New investment idea: invest in good businesses

Here's a recent article from the New York Times entitled "New Investment Strategy: Preparing for End Times."

It describes a host of "investment" vehicles designed to protect against "tail risk" or "black swan" events -- terms derived from the academic fields of probability modeling, which took over the financial world during the course of the past four decades, where the marriage of mathematics and financial engineering became known as "modern portfolio theory."

For our part, we never subscribed to modern portfolio theory in the first place, and we have written that MPT is about as "modern" as a 1974 Ford. In fact, it should be perfectly clear by now that the tendency to trust that a bunch of financial engineers who create complicated structured products designed to whisk away various forms of risk led directly to the Wall Street implosion of 2008-2009. Nevertheless, as we noticed all the way back in April 2009, instead of learning this fairly obvious lesson, advisors and investors were already clamoring for still more products based on the false premises of Modern Portfolio Theory.

The hallmark of Modern Portfolio Theory -- and all the latest manifestations of MPT described in the recent story from the New York Times -- is the belief that analysis of individual businesses or individual securities is a waste of time. Individual securities don't fit into the standard distribution curves with "tails" at which the high priests of modern finance worship. Because they don't fit their models, the devotees of MPT believe individual securities are less predictable and more dangerous than huge numbers of securities, or statistics, or indexes such as the "fear gauge" cited in the article.

As we mentioned in the previous post entitled "The ideology of modern finance," this is exactly the sort of belief that led to the idea that structured investments composed of thousands of securitized mortgages were more predictable than careful analysis of individual mortgages or borrowers. Those who are currently investing tens of billions of dollars into "tools engineered to bulletproof investors" (in the words of the NY Times article) might want to consider that fact of history.

Instead of rushing into "Armageddon funds" which are tied to everything but the fundamental analysis of individual securities, we would recommend that investors consider a novel investment idea: going back to the analysis of individual companies that prevailed before the Modern Portfolio Theory craze began to take hold in 1974.

A good place to learn about that time-tested approach would be the pages of this blog, where we have written many times about the fundamentals of the investment strategy that we have followed for twenty-five years, and which we in turn inherited from Richard C. Taylor, who inherited it from Thomas Rowe Price. We would also recommend some of the collected wisdom of the investment professionals who achieved decades of success before the advent of the ideology that took over modern finance, some of which is described in this previous post.

We believe that the concept of analyzing individual businesses for the investment of one's capital is the only method with a long-term record of success, and that the kinds of novelty vehicles described in the Times story have a long track record of being invented by Wall Street one month, only to be discarded a few months later when something new comes along.

This is something that anyone who lives through times such as these should understand.

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Some thoughts on inflation and the economy

Here is an insightful commentary from one of our favorite economists, Brian Wesbury, entitled "Inflation Now and Later."

In it, Mr. Wesbury explains how the Fed's mistaken belief that inflation is caused by high employment and strong economic growth is leading them to stay too easy for too long and introducing inflationary pressures into the economy. He notes that the Consumer Price Index (or CPI, a measure of inflation that looks at the price of a hypothetical "basket of goods and services" and compares it to previous prices for the same hypothetical basket) for the first six months of 2011 is up at an annual rate of 5.1%.

We discussed the CPI and inflation in this previous post from 2008 and in a series of other posts listed at the bottom of that one, pointing out the damage inflation does to purchasing power. A good or service whose price rises at an annual rate of 5% will double in price in about fourteen years.

We have also discussed the erroneous thinking that leads the Fed (and many other economists from a similar school of thought) to believe that inflation is influenced by strong or weak economic growth and employment, which is sometimes known as "Phillips Curve thinking." The counter to Phillips Curve thinking is the belief that inflation is caused by monetary policy, rather than by slower or faster economic growth, and it is typified by the work of economist Milton Friedman and Professor Friedman's quotation, cited by Mr. Wesbury, that "inflation is always and everywhere a monetary phenomenon."

On the other hand, note that while Mr. Wesbury believes that the Fed is too loose and allowing inflationary pressures, this is a far cry from saying that 1970s-style hyperinflation is right around the corner. He does not predict hyperinflation, and gives cogent reasons why not.

We believe that, while the Fed and the government have hurt the recovery by some of the policies they adopted in their attempts to help the economy, nevertheless businesses in general are in better shape than almost any time in economic history, with strong balance sheets and with productivity and efficiency at all-time highs.

Inflation has remained a threat to investors' purchasing power for several decades now, a scenario that is unlikely to change in the future. We believe the antidote, however, is the same as it has been in the past: participation through the investment of capital in well-run businesses positioned in front of fertile fields for future growth. There are many businesses out there today that meet that description, if investors know where to look.

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Do we have a "dead economy walking"?

Recent weaker-than-expected economic data sent the stock market into a six-day decline, particularly weak employment and manufacturing data. This is bringing back talk of a "double dip" recession, which has never been far from the headlines since the economic recovery began back in 2009 (see here and here for previous posts discussing the "double dip" fears).

Much of the recent economic discussion features this familiar argument: the government has been artificially propping up a broken economy, and now that the artificial stimulants are wearing off or losing their effectiveness, we are heading back down to the dark days of March 2009 and the bottom of the market, the depths of the recession, or even to a worse place than that.

This argument can be heard both from pundits who believe that government spending is good for the economy (generally, a Keynesian view, which we have discussed in previous posts such as this one and this one), as well as from pundits who believe that government spending is bad. The latter tend to think the economy was not ready to recover without those stimulants and such artificial "propping up" only served to delay a necessary "purging".

An example of the first group would be the author of this recent article from the Economist. In it, the author operates under the assumption that the government "swinging into action" is what saved the economy before, and that it is inexplicable that the Fed and the Congress are reluctant to stimulate it again since it appears to have crashed (the article features a graphic cartoon of an 18-wheeler truck -- labeled "Economy" -- crashing nose-first into the ground).

An example of the second group is Peter Schiff, CEO of brokerage firm EuroPacific Capital. He also thinks the "recovery" has been dependent on the government, but he thinks that intervention has been bad, because it has prevented the collapse of the institutions that led to the crisis in the first place. In this recent interview, he declares that:

The data that we’ve been getting for the last several weeks -- and of course today’s data merely solidifies that with the weak jobs numbers -- is that the effects of trillions in govt stimulus is wearing off, and the mother of all hangovers is now setting in. (Beginning around 2:20 in the video clip).

He then goes on to say:

This is a phony economic recovery – it’s basically a giant hallucination caused by the government stimulus, which is like a hallucinogen [. . .]. That’s why we’re seeing the economic data imploding like it has been – because it wasn’t real. (Beginning around 11:20 in the video clip).

While agreeing with Mr. Schiff that government stimulus is actually harmful rather than helpful (a position we have argued many times over the past years and which we explain here and here), we disagree with both points of view represented above.

Both of the above camps basically agree that the entire recovery has been the product of government engineering -- a sort of Frankentsein's monster re-animated by the government (playing the role of Gene Wilder). One side thinks that Dr. Frankenstein is a genius and that his constant supervision of the economy is a must, while the other side thinks he is a madman who is going to destroy the entire village.

We are in a completely different camp, in that we don't think the economy is a Frankenstein's monster at all.

In fact, we think that most of the time the economy resembles a pretty healthy individual, who should absolutely avoid the dubious prescriptions of the Keynesian doctors. We have written extensively about evidence that supports the view that the panic of 2008-2009 was the result of various forms of mad-scientist tinkering. This tinkering included:

• Direct government pressure to make questionable real estate loans.
• Tinkering by financial PhD's on Wall Street who subscribe to modern portfolio theory's false premise that risk can be eliminated with the right mathematical formulas and who used that theory to create billions of dollars of synthetic investment vehicles.
• And, last but not least, a well-meaning but disastrous accounting rule known as mark-to-market accounting, which caused the holders of those structured investments to panic like it was 1907.

Because we hold this view, we do not believe that the recovery has been a "giant hallucination," although we do believe the recovery would have been stronger without all the additional government "stimulus" that acted more like a narcotic than a stimulant. During the past few years, we continued to advise investors to look for investments in companies that are adding real value, and there are plenty of them if you look in the right places (we have highlighted several on these pages in recent months, such as here and here).

There are numerous voices out there dispensing advice to investors based upon the premise that the US economy is just a reanimated corpse and that the end is approaching. Some of these recommendations include:

• Investing in gold and commodities (we address some of the issues surrounding that advice here and here).
  
• Investing in variable annuities (which we believe is almost always a very bad choice, as we discuss here).
• Investing in foreign stocks and bonds (which often boils down to a bet against the US dollar, a game that is more difficult than it looks and which has burned some of the biggest investors in recent years, including George Soros and Warren Buffett).
• And, last but not least, investing in one of the 31 flavors of "alternative investments" (the ramifications of which we discuss in this and this previous post).

We are not saying that all is well with the US economy -- in fact, we agree with most of the arguments made by economist Martin Feldstein in his recent Wall Street Journal opinion entitled "Why the economy is worse than you think." But we don't agree with those who say that the profits of real innovative companies (such as those fueling the "unstoppable wave" of broadband and mobile technology applications) over the past two years have been nothing but a figment of the Fed's monetary stimulus (as we explain in this recent post about the end of QE2).

The bigger picture to this question is the idea that investors should be trying to time economic ups and downs, and to figure out whether the latest round of economic data reflects a "soft patch" or (as Peter Schiff says) "quicksand," and that they should be timing the markets based on their own economic gut feelings or those of someone else.

This is a form of "stock market guessing" and it is one of the main reasons that relatively few people make significant money from investing. In fact, such guessing is usually very, very harmful. We point out how harmful in our posts entitled "Don't get off the train."

We don't believe the pundits who are saying the current economy is a dead economy walking, whether those pundits are calling for more of Dr. Frankenstein's medicine or less of it. However, even if some rocky economic roads lie ahead, we do not believe that the answer is trying to time the market.

Instead, we believe investors are best served by sticking to a disciplined investment strategy founded upon commitment of capital to well-run companies positioned in front of strong growth opportunities.

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Debunking "we don't make anything here anymore"

By now, everyone is familiar with the argument that America's economic future is threatened because "we don't make anything here anymore."

We have highlighted this argument -- and our disagreement with it -- in previous posts, such as this one in which we took exception with arguments that America is left with nothing but a "phony service sector economy" now that we have thrown away all our manufacturing production. Examples of this line of argument abound, such as this article which bemoans the fact that there are fewer manufacturing jobs in the US today than there were in 1979, and this article which strikes a similar tone.

While there may be fewer workers actually employed in manufacturing today than there were in the 1970s, the undeniable fact is that American manufacturing output is enormously higher today than it was in the 1970s -- or at any time in the past for that matter -- as the chart above illustrates. Much of this increased productivity is the result of improved technology.

More goods being produced with fewer people is the very definition of increased productivity. Occasionally, someone will argue that producing more with fewer people is bad (because it reduces the number of available jobs), but that is a fallacious argument. If it used to take ten or twenty workers to produce one washing machine or Corvette or other manufactured good, and today it only takes two or three workers (plus some machines and robots that weren't available in the past), then it stands to reason that there will be relatively more Corvettes or washing machines available per person than there were before, and that such goods will actually become more affordable to a larger number of people. And in fact, this is exactly what has happened -- any examination of the statistics from the 1970s versus today will show that American households now have more cars, washing machines, televisions, and just about everything else than they had forty years ago. It is absolutely wrong-headed to argue that we should want to go the other way and use more people to produce the same amount of stuff, thereby making everything less affordable.

While many people do not come across examples of American manufacturing in their day-to-day lives, this does not mean they do not exist. There are a great many little companies all across America contributing to the tremendous manufacturing chart shown above. We come across them every day in the research that we do as managers of investment portfolios. Remember that the amazing rescue of the trapped miners in Chile last October was facilitated by a special drill bit that was invented and manufactured in Pennsylvania. Other American manufacturing success stories include the following companies* that you have probably never heard of:

• John Bean Technologies Corporation, a designer and manufacturer of equipment for the freezing and chilling of foods, the cooling of aircraft, and other airport and food-service equipment. Based in Chicago, Illinois.
  

• Kaman Corporation, a designer and manufacturer of complex power transmission components, motion control systems, aircraft bearings, and metallic and composite aerostructures used in the aviation and defense industries. Based in Bloomfield, Connecticut.

• Middeby Corporation, the inventor of the conveyor oven and a designer and manufacturer of industrial-strength ranges, broilers, steamers, fryers, charbroilers, and other cooking and food dispensing equipment. Based in Elgin, Illinois.

• Kemet Corporation, a designer and manufacturer of dielectric capacitor solutions using high-tech materials such as tantalum, multilayer ceramics, electrolytic aluminum, and other materials. Based in Simpsonville, South Carolina.

• MKS Instruments, a designer and manufacturer of instruments, components, and subsystems for vacuum and gas-based processes for a variety of industries, including the semiconductor, pharmaceutical, chemical, electronics, and energy industries. Based in Andover, Massachusetts.

• Kronos Worldwide, a producer of titanium dioxide pigments used in coatings, plastics, papers, fibers, foods, ceramics, paints and cosmetics. Based in Dallas, Texas.

These are just a few representative examples from a field of manufacturing companies all across America that are producing and manufacturing the things that we supposedly "don't make here anymore." The next time you hear that trope used to support an argument about America's "phony economy" and predictions of inevitable economic doom, remember that the facts tell a completely different story, for those who are willing to look at them.

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* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by John Bean Technologies (JBT), Kaman Corporation (KAMN), Middleby Corporation (MIDD), Kemet Corporation (KEM), MKS Instruments (MKSI), or Kronos Worldwide (KRO).

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