Thursday, February 26, 2009

Guide the market's invisible hand with a higher principle?




Above is a video of a Presidential address to some members of Congress after a meeting with Treasury Secretary Tim Geithner this past Wednesday, February 25.

In the last sentence of the speech (beginning at about 5:50 into this particular clip), the President declares: "I have the utmost confidence that, if these outstanding public servants standing beside me are working in concert, if we all do our jobs, if we once again guide the market's invisible hand with a higher principle, our markets will recover, our economy will once again thrive, and America will once again lead the world in this new century as it did in the last."

The famous phrase "invisible hand" comes, of course, from Adam Smith's 1776 work, An Inquiry into the Nature and Causes of the Wealth of Nations. There, he explained that:

"every individual necessarily labors to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest nor knows that he is promoting it. [. . .] he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good to be done by those who affected to trade for the common good" (IV.2.9).

Smith had earlier used the term in similar manner in his 1759 book, The Theory of Moral Sentiments. In both cases, he was expressing the truth -- proven over and over in the twentieth century -- that the best distribution of labor and wealth is achieved, not by those who claimed to be working for "the common good" but rather by allowing the individual who "intends only his own gain" to pursue it.

That this "invisible hand" works better than any other method seems on its face incredible to many, and there have been those throughout history who have put into action their belief that it is better to centrally "plan" or "guide" the economy than to allow such a risky idea as to leave individual to pursue "only his own gain."

Austrian economist Friedrich A. Hayek, in his classic 1944 work The Road to Serfdom explained that this long-running debate is often depicted as being between those who want "planning" and those who do not. But this is actually not true, he wrote. In fact, both sides want planning -- it is just a question as to whether planning is more effective when it is done by a central body of governing individuals, or whether planning is actually better effected when it is left to the plans of the millions of free individuals who are left to pursue their own interests for their own gain.

Hayek said, "it is not a dispute on whether we ought to employ foresight and systematic thinking in planning our common affairs. The question is whether for this purpose it is better that the holder of coercive power [i.e. the government] should confine himself in general to creating conditions under which the knowledge and initiative of individuals are given the best scope so that they can plan most successfully; or whether a rational utilization of our resources requires central direction and organization of all our activities according to some consciously constructed 'blueprint'" (41).

To say that "our economy will once again thrive" if we "guide the market's invisible hand by a higher principle" is to move towards the second position -- "some consciously constructed 'blueprint'" -- and away from the first. In fact, it also implies that a failure to "guide the invisible hand" is somehow responsible for the catastrophic financial events of 2008, which in fact the President has also asserted.

We would strongly disagree, and would note that this should be an issue not of politics, but of economics. Adam Smith, Friedrich Hayek, and their descendants in the economics profession have been shown time and again to have put forward sound economics, and the seductive idea that "outstanding public servants . . . working in concert" could somehow guide things better has been shown time and again to be most unsound economics.

As the late Nobel Laureate Milton Friedman wrote in an introduction to a 1971 edition of Hayek's Road to Serfdom, "Experience in the past quarter century has strongly confirmed the validity of Hayek's central insight -- that coordination of men's activities through central direction and through voluntary cooperation are roads going in very different directions: the first to serfdom, the second to freedom. That experience has also strongly reinforced a secondary theme -- central direction is also a road to poverty for the ordinary man; voluntary cooperation, a road to plenty."

We have advanced several arguments which demonstrate that the financial panic and related recession of the last four months of 2008 were not a failure of "the invisible hand" or a demonstration of the idea that individual self-interest needs to be guided with "a higher principle," in previous blog posts such as "Taking stock of 2008," "A failure of government, not of private enterprise," and "This week is not an indictment of free markets."

We believe very strongly that understanding this critical issue is of vital importance to every investor -- in fact, to every human being. We would urge you to take the time to read and appreciate the thinking of Adam Smith, Friedrich Hayek, Milton Friedman, and others who believed as they did, and to spread this message in any way you can.


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Monday, February 23, 2009

Professor Amar Bhide and his Praise of More Primitive Finance







In the previous post, we linked to the speech by Gerry Frigon given on January 26 in which Gerry showed a slide covered with modern portfolio theory algorithms and said, "This is what's wrong with Wall Street, and it's been wrong for about thirty years now."

What's wrong, he said, is "the financial engineering that's taken place on Wall Street over the last twenty or thirty years, and by that I mean the extreme level to which mathematics have played a role in investment decisions on Wall Street."

In the above video from this past Friday, February 20, Columbia Business School Professor Amar Bhide explains on Bloomberg Television some of the perceptive observations that he has been making for many years. Professor Bhide's insights are very much in agreement with our own experience, and are in line with convictions that we have held for many years as well.

In Friday's interview, he notes the influence of the 1975 article by Nobel Laureate Paul Samuelson in the very first issue of the Journal of Portfolio Management, called "Challenge to Judgment." We discussed that article in some detail in our December 15 post, "Beware of the witch doctors of modern finance," noting that Samuelson's "challenge" to the old-school investment managers with their "practical" experience was that they should have to prove that their way was not inferior to "the new world of the academics with their mathematical stochastic processes."

Since the publication of Paul Samuelson's article, the "new world" has been ascending. In fact, it has come to dominate the decision-making process in most financial firms. Professor Bhide observes that "people were eager and willing to follow his advice" and that too many "gave up on doing any analysis of either stocks or bonds" and instead "just constructed these mathematically well-tuned portfolios."

Professor Bhide argues that the ascendancy of the "new world of the academics with their mathematical stochastic processes" led directly to the disastrous situation Wall Street encountered in 2008. He explains that "it is mathematically convenient for the economics profession to reduce all uncertainty to quantifiable stuff, like the toss of a coin or the odds in a roulette wheel."

In a recent piece he published on January 28th, entitled "In Praise of More Primitive Finance," Professor Bhide elaborates on this problem in greater detail. He notes that in 2002 he wrote that "Everyone has bought into the belief -- investors, intermediaries and implicitly (through the promotion of market liquidity) regulators -- that diversified portfolios make the problem of bad judgment disappear. Actually, diversification complements due diligence and oversight; relying on diversification as a substitute exacerbates the problem of bad judgment" (page 11, note 6). For some of our views on that same subject, see previous posts here, here and here.

We are very pleased to observe Professor Bhide's efforts to articulate this important message to the public, to the financial community, to government officials, and to academia. We are also gratified to find confirmation from a scholar of his caliber of views that we developed independently through many years of practical experience in the day-to-day management of portfolios and "up-close and personal" study of the markets. It often seems as though such dissenting voices have disappeared from financial academia entirely!

We wish Professor Bhide continued success in his efforts, and recommend that investors (and policy-makers) pay close attention to what he has to say.


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Wednesday, February 18, 2009

"Managing Investments in the New Era"



















Recently, Gerry Frigon was invited to speak at the Andre, Morris & Buttery Central Coast Business Symposium on January 26, on the topic of "Managing Investments in the New Era."

Above is a link to the full presentation, complete with all the slides and Gerry's discussion (39 minutes).

After you watch the presentation, you may wish to review related blog posts in which we discuss some of the topics Gerry mentioned in his discussion, including:
  • Financial panics of 1907 and 2008, such as here and here.
  • The role of mark-to-market accounting, such as here and here.
  • The blind spots in "modern portfolio theory," such as here and here.
  • The importance of a focus on businesses in investing, such as here and here.
  • The teleputer and the Exaflood, such as here and here.
  • The "Unstoppable Wave" paradigm shift, such as here and here.
The discussion of the current "replacement rate" for houses and automobiles comes from the work of Brian Wesbury, Chief Economist of First Trust Portfolios, whose insights we always find valuable.

Disclosure: During the video, Amazon.com (AMZN) is mentioned. The principals of Taylor Frigon own shares of AMZN.

Video services courtesy of Gallagher Video, Paso Robles, CA.


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Tuesday, February 17, 2009

Return of the 1970s, part 2















During historic times such as this one, it is useful to go back in history to glean potential lessons.

Investors observing the massive increase in government spending are justifiably concerned about two negative side effects: a reduction in economic growth as government spending reapportions funds from the private sector to the public sector, and an increase in inflation. For a discussion of why these are justifiable concerns, see for example the video embedded in this previous post.

The period of history most closely associated with slow growth and rising inflation is of course the 1970s. While we are not suggesting that we are heading into an extended period of years which will exactly parallel the seventies, continuing government expansion into the private sector could well lead to an environment in which growth will be more difficult for companies, and therefore more difficult for investors to find.

We have previously observed in our first post entitled "Return of the 1970s?" that although the seventies were a difficult decade for the economy and for investors in general, there were some innovative businesses, particularly smaller companies, which outperformed tremendously.

We contend that exceptional, innovative companies will always be sought-after investments, but that in difficult economic environments where growth is hard to find, they become even more significant.

Take a look at the annual total return data listed in the chart above, published by Ibbotson Associates in their annual SBBI (Stocks, Bonds, Bills and Inflation) Yearbook. The total returns for large-company stocks (represented in this Ibbotson study by the S&P 500 Stock Composite Index) and for small-company stocks (represented in this Ibbotson study by the fifth capitalization quintile of stocks on the NYSE for years prior to 1981, and by the DFA Small Company Fund thereafter) are shown for the years 1973 through 1984.

The data for those years offer several lessons for the investor. First, it is clear that after the significant bear market of 1973-1974, stocks rebounded sharply in 1975. This alone is important for investors to appreciate, languishing near the lows of a current bear market that has been even more severe than the 73-74 bear market.

It is quite possible that the markets will snap upward with startling velocity when the current banking crisis is resolved. We believe that mark-to-market accounting continues to play a major role in holding the financial system hostage, as we have discussed several times previously (for instance here, here, and here). Repeal or even temporary suspension of the rule may well serve to ignite such a rally.

As impressive as the 1975 and 1976 rebound was for the market, the 52.8% return in 1975 and 57.4% return in 1976 for small-company stocks dwarfed the 37.2% and 23.8% returns for large-company stocks in those same years. In fact, from 1973 through 1983, small-company stocks decisively outperformed large-company stocks every single year, including 1977 and 1981 in which the S&P had negative years and small-company stocks returned 25.4% and 13.9%, respectively.

In 1984, large-company stocks outperformed, with a positive return of 6.3% compared to the negative 6.7% return of small-company stocks. This ushered in a period in which large-company stocks prospered for almost two decades, fueled by a benign environment of lower government intrusion, low inflation, and plenty of the liquidity that the giant enterprise corporations typically need in order to continue growing.

We believe that the market environment of 1984 through 1999 was positive for the kinds of large companies that make up popular indexes such as the S&P 500, and that this period led to the rise of the belief that investors should "just own the index" and they will do well. We have outlined our disagreement with some of the assumptions at the core of "index investing" in previous blog posts, such as this one.

However, during more economically challenging periods, where growth is harder to come by, the same larger companies can generally tread water, and selection of well-run companies involved in some kind of business paradigm shift can become much more important. (For those who look at the chart above and feel that the returns of the large-cap companies during the 1970s don't look too bad all by themselves, remember that during this same period of time, annual inflation was in the high single digits and even the double digits, severely impacting the investor's real return).

Those who continue to believe that investors should "just index" and that the S&P 500 should be the core of most investment portfolios may want to revisit the history of the so-called "Nifty Fifty" stocks that became popular in the 1960s. These large-cap stocks were billed as "one-decision" stocks that an investor could buy once and never sell.

While there is some variation between lists published of the "Nifty Fifty," as explained in this study, it is generally agreed that the Nifty Fifty companies and their stocks prospered in the liquidity-rich 1960s and early 70s, only to be decimated in the 1973-1974 bear market and languish thereafter. The strategy is now history.

We would suggest that such "passive" investing strategies as the Nifty Fifty and the "just index" idea may arise in certain periods that allow broad swaths of companies to grow, but that in difficult environments, a much higher percentage of companies may become bogged down or mired in place, and that serious growth must be found outside of the broad herd and among the narrower population of nimbler, more innovative companies. History suggests that these nimbler innovators will more often be found among smaller companies.

We believe that we may be entering just such a period of investing. For some insights into the investment process that we have always used to find these kinds of businesses, you can use the search window in the upper left corner of the screen to find previous posts on "growth stock investing," such as this one.

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Tuesday, February 10, 2009

Red herrings


The "new Financial Stability Plan" announced this morning by Treasury Secretary Tim Geithner made no mention of the removal of mark-to-market accounting, despite hints last week that the government might finally remove the disastrous accounting rule at the heart of the ongoing banking problem.

In fact, he made a statement which appears to perpetuate the reliance upon only market pricing, rather than alternate methods based on cash-flow valuation, when he said: "Our objective is to use private capital and private asset managers to help provide a market mechanism for valuing the assets."

Instead of the crucial central role of mark-to-market regulation, the Treasury Secretary indicated that the current problems have to do with a lack of lending and credit, saying: "Borrowing costs have risen sharply for state and local governments, for students trying to pay for college, and for businesses large and small. Many banks are reducing lending, and across the country they are tightening the terms of loans."

This assertion is not borne out by the available data, as we pointed out in our previous post entitled "It's a panic, not a Great Depression."

Other red herrings dragged across the trail include condemnation of Boards of Directors regarding compensation, and the specter of rising foreclosure rates. While both of these issues pack a significant emotional charge, arousing a visceral response in many listeners, neither one of them is as critical in destroying bank balance sheets as the far less emotional -- even downright boring -- issue of accounting regulations and specifically the "fair value" accounting regime that was put into place over the past several years, with the final stage going into effect in 2007 and -- in our view -- contributing directly to the panic of 2008.

We would suggest that the significant decline of the market after the Secretary's announcement has nothing to do with the analysis that the new plan is "too little, too late," as some in the media are already suggesting, but rather has more to do with the failure to address this critical problem.

We have no idea why policymakers are choosing to focus on "lack of lending" and other red herrings rather than steps which could immediately mitigate the problem. Perhaps they view these steps as too simple to be the real fix. This is not a good sign for future business activity and investment going forward, and suggests that the principles of selecting companies which we have discussed many times in this blog will become even more critical to investors in the years ahead.

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Wednesday, February 4, 2009

Clayton Christensen, disruptive technology, and your portfolio recovery plan




















The above image of Harvard Business School Professor Clayton M. Christensen is a link to a recent interview in EE Times with Professor Christensen.

The interview, and the work of Professor Christensen, is noteworthy on many levels, and contains important insights with which all classic growth investors should become familiar.

Professor Christensen's 1997 bestseller, The Innovator's Dilemma, introduced his thinking on the concept of "disruptive technology" and its importance in explaining the perplexing phenomenon by which firms at the top of their industry almost inevitably fall out of the top tier altogether.

As he explains in that book, illustrated by extensive data from the business world and numerous examples from recent business history, it is not that these companies simply failed to continue to improve or to innovate, in a world that never stands still.

Instead, it is that companies tend to improve their existing products (a form of innovation that Professor Christensen calls "sustaining innovation") beyond the requirements of even their most demanding customers, even as new entrants introduce technologies that he calls "disruptive innovation."

These new technologies are typically cheaper, and previously were not practical for the mainstream customers, applying perhaps to a small niche, but as they improve they become good enough, and upend the industry, toppling the former leaders who have been focusing on improving the old technology to levels that nobody needs anymore. You can see a short clip of Professor Christensen explaining the distinction between "disruptive innovation" and "sustaining innovation" at his website at this address.

Professor Christensen's work dovetails nicely with the important concepts from Joseph Schumpeter (also a professor at Harvard) concerning "Creative Destruction" and the insight that industrial progress and business progress "is a history of revolutions."

As we explained in our previous post on Schumpeter, the crucial role of innovation is completely ignored by the mathematical models that underlie "modern portfolio theory" (as well as by most of the mathematical models that underlie Keynesian economics, leading to the idea that you stimulate an economy by stimulating consumption, rather than by removing government barriers to production and disruptive innovation).

Instead of focusing on charts of the "efficient frontier" and formulas that purport to tell them how much "beta" and "R squared" they have in their portfolios, investors should focus on the concepts of innovation articulated by Schumpeter and Clayton Christensen.

We have said that investing should be looked at as providing capital to innovative companies. If the investor is providing equity capital, he is hoping to participate in the rewards of adding value through innovation. If the investor is providing debt capital, he wants to be sure the company is not going to be put out of business by a stubborn adherence to "sustaining innovations" in the face of a new disruptive innovation.

In previous posts, we have explained how this crucial concept of "disruptive innovation" or "Creative Destruction" can be practically applied to investing. See for example the posts relating to "paradigm shifts," the "topple rate," and the discussion of what growth-stock theory innovator Thomas Rowe Price called "fertile fields for future growth."

Finally, note carefully what Professor Christensen says in the recent video interview about the current environment and what businesses are probably doing during the economic downturn. He explains that adverse circumstances can be "framed" as either an opportunity, or as a threat. Those who perceive them as a threat typically "hunker down," become defensive, and hope they survive. On the other hand, he predicts "strong companies kind of using this piece of down-time to really aggressively prepare for when the economy turns around."

This insight applies to companies, but it is equally applicable to investors, who can themselves choose to "frame" the current environment as a threat, or as an opportunity.

For all these reasons, it would behoove investors to become familiar with the work of Clayton Christensen.

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Monday, February 2, 2009

First, do no harm

























The current stimulus plan working through Congress is a terrible plan! It is full of pork spending and little incentive for growth. The best solution for solving the current crisis includes an end to mark-to-market accounting, a program of incentives to business and investors which keeps marginal tax rates low (preferrably flat as well), and continued support of the credit system by the Fed and the Treasury (as should be their role in a crisis). These are all issues we have discussed previously at length but the looming threat of passage makes restatement critical, in our view.

Our post entitled "The consumption / production distinction with regard to stimulus plans," in which we explained why we disagree with the stimulus bills in general, demonstrates that the current stimulus bill does not have solid intellectual arguments in its favor nor does it have any previous historical examples of success from similar legislation.

In fact, there are plenty of examples from history which show that such misguided stimulus can be quite harmful.

Recently, Professor John H. Cochrane of the University of Chicago's Booth School of Business published an article entitled "Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?" in which he details the many possible deleterious side effects possible from the stimulus package now being debated.

Noting that medical analogies are often used in order to argue that "we have to do something," Professor Cochrane asserts that if we are going to use medical analogies, then the medical rule we should observe right now is "First, do no harm" and proposes that 90% of good economic policy is encompassed in that simple dictum.

He goes on to note that the kind of stimulus proposed by John Maynard Keynes has long fallen into disfavor in economic thought, and that even the neo-Keynesians now reject the solutions that Keynes proposed prior to the insights of Friedrich Hayek and Milton Friedman.

Professor Cochrane says that "Fiscal stimulus advocates are hanging onto a last little timber from a sunken boat of ideas, ideas that everyone" including the Keynesians themselves have abandoned.

We explain the role of mark-to-market accounting in greater detail in previous posts, including "Taking stock of 2008" and "It's not worth zero, but if the market says it is . . ."

Removing the mark-to-market requirement (or allowing it to be used in parallel with other valuation methods based on cash-flows or the value of the collateral, as suggested by Alex J. Pollack), providing tax rate cuts, and allowing the actions that the Fed and Treasury have already taken to do their work, will resolve the problem without the potentially disastrous consequences of the stimulus now being proposed by Congress.

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