A Market Transition? We Hope So!

image: Wikimedia commons.

It has been a lousy stock market lately, although we suggest that this is part of a healthy reassessment which has actually been going on for a long time -- well over a year, in fact, since many small and middle-sized companies are already considerably off of highs reached before then. We believe the market needs to shake off its dependency on the U.S. Federal Reserve's easy monetary policy.  Essentially, we think we may be starting the much-needed process of weaning markets off of the perceived need for liquidity from the Fed as the basis for keeping the markets afloat.

It is our view and has been for some time that the world needs to transition from liquidity as the driver of value to business fundamentals; that we need to get back to investing for investment's sake and off of financial engineering, whether that engineering is done by the Fed or by businesses themselves. And while the process may be painful in the interim, particularly because growth oriented companies get caught up in a "risk off" mentality, we think the focus will eventually turn to business acumen, and the business merits of companies as the determinant of stock values.

At this time, the mentality of the market is to be afraid of a stronger dollar and higher interest rates.  The truth be told, many of today's market participants have only experienced the Fed-induced market of the 21st century in their careers. They've only been in this business during this period of great Fed influence. We believe we will eventually return to a 1980s-90s-type of market in which the U.S. Dollar, interest rates, and stock markets are more positively correlated (at least in the sense that the absolute level of interest rates is higher, not that interest rates need to drop) and commodities ease, including gold (maybe most notably gold).  This will allow for a much healthier market environment and one which is more friendly towards businesses that are performing well from a business standpoint, not just those who are managing stock buy-backs and "tax inversions" as the means to drive stock prices.  It will also incentivize businesses to increase capital investment, which has been sorely lacking in this anemic economic recovery, thereby fueling more overall business activity, and solid growth.  As we stated earlier, this may be a bit painful but in the longer term it is very healthy.  And we would also add that in order to really get this transition on track, we will need more business- and investment-friendly policies out of Washington.  

Stay tuned!

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Have you heard of this company? PRAA

The previous post discussed the investment philosophy of Thomas Rowe Price, Jr., and his conviction that investors should focus primarily on the business merits of the company, and on finding well-run businesses positioned in front of fertile fields for future growth, and then should consider owning those selected companies through the inevitable ups-and-downs of market cycles.

This approach was a stark contrast to the much more prevalent investment styles, both in Rowe Price's day and in the present day, of trying to predict different turns in the economic cycle or the market cycle, and trying to jump in and jump out of different stocks, sectors, geographies, currencies, or other asset classes based on those predicted inflections (we've written about the problems with this approach many times in the past, including here, here, and here). 

In the past, we've published several short profiles of companies that we own in the portfolios that we manage and that exhibit the classic growth-stock characteristics that Thomas Rowe Price and Richard Taylor sought out, and that we have owned through the cycles of relative popularity or unpopularity on Wall Street, often with happy results for our clients (see lists in these previous posts, here and here and here). 

An example of a Taylor Frigon growth company which we have owned for many years and which often falls in or out of favor with Wall Street based on the popular attempts to predict different turns in economic cycles is PRA Group, a specialty finance company providing accounts receivable management*. "Accounts receivable" is an accounting term referring to an asset in which another party has yet to pay for a good or a service, and therefore owe some payment, which the asset owner expects to someday receive -- hence, a "receivable." 

PRA Group helps to encourage the payment of the receivable payment: simply put, PRA Group performs debt collection. The business model that PRA follows is fairly straightforward. It buys the receivables of companies who have given up on trying to collect on those receivables and who just want to get something for them rather than nothing. PRA can buy these defaulted receivables for literally "pennies on the dollar," because the originator of the accounts has basically despaired of getting anything on them at all. PRA then assigns their own experienced and well-trained teams to work on getting some of the receivables.

PRA has tremendous experience in valuing and purchasing the debt that they believe they can still collect on, and because they have now paid off the first lender, if they are able to recover more than what they paid for the receivable that amount will belong to PRA. They thus perform a service for the original owner of the receivable (who would prefer to get something back on a defaulted extension of credit to another person) and often to the party who owes the money as well, since simply continuing to not pay is often not the best choice unless bankruptcy is imminent. 

In some cases, PRA will work on a "contingency" basis, in which they do not actually purchase the receivables from the originator, but instead will perform the collection services on a contingency basis, keeping a percentage of the collections as a fee from the originator who has chosen for whatever reason to outsource the collection instead of making all the calls themselves.

Although this business model is fairly straightforward, that does not mean it is easy to be successful at it: PRA has seen most of their competitors in the same field drop out of the business. Many of their competitors relied on borrowing huge amounts of money (leverage ratios well above 1) in order to finance their own purchase of receivables, and/or on bundling up and "securitizing" the receivables that they themselves bought, to sell them to Wall Street as a security to sell to investors. PRA Group relied on neither of these two strategies, and have watched many of their competitors who did use these approaches exit the business or fail. This has left PRA Group in the enviable position of dominating a market with little competition -- and while there are not necessarily that many barriers to entry, history has shown that succeeding in the market can be difficult.

PRA Group has managed to grow operating earnings by a compound annual rate of 28.7% for the past five years. The company's return on assets is approximately 10.9%, and return on equity is approximately 17.1% (on total debt-to-assets of 0.46). This previous post cited some of the "hurdles" in some of those departments that Thomas Rowe Price used to look for in a company, and PRA exceeds the standard in each category by a wide margin.

Some investors may have some qualms about investing in a company which performs debt collection services, on the grounds that consumer credit problems are often a major burden to individuals and families in difficult circumstances and difficult economies, which is a valid concern (and one that is tied to the larger problems of erroneous neo-Keynesian economic theory and excessive central bank "perpetual emergency stimulus" policy).

However, while we agree that this is a serious issue and a serious problem, it would be foolish to argue that credit or receivables are not very important aspects of an economy. Without such mechanisms, no one would be able to start restaurants or dry cleaning businesses unless they had enough cash of their own before they even opened their doors (which would exclude all but a very small percentage of the population). There are many other examples of places in which purchases using credit can be appropriate and prudent. 

If we grant that receivables have an important role to play, then it stands to reason that the recovery of receivables is an important task as well. We would also hasten to point out that PRA Group approaches this necessary task in a professional manner, and can be held to account in doing so by the fact that they depend on their reputation for business -- and for investors!

While the economy has gone through many gyrations since we first invested in PRA Group, we believe that it is better to own good companies through cycles than to try to predict when things will be better or worse for their specific industry and try to "jump in" and "jump out." The name is up well over 230% since we first invested in PRA Group.

We believe that this is a valuable example of a well-run business operating in a market with significant potential for future growth -- and an even more valuable example of a name that many investors would be tempted to trade based on predictions about economic cycles, but that proves the value of the Growth Stock Investment Philosophy's emphasis on owning good companies through the inevitable cycles.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by PRA Group (PRAA).

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Thomas Rowe Price and the Growth Stock Theory of Investing

Kudos to Andrea Riquier of Investors Business Daily for her informative and timely story on Thomas Rowe Price, Jr. (1898 - 1983), and his timeless investment philosophy, entitled "T. Rowe Price was right with bet on American growth."

Her article points out that Price's convictions about the benefits of ownership of shares in well-run businesses operating in "fertile fields for future growth" were strong enough for him to decide to launch his investment advisory business in 1937, in the depths of the Great Depression. The parallels to the situation today could not be more pointed. 

History has borne out time and again the validity of the investment philosophy in which he believed and which formed the foundation of an investment portfolio which achieved a compound annual growth rate of 9.4% over the course of thirty-seven years between 1934 and 1972, according to a paper Mr. Price wrote outlining his growth-stock theory in 1973, soundly beating the market averages over the same period. He calculated that, if income had been reinvested in the portfolio at the end of each year, a $10,000 investment made on 12/31/1934 would have grown to a value of $2,712,011 on 12/31/1972.

Taylor Frigon Capital Management's founder and Chief Investment Officer, Gerry Frigon, whose investment discipline is descended from that of Rowe Price by way of being descended from the investment discipline of the late Dick Taylor, who was a portfolio manager with Mr. Price, is quoted in the article as well, explaining that one of the core principles of the approach is to concentrate on the investment merits and potential of the underlying business rather than the stock and its movements in the exchanges: a crucial distinction which seems so obvious and yet which continues to elude investors large and small, professional or amateur, to this day.

We have written many previous articles expounding some of the foundational concepts of what Mr. Price called "The Growth Stock Theory of Investing." Some of these include:

• "The Classic Growth Stock Investment Philosophy"
• "The business focus of the great 20th century investors"
• "'Inflection points' and the Growth Stock Theory"
• "Beautiful Growth Companies, Part III"
• "Look for paradigm shifts, part 2"

At a point in history at which many investors, and many of the voices featured in the media, seem to be giving up on the possibility of ingenuity, innovation and even free enterprise itself, it strikes us as extremely appropriate to think back to those dark days of the 1930s, when Thomas Rowe Price was formulating the pioneering investment philosophy which was built upon finding well-run, innovative companies operating in fertile fields for future growth, and owning shares in those companies through the ups and downs of the various economic and market cycles. His vision and courage to follow his convictions were certainly rewarded by success over the years, both for his portfolios and for those who invested with him using that approach.

Thanks to Andrea Riquier and to Investors Business Daily for reminding us all of this uplifting lesson.

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John Maynard Keynes R.I.P....And Keynesian Economic Theory!

John Maynard Keynes (right) in 1946, at the inaugural meeting of the IMF Board of Governors.

Last week, economist Scott Grannis published a remarkable post over at his Calafia Beach Pundit blog in which he says: 

The past six years in effect have been a laboratory experiment to determine whether Keynesian economic theory is valid. The result? Keynesian economic theory is (or should be) officially dead. It doesn't work. Government can't boost the economy by borrowing or spending more money. Politicians will be unhappy to hear this, of course, since they would prefer that we think they can dispense growth and prosperity on demand. Those who insist in perpetrating this myth should be voted out of office.

These are strong words, but Mr. Grannis backs up his statements with data. He concludes that the private sector -- that is to say, men and women in the United States going to work in areas outside of the "public sector" of the government -- generated $8.9 trillion in profits over the course of the past six years (an all-time record), but the reason things feel so terrible is that "the federal government borrowed 83% of those profits to fund a massive increase in transfer payments, income redistribution, bailouts, subsidies, and a modest increase in infrastructure spending." 

As a result, he says, almost all of "the most incredible surge in profits in modern times was squandered by our government, flushed down the Keynesian drain."

When he refers to "the Keynesian drain," Mr. Grannis is referring to John Maynard Keynes (1883 - 1946), who championed the theory that economic weakness and recession is caused by a lack of consumer demand, and that government can "stimulate" demand by giving money to consumers, either directly or indirectly, in order to cause demand to pick back up and thereby jumpstart the economy.

Elsewhere in his post, economist Grannis explains the problem with Keynesianism in a nutshell: "The government can't stimulate the economy by borrowing from Peter and sending a check to Paul, because that doesn't create any new demand -- it's like taking a bucket of water from one end of the pool and pouring it into the other end; the level of the water doesn't change."

There's an even bigger problem with Keynesian economics which Mr. Grannis doesn't mention, but we will: it's immoral. Not only does "robbing Peter to pay Paul" not work -- it wouldn't be right to do so even if it did "work." That being said, it also does not work, in addition to being immoral, and as Mr. Grannis points out, the past six years provide ample proof (on top of abundant proof that already existed prior to 2008) that Keynesian economics absolutely do not work.

In fact, all the way back in January of 2009, when the economy was still in the middle of the financial panic and the turn that took place on March 9 of that year was still nearly three months away, we published this post criticizing the proposed "stimulus plans" and containing a link to an excellent video by Dan Mitchell entitled "Keynesian Economics is Wrong: Bigger Government is Not Stimulus." That video is well worth another watch today, and it contains extensive evidence stretching from Herbert Hoover to Gerald Ford to George W. Bush that government spending financed by government debt does nothing good for an economy.  

That video concludes that, since the theoretical problems with Keynesianism should be well known by now (taking money from one side of the pool and putting it in on the other does not create any new growth), and since the historical track record of Keynesianism is also clearly terrible, the real reason that Keynesian policy is still around is probably that politicians like to spend other people's money, and "Keynesian economics" provides them with a academic cover in order to do so (and, we might add, a host of academic-sounding terms, such as "stimulus" and "multiplier" to use in speeches, as they redistribute the wealth).

Mr. Grannis seems to echo this conclusion, when he notes towards the end of the passage quoted above that politicians don't want to learn that Keynesianism is a bankrupt economic theory, because "they prefer that we think they can dispense growth and prosperity on demand."

In fact, it is likely that both Mr. Grannis and Mr. Mitchell have hit upon the real reason that Keynesian economics is even remembered today anywhere outside of the history books. According to Austrian economist F. A. Hayek, who knew him personally and had many long conversations with Keynes during his life, Keynes wasn't really even that interested in economics! In the interview below, Hayek remembers his friend Keynes and admits that Keynes had one of the most brilliant intellects that he had ever encountered, but that economics was really "just a side-line" to Keynes, and that Keynes never even bothered to read the economic thinkers who published important contributions to the field in English, let alone those who published in German! Keynes was really into many other subjects, but "he knew very little economics," according to Hayek (we have written about the tremendous contributions of F. A. Hayek to the subject of economic freedom in previous posts such as this one and this one).

It is clear that Hayek had a great deal of admiration for his friend Keynes, but that he recognized that economics really wasn't Keynes' area of expertise, and that the theories that Keynes published were actually very shoddy and in fact dangerous. At another point, Hayek once opined that Keynes in later years seemed to be moving away from the economic theories that came to be associated with his name, but that Keynes died in 1946 and his followers carried on with "Keynesian economics" in his name, in a direction that Keynes himself would no longer have agreed with.

In any case, the world now has nearly seventy more years of evidence that Keynes' earlier theories were just plain wrong, and that they should be abandoned. Politicians should not be allowed to use "Keynesian economics" to give the impression that they can "dispense growth and prosperity on demand," in the words of Scott Grannis. 

Keynes himself may have dropped that idea before he passed away in 1946 -- we wish Keynesian economics would find its way into the history books as well, before it does any more damage than it has already done.

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