We recently published our quarterly Investment Climate for the end of June, 2013. It is entitled "Have Interest Rates Bottomed?"
"A high-entropy, bull-in-the-china-shop distortion"
Here's a link to a recent article by John Tamny of Forbes entitled "All eyes are on the Federal Reserve, and that's the problem." We believe it should be required reading for anyone who either chooses to invest in market securities or is in any way impacted by the monetary policy of the United States central bank (which is to say, just about everyone).
In the article, Mr. Tamny puts forward the thesis that "the Fed’s machinations have served as a massive barrier to a true bull market." We agree with this assessment.
In fact, we have been saying pretty much the same thing for years. We recommend a quick trip down memory lane to the following posts on this subject:
- "The Fed's oversteering and the wreckage of the past decade," July 23, 2009.
- "Caution: Fed oversteering ahead," August 13, 2009.
- "Why do we want the Fed to steer the economy?" September 01, 2010.
- "Likelihood of Fed oversteering increases," January 25, 2011.
- "The end of QE2," March 29, 2011.
Mr. Tamny's article is also important for contrasting the excessive Fed focus with what investors should be focusing on: business, and particularly successful and innovative businesses.
He writes:
Rather than judge companies on their individual merits, investors must waste valuable time playing junior Kremlinologist in order to divine the future actions of the second rate economists who populate the Federal Reserve. Investors aren’t doing this because our central bankers have any useful knowledge to impart, but because what should be a low-entropy monetary input has become a high-entropy, bull-in-the-China-shop distortion whose actions must be priced.Far from a driver of positive economic evolution, a Fed that we all have our eyes on has become an economy-shrinking distraction that forces us to consider the macro over the all-important micro. Instead of focusing all of our attention on commercial ideas not yet hatched but that need investment, on existing companies that simply need new direction, not to mention healthy companies that would grow even larger and healthier if entrusted with more funds, investors must, in the words of George Gilder, spend inordinate amounts of time so that they can “predict the exercise of government power” over predicting which technology highflyer will become the next Apple*, or which corporation is best suited to cure cancer.
This contrast is the most important message in the article. We believe it goes right to the core of investing, and that investors should keep this message at the forefront of their thinking at all times.
* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple (AAPL).
Municipal bonds
In the classic 1988 film Bull Durham, the frustrated manager throws a staged tirade in order to turn his team around, a tirade which includes the immortal lines:
"This is a simple game. You throw the ball. You hit the ball. You catch the ball."
In spite of all the mystique that for some reason surrounds the world of finance (including the numinous world of "high finance"), our opinion is that finance is a simple game as well:
"You invest capital. You hope to get your original amount back. You hope to get something in addition to that original amount to compensate you for your trouble and the use of your capital."
That's it. Not quite as eloquent as the manager of the Durham Bulls, but simple nonetheless.
If the arrangement is a loan, you hope to get back your principal plus interest. If the arrangement involves equity in a business, you hope that the value of your equity stake grows enough to return your original investment plus some capital gains. You may also get dividends. If the entity asking for the capital is well-connected politically, it might be able to offer you interest that is not subject to taxation.
Other more complex capital structures might involve debt that returns your principal plus interest plus a chance to convert into equity. There are really no limits to the way the investment can be structured -- theoretically you could craft a deal that would promise to return your principal plus one pizza a month for twenty years, if you really wanted to.
However, if you decide to enter into this business and you want to have any hope of seeing your original amount come back to you, let alone anything extra, you might want to do a little bit of analysis of the entity to whom you are giving your money. After all, if you walk into a bank and ask them for a million dollars in financing, they won't usually just hand it over to you -- they will typically want to ask you a few questions about your income, your other debts, your credit history, etc. Investors would be wise to do the same before they get into the business of financing.
That's why at Taylor Frigon Capital Management, when investing capital on behalf of our clients, we exercise extreme caution with regard to investment in municipal bonds. Not only do we feel that many of them have terrible answers when it comes to their income, other debts, and credit history, but there have also been examples of municipalities being slightly less than forthright in their answers to those questions (in other words, making their answers sound better than the actual situation would suggest is the case).
Recently, the US Securities and Exchange Commission charged two borrowers with securities fraud for allegedly deceiving those considering the loan of capital to them. Those borrowers were municipalities: Harrisburg, Pennsylvania, and South Miami, Florida. As municipalities, they borrow money by issuing municipal bonds. States in the US also borrow money by issuing municipal bonds (when the federal government borrows money, they issue Treasury bills, notes and bonds).
In an article entitled "The Many Ways Cities Cook their Bond Books," Steve Malanga of the Wall Street Journal explains that the SEC has previously charged states with making "material omissions" and "false statements" in their municipal bond documents, including the state of New Jersey in 2010 and the state of Illinois in March of this year. The article explains that:
With Harrisburg, however, the SEC has gone further and charged the city government with "securities fraud for its misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated." The SEC says this is the first time the regulator has "charged a municipality for misleading statements made outside of its securities disclosure documents."
The article explains that such fraudulent activity in misleading potential and actual investors is nothing new in the municipal bond market. It notes that when Stockton, California, filed for bankruptcy, the city's new financial managers found evidence that Stockton had been hiding "significant costs, including the real cost of employee compensation and retirement obligations," and that after San Bernardino, California, filed for bankruptcy, some observers alleged finding evidence that the city "had been filing inaccurate financial records for nearly 16 years." Just read that last quotation again slowly in order to let it sink in.
All of this is related to the issue that we have called "The question of our time," which is the fact that "retirement obligations" (as in pensions for government employees) and other government benefits (including health insurance programs) have been promised far in excess of what government incomes can sustain, not just in US cities and states but in fact all over the world (Japan and Europe are two other examples recently in the news).
Those who decide to loan money to a government entity should conduct a thorough examination of such obligations and the income that is supposed to be supporting those obligations, before committing capital. As the article points out, however, it is always more difficult to do that when the entity asking for the loan is deliberately falsifying their books.
In the end, financing really is a very simple business. If you intend to offer your capital to some entity, in the expectation of getting it back some day with "something extra" (whether interest payments, dividends, capital gains, or some combination), it would be wise to consider the potential for growth of that entity's incomes and financial obligations.
Rip Van Winkle, revisited
Here's a link to recent commentary entitled "Still Bullish," from one of the most insightful economists we know, Brian Wesbury.
In it, he proposes a mental exercise, asking readers to imagine that they had gone to sleep on October 09, 2007 (when the major US stock indexes were making record highs, but just before they began their decline towards what became one of the deepest and most gut-wrenching bear markets in history), and just woke up this week. In this exercise, he explains, our modern-day Rip Van Winkle would have slept through 67 and 1/2 months, nearly six years.
He then asks readers whether, knowing where equities are today and where they were at that time, they would have chosen to buy equities or not before this long nap. If the answer had been "buy," then even though the economy suffered a violent recession and the markets were ravaged in the interim, Rip would have awakened this week to find the Dow Jones Industrial Average 8.4% higher than when he started his nap back in October of 2007.
We believe investors should carefully consider the implications of Mr. Wesbury's article, and the data he provides to support his arguments. In fact, we used the very same Rip Van Winkle analogy in two blog posts in the past, both of which are worth revisiting today:
- "If Rip Van Winkle took a one-year nap before September 14, 2008," published on September 14, 2009.
- "Rip Van Winkle, 2010," published on October 11, 2010.
In those articles, we pointed out that this analogy is helpful, but only to a point. We obviously do not advocate simply ignoring one's investments under the mistaken belief that things "always turn out for the best." Many who have not read Washington Irving's actual tale do not realize that his Rip Van Winkle was not exactly a sympathetic character, but instead was one described as having an "insuperable aversion to all kinds of labor," and one who would rather "starve on a penny than work for a pound."
We also don't advocate the idea that investors are best served if they just "own the market" rather than spending energy evaluating individual companies to find superior destinations for investment capital. While Rip would have been better off had he bought all the companies in the S&P 500 before his nap than if he had left that money in cash, he would have been even better off if he had been able to buy the shares of a smaller number of truly exceptional companies instead. Note that in the "nap interval" selected by Mr. Wesbury, the thirty-name Dow Jones Industrial Average outperformed the 500-name S&P index by a fairly wide margin.
However, the main point of the Rip Van Winkle exercise is to highlight the fact that for the vast majority of investors, investing in equities must be a long-term decision, appropriate for assets that one can afford to leave invested for many years. When that is the case, then investors can afford to take the longer view, and avoid over-reacting and potentially causing self-inflicted wounds during the intervening period. Like the hypothetical investments of Rip Van Winkle in the illustration of Mr. Wesbury or in our blog posts above, the markets can go through all kinds of gyrations in the intervening years, but none of that matters if your investments are worth more in the long run than they would have been worth had you made a different choice.
This is a very important point to keep in mind during times of turmoil.
Crossing the chasm to IPO becomes even more difficult
Here is a link to the website of Renaissance Capital of Greenwich, Connecticut, which shows U.S. IPO volume by capital raised for the past decade, beginning in 2003 and showing each year up through the year-to-date figures for 2013. The graph below shows the status as of the publication of this post, May 16, 2013:
Clearly, the total volume of capital raised has yet to return to the levels reached prior to the meltdown of 2008-2009. IPO volume reached $48.7 billion in 2007, before being cut in half in 2008 to $21.8 billion, and declining from there in 2009 to $21.8 billion. Although the volumes have rebounded since 2009, they have yet to reach 2007's watermark.
The above chart begins in 2003, which was the first year of recovery after the previous market meltdown of 2000-2002, and that year the total volume was only $15.2 billion. In 1999, the final year of the roaring bull market and accompanying IPO mania, volume reached an all-time high of $69.1 billion in capital. Clearly, nothing in the intervening years has come close.
It strikes us that this dearth of IPO volume is not a healthy sign for free enterprise. While it is certainly possible to argue that the 1999 IPO market became distorted on the upside, with some of the volume made up of companies who had no business going public, in general the emergence of new businesses is healthy for competition and innovation.
But, the capital volume figures do not even tell the entire story. The same Renaissance Capital website also shows charts for IPOs by number of filings. This data is even more revealing. Again, the chart showing the status through the date of publication of this post is shown below:
This chart reveals that the number of filings has been dropping since 2004, dropped precipitously in 2008 and 2009, and is still well below the numbers reached in 2007 and 2004. The number of IPO filings in 2004, numbering 314 filings, was still well below the whopping 541filings recorded in 1999!
In the previous chart, capital raised for 2012 was above the capital raised in either 2011 or 2010, but in this chart it is clear that the capital raised in 2012 was done with far fewer IPO filings than in either 2011 or 2010. This comparison reveals that the capital raised is coming from fewer, larger IPOs. The capital volume is being boosted by mega-IPOs, such as Facebook (May 18, 2012).*
We believe that these charts highlight a very unhealthy trend: fewer companies are able to make it to IPO, and those that do are much bigger when they finally do go public. This situation is unhealthy in several ways. First, it means that fewer companies are shaking up the status quo in any given industry. The entrenched incumbents have less to fear. Less competition often means higher prices and lower quality than might otherwise be available, as complacent incumbents have less to fear. More competition often means lower prices and greater improvements in quality.
A second negative consequence of the mega-IPO trend is the fact that the average investor has less opportunity to participate in a growing company in its early years. By the time Facebook went public, it had already reached a valuation of over $104 billion. If it had gone public at an earlier stage, smaller investors could have been along for the ride before it reached that valuation. As it was, only the insiders and others with access to private shares in the company were able to participate prior to the company's reaching of that lofty valuation.
Even more disturbing, however, is the fact that the trend towards fewer and larger IPOs means that venture investors who fund companies looking to "cross the chasm" between start-up and fully-fledged, independent public company will become even more selective, holding out to fund only the companies that can become big IPOs. Valid businesses, which might never have a chance of being "the next Facebook" but which in an earlier era might have had a smaller IPO and become a successful independent player, might be passed by and never get the funding they need to cross that chasm.
In fact, we believe that the bridge across the chasm from start-up to IPO has been blown out in the years since 1999, and especially since 2008-2009. While it was never easy to make the perilous crossing to an IPO, nowadays the funding is even harder to come by, especially in the "middle parts" of the bridge. Companies might be able to find angel investors and early-stage investors to get them launched, but unless they are looking like "the next big thing," finding funding at the middle sections of the journey has become much more difficult. Many now languish in the middle sections, and some will die there. The successful ones are more likely to be scooped up by existing companies in their industry (the incumbents) than to make it all the way across to an IPO of their own.
This is an important phenomenon for investors to understand. There are probably many causes, including increased government regulation and increased skittishness on the part of venture investors in the wake of the two meltdowns mentioned earlier.
Another probable contributing factor has been the pied piper of "green" projects that collectively seduced many of the Silicon Valley venture firms during the decade that followed the 2000-2002 tech meltdown. Leery of tech investments after the crash, and yet flush with investor dollars that needed to be invested somewhere, many venture investors turned to green energy start-ups, possibly lured by the various state and federal incentives that were being dangled in front of companies in that field. This recent article in Forbes magazine highlights the woes of one famous venture firm during the period, and contains a quotation in which its founder calls one of those investments the "most tragic venture-capital-backed debacle in recent history."
Articles like that one are a clear indication that the venture capital world is waking up from their trance, which is a good sign. If government loosens the stranglehold of some of the regulation that was put in place as part of the backlash against the economic disruptions of 2000 and 2008 (much of which serves as only a minor annoyance to the huge incumbents but which can effectively choke out the start-ups who could become potential competitors to those incumbents), we expect to see the situation improve.
Then, healthier levels of traffic across the chasm that stretches from start-up to IPO would no doubt return. In the photograph at top, an intrepid individual makes his way by rope across a blown-out section of the old bridge over the Blue Nile river near Amhara in Ethiopia, clutching a walking stick in one hand as he does so! This bridge was replaced in 2009 with a new suspension bridge through the philanthropy of charitable individuals, and the new bridge now services about 500 travelers crossing the canyon every day. It is almost certain that traffic was lower than 500 travelers per day when the only way across was by rope!
* As of the date of publication of this post, the principals of Taylor Frigon Capital Management do not own securities issued by Facebook (FB).
