Wednesday, April 29, 2009

Back to the old drawing board!

























Back in January, we published a post in which we noted that "financial advisors" and other intermediaries were "reeling" and that they (and their clients) were probably at a point at which "they know that something needs to change, but they have not been equipped to know exactly what."

Now comes a story in today's Wall Street Journal confirming our assertions from that earlier post, and providing examples and quotations from intermediaries who are trying all kinds of new ideas in the wake of 2008, from leveraged ETFs to managed futures to computer algorithms designed to tell them when to get into and out of the market.

As the old saying goes, they have decided to say, "Back to the drawing board!" (a reference to an old pre-computer technology called a "drawing board," shown above). One wonders how many times they have said this before, and how many more times they will go "back to the drawing board" in the future.

We have previously pointed out that this kind of inconsistent investment philosophy -- this willingness to completely re-work the entire system of what principles govern where and how to invest -- is a common feature in the modern financial landscape, dominated as it is by intermediaries who do not actually manage money themselves but instead spend their time evaluating third party managers and telling their clients when to switch from one manager to another.

In fact, in January of 2008 we wrote a post entitled "Can your advisor answer this question?" in which we noted the deleterious results that such activities can have on investor returns over a twenty-year period. We believe that data from numerous studies showing poor long-term investment performance by investors should be linked to this kind of "back to the drawing board" behavior by their "advisors."

The Journal story referenced above also fails to point out that the kinds of "alternative investments" that advisors mention in the article, such as "currencies or managed futures that they believe will rise when stocks fall", are exactly the kind of "diversification" that caused catastrophic problems for many investors in 2008, as we noted in this post from November. That post also linked to a Journal article, entitled "No place to hide," which revealed that following the advice of "investment pros" who recommended moving into foreign funds, currency bets against the dollar, and commodity speculation during the first half of 2008 had resulted in many investors doing far worse than even the plunging U.S. equity markets by the second half of the year.

Another misconception in the article is that jumping in and out of markets is "actively managing clients' money" (see the third paragraph from the end of the article) and that anything else is a form of "buy-and-hold." Both of these assertions are incorrect.

Active management is a term used to distinguish between following a "passive" or index-based approach, and an approach based on the belief that one can find companies that will outperform the broader market over time (see for example the discussion in this previous blog post). "Buy-and-hold," on the other hand, is one form of investing that does not try to time markets, but by no means the only form. While we do not believe in timing market cycles, we also do not believe in holding a single company forever, the way "buy-and-hold" advocates might. The subtleties of that distinction are explored in a post we published entitled "Remaining calm without being blind or obstinate."

The article also notes that some advisors are turning to computer models to help them time market cycles, saying "We trust the computer." We would point out that such "black box" methods, in which an investor relies upon a computer algorithm to tell him when to buy or sell a stock, or when to get into or out of the market, are directly related to the kind of financial engineering and trust in computer models that helped cause the financial sector's disastrous meltdown in the first place, as we explained in "Beware of the witch doctors of modern finance."

We do believe that the events of 2008 should cause investors and advisors alike to consider going "back to the drawing board" and rethinking their entire approach to investing. However, it is clear that many are gravitating towards the same ideas that have been repudiated by the events of the past year.

Instead, we would offer a return to the kind of investing that was much more common prior to the dramatic spread of "modern portfolio theory" after 1974. We recommend investors think about investing as providing capital to businesses -- a concept which is entirely absent from the article referenced above.

Doing so is the best way to go "back to the drawing board" and to design a foundation for investing that will stand the test of time.

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Thursday, April 23, 2009

Look for paradigm shifts, part 2










As companies report their results from the first quarter of 2009, investors are noticing a divergence between companies reporting surprises that strongly beat expectations, and companies whose results can be seen as confirmation of the economic recession.

For example, today's Wall Street Journal calls attention to extraordinary earnings from Apple, which beat analyst estimates on continued strong sales of iPhones, while at the same time noting that "United Parcel Service, which is often seen as an economic bellwether, said its first-quarter net fell 56%, and projected second-quarter earnings short of analysts' estimates."*

Many times in the past (going back, in fact, to our very first blog post) we have quoted the assertion of Mr. Thomas Rowe Price in which he declared, "When selecting growth stocks, the most important requirement is capable, dynamic management operating in a fertile field of future growth."

We would note that in the examples from the Journal story above, the difference between the two companies might be expressed in terms of "fertile fields of growth." We have explained that one way of assessing fields of growth is to look for paradigm shifts, which open up new fields of growth as individuals or businesses change to a new way of doing things that adds new value.

In the case of the iPhone, it is clear that the rise of the smartphone (a category that the iPhone revolutionized upon its introduction in 2007) creates a fertile field of growth, the beginning of a paradigm shift that will eventually make traditional cellphones obsolete. In the case of UPS, it is clear that while they helped create a paradigm shift away from reliance on traditional postal service, that paradigm shift has largely penetrated most of society, and they are today much more tied to the cyclical ebbs and flows of the economy.

In our previous study of the difference between the broad investment periods of the 1970s, 1980s, and 1990s ("Return of the 1970s, part 2") we suggested that during periods of strong economic expansion (such as the period from 1984 to 1999), companies which had already grown to dominate their industries often did well, growing their sales and benefiting from strong liquidity and commanding balance sheets. During that period, and during the 1960s as well, large stocks generally performed well, as did index funds favoring large stocks such as the S&P 500 or the 1960's "Nifty Fifty" (a sort of large-cap index popular at that time).

During the economically rocky 1970s, however, there was a serious divergence between the performance of larger companies and smaller ones. Larger companies, whose businesses were less likely to be exploiting a new paradigm shift and were thus likely to be more tied to the ups and downs of the overall economy, lagged significantly. Smaller companies, which were more likely to be dependent upon some new field of growth for their opportunity to make money, considerably outperformed during that decade and into the early 1980s, in spite of the vicious 1981-82 recession.

We would suggest that there is evidence that the same phenomenon may be starting to take place today. Investors should therefore be thinking carefully about where there are fields of growth, or paradigm shifts, and what companies can best pursue them.

As we stated in our previous post on paradigm shifts, "a paradigm shift can take place from the creative application of almost any new and more efficient business model, whether it uses some new technology or not." In other words, the field of growth can arise from a very subtle trend.

For example, Quest Diagnostics, which just reported 20% growth in earnings over the results of the same quarter in 2008, is taking advantage of a variety of trends that point towards greater use of lab testing. One trend is that lab test usage increases with age, and the demographics in the US and other countries are such that we will witness an aging population in the decades ahead. Another trend is toward greater use of diagnostic testing sooner, in order to provide physicians with greater situational awareness on a more timely basis. Related to this trend is a growth in esoteric testing, laboratory tests which require greater human analysis from trained personnel and which are often used to detect less common health issues. These tests are often more expensive and carry higher margins for lab test providers such as Quest Diagnostics.**

These types of paradigm shifts are perhaps less obvious, but represent the kinds of fields of growth that well-run businesses may be able to follow for many years. Investors should carefully consider this concept, especially at a point in time where there may be an increasing divergence between companies that meet the definition of "capable, dynamic management operating in a fertile field for future growth," and those that do not.


* The principals of Taylor Frigon Capital Management do not own securities issued by Apple (AAPL) or United Parcel Service (UPS).

** The principals of Taylor Frigon Capital Management own securities issued by Quest Diagnostics (DGX).

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Wednesday, April 22, 2009

'Earth Day' investment lessons

























Our most recent post contains a discussion of the dangers of zero-sum thinking and notes that many international organizations, such as the UN's Population Fund (UNFPA) are clearly coming from a zero-sum worldview when they support assertions such as: the "solution to climate change and food security must tackle population growth."

Sadly, children in schools around the world today will be taught "Earth Day" lessons replete with messages that humans are rapidly depleting the planet's scarce resources. Readers who doubt the level of rhetoric that has been directed at the upcoming generation on this front can peruse the book reviews offered last week by the Wall Street Journal's children's books columnist Meghan Cox Gurdon, who lamented the heavy-handed "eco-propaganda" directed at children in a piece entitled "Scary Green Monsters."

As we have pointed out in a previous post, there are serious economic consequences to proposals for "sweeping global goals" designed to force individuals and economies to "curb energy use and greenhouse gas emissions," such as those called for in a NY Times blog that we cited in our post from 2007.

Most basically, it is by no means settled that human activity is causally related to global climate, as the talk given by Professor Noah Robinson of the Oregon Institute of Science and Medicine linked previously explains.

Further, even if one were to grant a causal relationship, it does not necessarily follow that the best response to such a causal link would be to impose government restriction of free enterprise. On the contrary, it can be demonstrated using empirical data that economic freedom and the corresponding increase in wealth, productivity, and technology that it brings about is the very thing that enables greener and cleaner societies and improvements in the health of the environment.

For example, as economics Professor Mark Perry of the University of Michigan's Flint campus demonstrates in his excellent Carpe Diem blog yesterday, various measures of air quality in the US have improved dramatically over the past twenty to thirty years (a 28% decrease in particulates over the past seventeen years, a 76% decrease in carbon monoxide levels over the past twenty-seven years, and a 91% decrease in lead levels over the past twenty-seven years), despite the fact that the US population has increased by 50.25% since 1970 and the number of miles driven has increased by 159% (see "Earth Day 2009: Air Quality's Better than Ever.")

Professor Perry links to other examples that support the fact that free enterprise and rising prosperity are the best prescriptions for environmental health, such as this article by John Tierney in Monday's New York Times.

Government interference can not only smother the kind of innovation and economic value-creation that help improve air quality and other measures of environmental health, it can also act to artificially direct capital towards projects that are wasteful.

Normally, capital flows towards innovation based on rational decisions made by those who provide the capital based on their potential rates of return. However, when governments artificially tip the playing field, capital can flow into areas that it normally would not, a phenomenon properly termed "malinvestment."

For example, the government gives out subsidies for the use of solar technology in order to make it appear to be more economically viable than it actually is. Unlike the profits earned by an unsubsidized business, which must demonstrate value to customers who then voluntarily trade their money for the products or services of the business, these subsidies come from taxes which are taken from taxpayers using the force of law.

Venture capitalists and other investors will allocate more capital to solar start-up companies than they normally would, and those solar start-ups can make profits they otherwise would not be able to make. Thus, capital flows towards solar which might otherwise be more profitably employed towards a technology or innovation that would be able to stand on its own merits. It should be noted that there are plenty of recent examples of government-induced malinvestment, such as the real estate bubble, in which the government encouraged more home lending than would otherwise have occurred.

The argument that government should encourage home ownership is exactly parallel to the argument that government should support solar energy, and the results of the malinvestment in residential housing should be a warning to those who assume government should be tilting the playing field and encouraging capital to flow where it otherwise would not.

While individual investors cannot do much about the government's decisions to encourage capital to flow towards "green" initiatives (or the use of their tax dollars to subsidize such initiatives), they can make sure that they don't fall into the same trap when they are making the decisions about the allocation of their own investment capital.

While the areas that receive huge inflows of capital due to malinvestment appear to flourish for a while (think of real estate related investments during the period from 2003 to 2006, for instance), artificially-induced bubbles inevitably deflate. As we have written several times before, investors should remember that investing is ultimately about "providing capital to businesses" -- and if those businesses are making profits in large part because of government subsidy, they may not be a very wise place to direct your capital.

Ultimately, we would argue that the best lessons investors can contemplate on "Earth Day" are the importance of free enterprise, and the importance of allocating their own investment capital to the very best enterprises that they can find.



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Monday, April 20, 2009

The dark side of zero-sum thinking
























Zero-sum thinking is often explained using the metaphor of a "fixed pie" view of the world: there is only so much wealth out there, and the more people there are competing for any given portion of it, the less there is for everyone else to squabble over.

Those who have a fixed-pie or zero-sum view of the world naturally see others as potential competitors for resources, and even support measures to reduce the addition of other people whom they view as making everyone's pie even smaller.

For instance, the United Nations Population Fund (UNFPA) uses the euphemistic term "population issues" to refer to the "link between population and poverty" -- as if additional human beings are always a burden who decrease the resources available to everyone else.

In their advocacy of this zero-sum viewpoint, they participate in various "global and regional forums" such as this one which they link on their website, which declares that the "solution to climate change and food security must tackle population growth." At that forum, from December of last year, the UNFPA's G. Giridhar, "speaking on behalf of UNFPA," praised the benefits of "lower fertility, smaller families, and slower population growth, thus reducing the burden on the environment."

We have written about the problems with such zero-sum thinking many times in the past, such as here and here. The biggest error those who hold such a "fixed-pie" view make is in their failure to realize that every single person is a potential producer as well as a potential consumer -- every single person has the ability to make the pie bigger. The pie, in other words, is not "fixed" in its size.

When individuals and groups of individuals think of new ways to add value to others (which translates into making money for themselves, in exchange for the value they add), the pie grows. You can probably think of dozens of things that you use today that did not even exist ten years ago -- iPods, cellphones with video cameras and GPS capability, high-definition television sets -- and that is just scratching the surface of consumer goods, to say nothing of medical breakthroughs, manufacturing breakthroughs, and other business innovations that we don't usually notice on a daily basis.

The zero-sum fallacy sees people as liabilities rather than as they truly are: potential contributors to the prosperity of everyone else, because to the extent that they contribute to the economy, they actually enlarge the pie.

In an essay we have linked previously, first published in 1964, economics professor George Reisman of Pepperdine University wrote that this erroneous focus leads to the fear "that the work performed by machines leaves less to be performed by people, that the work performed by women leaves less to be performed by men, that the work performed by children leaves less to be performed by adults, that the work performed by Jews leaves less to be performed by Christians, that the work performed by blacks leaves less to be performed by whites, and that the extra work of some leaves a deficiency of work available for others."

It is appropriate to revisit the dangers of the zero-sum mindset, especially because tomorrow is Holocaust Remembrance Day, established to commemorate those murdered by people subscribing to thinking that is clearly linked to what Professor Reisman describes in the paragraph above.

Nevertheless, the news continues to provide examples of despotic leaders from countries with closed economies built upon zero-sum thinking who have taken their zero-sum thinking to violent and racist levels, such as Iran's leader today at the United Nations.

In the aftermath of an economic crisis, it is extremely important to understand the dangers of such thinking, because history has proven that such crises can cause a retreat into just such fixed-pie behavior. Thirty years ago, writing in an edition of the Journal of Portfolio Management that we have mentioned before, Rose and Milton Friedman observed:

"The spread of the Depression to other countries brought lower output, higher unemployment, hunger, and misery everywhere. In Germany, the Depression helped Adolf Hitler rise to power and paved the way for World War II. In Japan, it strengthened the hold of the military clique dedicated to creating the Greater East Asia co-prosperity sphere. In China, the aftermath of the Depression destroyed the monetary system, weakened the ability of the Nationalist government to resist the Japanese and then the Communists, and fostered the final hyper-inflation that sealed the doom of the Chiang Kai-shek regime and elevated Mao to power."

We feel that it is important to understand the connections between economic ideas and political events, and that it is critical that everyone be able to recognize zero-sum thinking, and able to explain why it is so fallacious and so dangerous.


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Wednesday, April 15, 2009

Four-letter government words







Milt Friedman once declared, "Given our monstrous, overgrown government structure, any three letters chosen at random would probably designate an agency or part of a department that could be profitably abolished" (cited in this Wall Street Journal obituary written about him the day after his death on November 16, 2006).

To the "three-letter" agencies of that quotation, we can now add a few "four-letter" government programs, notably TARP, TALF, PPIP, and the ARRA of 2009.

Scholars will debate for decades to come whether or not the bailouts enacted at the height of the market panic during the end of 2008 were necessary to save the financial system. What is clear at this point in time, however, is that continuing bailouts are no longer necessary.

In fact, as the video clip above indicates, banks are rushing to give the TARP money back, in order to escape the onerous interference that comes along with having the federal government as a part-owner of your business. In that video, First Niagara Bank CEO John Koelmel says that his bank is doing the same thing that Goldman Sachs is doing -- raising capital on their own and giving back the capital from the Treasury.*

We would argue that at this point, further extensions of TARP are not necessary, especially now that the boot of mark-to-market accounting has been removed from the throats of financial institutions. We would say the same about TALF (the "Term Asset-backed securities Loan Facility") plan, which established a credit facility by which the Federal Reserve Bank of New York would lend to financial institutions in order to support student loan activity, small business loan activity, car loan activity, and credit card loan activity, at a time when the disruption of markets for securities backed by such loans threatened to bring such lending to a halt.

Nevertheless, there are some who want to keep right on extending TARP's reach, including expanding it to include troubled insurance companies. Larry Kudlow disagrees in this well-argued recent post from his blog, and we are with Larry on this issue.

We would argue that the best thing the government could do now would be to eliminate further expenditure of tax dollars through TARP, as well as the more recent PPIP (the Public-Private Investment Program, designed to help banks by buying up their "toxic assets" or "legacy assets" using a consortium of selected private buyers partnering with the government). It should be clear at this point from the video above, for instance that PPIP is not necessary.

The testimony that former FDIC chair William Isaac gave before the House Subcommittee on Capital Markets, Insurance, and GSEs on March 12 presents a masterful case illustrating that these so-called "toxic assets" were being made toxic by the misguided 2007 accounting rule that forced them to be valued at well below their actual cash-flow value.













Using an anonymous example from an actual US bank, he illustrates in the graph above on a billion dollars in securitized mortgages. The purple bar on the far left, totaling $1.8 million so far, shows the actual losses that the portfolio has sustained, while the blue bar in the middle is the estimate of the maximum losses over the lifetime of all the mortgages in the portfolio, at $100 million. The green bar on the right shows the losses required to be marked against the portfolio of loans by the accounting rule in effect before the change: $913 million or over 90% of the value of an asset currently receiving payments on 98.2% of its assets.

In other words, it is quite clear that the reason those assets were so "toxic" to banks was because of the poisonous accounting rule. We have explained this problem several times, and have included links to Bill Isaac explaining this problem before, such as in this post from November. We would advise all investors to read his entire Congressional testimony linked above.

Particularly on the day that Americans remit their taxes to the government, it is appropriate to examine the case against continuing further "emergency" measures. The government has already taken significant steps to end the causes of the emergency, by addressing mark-to-market and the uptick rule and by flooding the economy with money.

We have argued that the problem was a financial panic, not a "depression," and because of this maintain that continued stimulus beyond addressing the technical factors at the heart of the panic is not necessary. In fact, we have given several reasons why government "stimulus" is harmful, rather than helpful.

While it is not likely to happen, Congress should realize that the technical factors at the heart of the panic have been addressed, and draft legislation to stop the "stimulus" spending in the American Recovery and Reinvestment Act of 2009 that has not yet taken place, and instead allow the massive monetary stimulus that the Fed has unleashed to do its job.

The remainder of ARRA, TARP, TALF and PPIP are "four-letter" government activities that, in the words of the late Professor Friedman, could be "profitably abolished."




* The principals of Taylor Frigon Capital Management do not own securities issued by First Niagara Bank (FNFG) or Goldman Sachs (GS).

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