prompts a continuation of the transfers. Until conditions and compliance functions change, these activities will continue. Most of these frauds “go with the flow” of enthusiasm in rising markets.
Showing both my age and my experience as an aerospace analyst, I was attracted to the competition to build the next experimental fighter aircraft, which led to a procurement of thousands of aircraft, translating into tens of billions of dollars. Another, larger weapon system is also labeled “FX,” and has a similar order of magnitude cost. This second FX is Foreign Exchange transactions, not a weapon that can travel the world in supersonic speed, but one that can span the globe in milliseconds.
Even in today’s world of expanding global trades, and the need to pay for goods and services in different currencies, the share of the FX market needed to settle these transactions is believed to be a small part of the total FX market.
The bulk of the FX market is made up of two components. The first is the exchange of currencies required to settle securities trades, e.g. the American buyer of a German bank share. The second component is those transactions that are undertaken to make a profit. In the most recent weekend edition of the Financial Times there is a long interview with George Soros, who I knew years ago as a struggling defense/aerospace analyst. The article includes a brief description of his $10 billion trade against the pound sterling. As a result, he and his funds made $ 1 billion, and received the title, “The man who broke the Bank of England.” The bank was on the other side of the trade, trying to support the pound. What is not publicly known is how much of the position was equity, and how much was borrowed. In those days and today, one can borrow up to 99% against currency collateral.
Numerous advertisements on financial cable channels point out that the FX market trades more each day than any other financial market, and is never closed. These purveyors will make their money by loaning capital to the retail investor who wants to take the relatively small daily changes in currencies and multiply it by the use of margin. The ads focus on the lack of regulation. In the scheme of things these activities can be described as small potatoes.
The big enchilada is the trades with and among the banks. To gain some insight into this size, we can learn from the fourth quarter statement of 3 trust banks that have large custodian business and whose foreign exchange earnings were in the hundreds of millions of dollars (one of the few earnings plusses for the quarter). The unknown players in this market are the investment banks’ FICC Groups (Fixed Income, Currency and Commodities), dealing through their proprietary desks and other hedge funds. Some or all of these use various derivatives including currency forwards.
My bottom line is that the FX markets are huge, largely unregulated, with complex compliance procedures which may not be fully water-proofed, and fueled by the prospect of large gains and oversized bonuses. As with my aerospace days, FX can be a major weapon of destruction. Don’t say that you weren’t warned.
One of the attributes of securities fraud is that the ultimate size of the transfer of wealth is usually large. In most cases of embezzlement, the initial transfer is small and is designed to cover an error or unauthorized trading loss. However, once the person learns how easy it is to cover the tracks, the need to fill an ever larger hole or desire often prompts a continuation of the transfers. Until conditions and compliance functions change, these activities will continue. Most of these frauds “go with the flow” of enthusiasm in rising markets.
Showing both my age and my experience as an aerospace analyst, I was attracted to the competition to build the next experimental fighter aircraft, which led to a procurement of thousands of aircraft, translating into tens of billions of dollars. Another, larger weapon system is also labeled “FX,” and has a similar order of magnitude cost. This second FX is Foreign Exchange transactions, not a weapon that can travel the world in supersonic speed, but one that can span the globe in milliseconds.
Even in today’s world of expanding global trades, and the need to pay for goods and services in different currencies, the share of the FX market needed to settle these transactions is believed to be a small part of the total FX market.
The bulk of the FX market is made up of two components. The first is the exchange of currencies required to settle securities trades, e.g. the American buyer of a German bank share. The second component is those transactions that are undertaken to make a profit. In the most recent weekend edition of the Financial Times there is a long interview with George Soros, who I knew years ago as a struggling defense/aerospace analyst. The article includes a brief description of his $10 billion trade against the pound sterling. As a result, he and his funds made $ 1 billion, and received the title, “The man who broke the Bank of England.” The bank was on the other side of the trade, trying to support the pound. What is not publicly known is how much of the position was equity, and how much was borrowed. In those days and today, one can borrow up to 99% against currency collateral.
Numerous advertisements on financial cable channels point out that the FX market trades more each day than any other financial market, and is never closed. These purveyors will make their money by loaning capital to the retail investor who wants to take the relatively small daily changes in currencies and multiply it by the use of margin. The ads focus on the lack of regulation. In the scheme of things these activities can be described as small potatoes.
The big enchilada is the trades with and among the banks. To gain some insight into this size, we can learn from the fourth quarter statement of 3 trust banks that have large custodian business and whose foreign exchange earnings were in the hundreds of millions of dollars (one of the few earnings plusses for the quarter). The unknown players in this market are the investment banks’ FICC Groups (Fixed Income, Currency and Commodities), dealing through their proprietary desks and other hedge funds. Some or all of these use various derivatives including currency forwards.
My bottom line is that the FX markets are huge, largely unregulated, with complex compliance procedures which may not be fully water-proofed, and fueled by the prospect of large gains and oversized bonuses. As with my aerospace days, FX can be a major weapon of destruction. Don’t say that you weren’t warned.
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