Monday, December 20, 2010

Too Conservative?

Is it possible to be too conservative in the face of all that is going on in the world right now, both economically and geopolitically? We don’t think so.

During the last year, we have patiently developed a portfolio designed to bring consistent, compounding returns over several years. We have focused on dividend yield and capital preservation, as we carefully invest our cash position. Through the first eight months of 2010, the market was extremely volatile (remember the “flash crash” in May?), while our portfolios held steady, maintaining a sizable advantage in returns. Ironically, right about the time we started seeing widespread value in the stock market, the Federal Reserve hit the panic button in the face of a softening economy, to ward off deflation. The “Bernanke Playbook”, about which we’ve previously written, is in full effect and lifting the stock market. While we benefit from this increase, our conservative strategy (which incorporates both stocks and bonds) is naturally slower to respond than the overall stock market, at least for the moment.

Get With the Program

The Fed’s current, extreme and historic quantitative easing effort (QE2) to buy newly issued, longer-term government bonds is an attempt to raise inflation expectations and lift asset prices, in particular equities (yes, they actually said that). The thinking goes like this: lower the longer-term cost of capital, making current equity valuations look attractive. By bringing investors into the equity markets, companies can access capital on better terms (e.g. the General Motors IPO). That, of course, assumes there is an abundance of viable capital projects that can return in excess of this lowered cost of equity. If so, then you get immediate job creation as capital spending increases.

The question is, when this explicit subsidy to the cost of capital is removed (through future Fed tightening), are those newly formed investments sustainable? Furthermore, the unintended consequences of inadvertently financing subpar “investments” (i.e. housing) can have dramatic consequences. An increase in equity values supports greater amounts of debt. If equity values falter, the debt becomes highly onerous.

The first round of Fed quantitative easing (QE1) in 2009 was probably effective in preventing a liquidity crisis from exacerbating an already deepening insolvency crisis. Now, with an extra $600 Billion promised over the next six months, coupled with a lenient tax policy, you can see that our country’s monetary and fiscal leaders have implemented an all out go-for-growth (go-for-broke?) strategy. While all of this might create growth, we remain skeptical that it will create sustainable value. For now the stock market has taken the bait and gone higher. However, bond yields have also gone higher, giving a confusing signal about expectations for growth, inflation, and future unfunded deficits. To what extent will the Fed tolerate such rate increases before embarking on another round of bond purchases?

That said, there are signs of stability in the economy and we are encouraged to see the productive spirit of the private sector deliver profits. Unemployment is still high and likely to grow, but new jobs are usually seen late in a recovery. The banks appear stabilized, although a persistent decline in real estate prices keeps them in capital preservation mode. Right now the stock, bond, and commodity markets appear certain that the economy will grow unabated, given the aid of massive stimulus.

What Happened to The Road Not Taken?

I shall be telling this with a sigh

Somewhere ages and ages hence:

Two roads diverged in a wood, and I--

I took the one less traveled by,

And that has made all the difference.

-Robert Frost, The Road Not Taken

Certainty in the market makes us wary. Such confidence emanates from what has become Wall Street’s Golden Rule: “Don’t Fight the Fed”. Oddly enough, for the past 12 years, the exact opposite would have been more rewarding. Perhaps that rule should be rephrased: “Get Rich or Die Trying”. That doesn’t sound quite as appealing. Needless to say, Wall Street is feeling bullish these days. We’ve seen this road before.

The list of headwinds to economic recovery is long. But that is not what primarily concerns us. Most of them are well known to investors already. We are concerned with the risk of government policies preventing the market from functioning efficiently. For example, we are encouraged by the pace of domestic private sector deleveraging (whether through default or pay down) and the concurrent increase in personal savings. Such headwinds to growth will eventually become tailwinds. Our greater concern is whether productive, market-clearing processes are interrupted by potentially false perceptions created by chronic money printing and stimulus spending. Rising asset prices without wealth creation leads to debt/payment obligations with no collateral value. Again, we’ve been down this road before.

Feeling Like a Contrarian

At least for the moment, our year-to-date equity performance trails the market, as investors have ramped up their risk-appetite. Yet, we are very confident in maintaining our conservative position. Even though we wrote about the potential for QE2 this summer, perhaps we mistakenly believed the political fallout over printing money would have short-circuited its occurrence. Or perhaps that story has yet to be told. There’s nothing like a political vacuum, created by an election season, to give the Fed free reign. Either way, since we ourselves cannot print money, we choose to stick with prudent capital management on behalf of our clients. We are moving down the road we want to take, looking for consistent, compounding returns.

We are avoiding market-timing, looking instead to “draw our own line” that wavers less than the markets. We do this by investing only where we see value and value-creation for the long-term, sometimes regardless of the level of the stock market. As frustrating as the past decade has been, that strategy has worked for us and resulted in consistently better returns than the market over time. Making predictions about future stock market values can be eternally futile. We will stick with what we know and pursue our strategy of creating wealth and preserving capital by investing in companies that consistently create value for shareholders.

Hopefully we have been able to clarify what’s going on in the economy and the markets, here at the end of 2010.

Holiday greetings to all,

Peter and Jack Falker

December 20, 2010

Tuesday, August 24, 2010

Confronting the Boogieman (or Why the U.S. Economy Isn't Growing)

Concern over deflation has started going mainstream. This is not a simple concept to embrace, especially with the backdrop of an easy Fed and massive government spending. But that is the paradox of easy money in an era of over-indebtedness. Identifying why this is happening allows us to formulate a sensible, constructive investment strategy during this very unusual time.

With confidence weak and high levels of debt to income, easy money does not prevent dollar hoarding and debt reduction. People are not induced to take risk or borrow money, even with very low yields on savings. This puts downward pressure on the demand for goods, services, and investment, resulting in an embedded deflationary bias in pricing. That includes both consumer prices and nominal interest rates.

Deflation is the scourge of central bankers, rendering them useless (which they probably are anyway) as society embarks on a rational policy of saving and reducing debt. In previous blog posts I have mentioned Ben Bernanke’s 1999 paper entitled “Japanese Monetary Policy: A Case of Self-Induced Paralysis”, which lobbed hefty criticism at Japanese policy-makers for being too rigid during their decade-long battle with deflation (that’s now two decades and counting). I highly recommend reading the section “How to Get Out of a Liquidity Trap” starting on page 14. Call it the Bernanke Playbook.

Here is a link to the pdf file of that paper if you are interested.

This type of hubris keeps us thinking that simply the “right” monetary policy, or even the right policy-maker can fix our problems. Markets spin with talk of the Fed initiating what is dubbed QE 2 (the first quantitative easing was the $1.25 Trillion purchase of mortgage-backed bonds), a sort of monetary nuclear option to obliterate the threat of deflation. Recently the Fed announced they will use the receipt of interest and principle from their mortgage portfolio to buy U.S. Government bonds to maintain the size of their balance sheet. While not at a full court press as of yet, the Bernanke Playbook is getting more attention. (see it referenced here in Paul Krugman's blog)

The Bernanke Playbook has not been fully initiated yet, likely because it is too politically challenging for the Fed to engage any further in the outright purchase of Treasury bonds or pursue more unconventional asset purchases. They are letting the economy bleed out as many bad credits as possible, while staying very accommodating to prevent a liquidity crisis that could boil over into further insolvency.

But why then is the economy so sluggish, and why is job creation missing? Remember something I mentioned in a previous blog post: Every recession since WWII has been accompanied by growth in private sector credit. If we are confused by the current progress of recovery, it is because we are simply not wired for this environment. It’s very hard to grow when credit is contracting.

All questions regarding tax policy, capital spending, jobs, bank lending, etc. have more or less to do with this largely unprecedented reduction in private sector debt, or deleveraging, in a consumption driven economy.

Interestingly though, the process of saving more and reducing debt is extremely rational and almost too much for us to handle. Strategic default and foreclosure, for example, while ethically disturbing, is very rational behavior, given the structure of housing finance and mortgage contracts in this country.

So what is the endgame here? In truth, the end will justify the means as less leverage and more equity in the economy decrease risk and increase future wealth creation. However, the means carry all the risk and that is our primary concern. At the top of the list is whether private sector credit is simply transferred and concentrated within the government. That will only increase the risk of a systemic breakdown (e.g., a failed Treasury auction) in the future. We need to see total debt levels, i.e., private and public debt, reduced. If that results in sluggish growth and a long trough in this depression-like environment, so be it. Be conservative and patient in your investments.

This is what we are closely watching. Deleveraging is the “boogieman”, striking fear into the hearts of central bankers and policy makers, because it can spiral into deflation, potentially unrestrained by any policy initiative.

Below are some numbers and more pictures to help explain what is happening. I intended to publish this earlier in the summer, when the Fed released the data, but the next set of numbers is not released until September 17th anyway. That will update us for the 2nd quarter, but I think these numbers tell the story.

Out of roughly $55 Trillion in total outstanding U.S. debt:

Total U.S. debt reduction in 2009: $201 Billion

Total U.S. debt reduction Q1 2010: $260 Billion (5.1 X the run rate of 2009)

Household sector debt reduction 2009: $240 Billion

Household sector debt reduction Q1 2010: $98 Billion (1.6X the run rate of 2009)

Financial sector debt reduction 2009: $1.5 Trillion

Financial sector debt reduction Q1 2010: $646 Billion (1.7X the run rate of 2009)

State and Federal debt INCREASE 2009: $1.5 Trillion

State and Federal debt INCREASE Q1 2010: $506 Billion (1.3 X the run rate of 2009)

It is also interesting to note that debt reduction in the small business sector since the beginning of 2009 has been entirely offset by increases in debt financing done at the large company level. The banks are not increasing lending to small businesses, but the capital markets are open to companies with access. In other words, easy money is not trickling down to where it needs to go.

It’s also important to highlight that total debt is declining (government borrowing is not keeping pace with the private sector reduction), albeit at a very slow rate. That is a good thing from my point of view and we need to keep a close eye on that. We are also watching the transfer of mortgage debt financing to the balance sheet of GSEs. Here I am talking about the increase in debt levels for Fannie Mae and Freddie Mac since they were placed into the conservatorship of the Federal Housing Finance Agency in 2008. The once assumed guarantee of the Federal Government is now explicit. This is where the risk from consolidating debt at the government level is most concerning.

Now some pictures and notes.

People are simultaneously saving more....

and reducing debt....

In addition to reducing debt, households have gone from being net sellers of Treasuries two years ago, to buying almost 20% of new issuance in the 12 months ending in Q1 2010. Some may argue with the wisdom of buying Treasuries, given current interest rates and deficits, but clearly the household sector is trying to save without adding risk. From the late 1940s to the late 1990s, the household sector owned between 20% and 30% of publicly held Treasury debt. Today it owns about 10%, up from 4% in 2008. Could the household sector be the new marginal buyer, replacing foreign capital? Consider that potential trend, given how low interest rates are today.

Bank credit, the lifeline of small businesses, is shrinking.

As deposit growth is a function of credit expansion, we would expect deposits to start shrinking as bank credit continues to contract. Notice that deposit growth turned negative somewhere between 1992 and 1995. However, it was not preceded by a contraction in credit. What happened is money temporarily moved out of the deposit base into the broader economy, providing fuel for a capital spending boom that resulted in the tech mania of the late 1990s. The chart below, depicting the velocity of money (representing how quickly money is circulating in the economy), clearly shows this.

The other side of this “rainbow” is signaling exactly the opposite effect of the mid-1990s, as money is leaving the wider economy through deleveraging. Money (read credit) that was once flying around the economy is coming home to roost in the form of excess reserves at the Fed. Advocates of hard money expect to find their pot of gold at the end of this rainbow to keep money supply growth under control in the future. While not an advocate of the gold standard or the Federal Reserve for that matter, Milton Friedman said in an August 2006 interview that only a major financial catastrophe could bring about a radical change in how monetary policy is administered, so as to reduce the risk of policy mistakes. He died less than three months after that interview, on the eve of just such a crisis.

And to sum it all up....

That little downturn at the top is what we have to show for our efforts, but at least it’s going in the right direction. Confirmation that we had too much debt lies in the fact that debt levels are starting to fall, seen in the chart above relating total debt to national income. Remember, growth will make this line fall even further. If we reach a point of sustainable debt levels, possibly we will see that growth.

Clearly, deleveraging can explain, in large part, why the current recovery is so weak and ripe for a prolonged recession. But is that something to fear?

As I said before, the process itself carries all the risk, as any shock or further loss of confidence (no jobs, further debt trouble in Europe or Japan, war etc.) could quickly intensify debt reduction, as the private sector could go beyond saving excess income and into asset liquidation. On the other hand, if the so-called “bad” credits (such as credit used for consumption and sour real estate investments) can bleed-off without causing a disorderly unwind of the entire debt structure, the economy and markets will eventually face less risk and a more robust future.

Confronting the Boogieman

So we have a rare, so-called outlier, event taking place right in front of our eyes, i.e., the deleveraging of the U.S. economy. We know from history that events thought to be statistically improbable are by far the most consequential when they occur. The obvious reason for this is that society doesn’t prepare for what is mistakenly thought to be highly unlikely. That makes sense, but financial and social matters tend to ignore probabilities. If you see something coming, but do nothing about it, it is irresponsible. In other words, don’t just lie in fear of the boogieman. Confront him.

Here’s how we are confronting him. We are intensely focused on our EVA strategy, which is vitally important in today’s world (a subject for an upcoming blog). Our equity holdings have been outpacing the market lately while overall returns are somewhat moderated by our sizable bond and cash positions (i.e., we don’t go down as much and we don’t go up as much). We are ahead of the overall market in our model portfolio year-to-date because we are doing more with less by holding cash. We are more protected, taking much less risk by being 50-55% invested in the stock market, but good performance in that select group of EVA-producing equities is driving solid returns overall. The cash position is an intentional allocation aimed at protecting capital, as the risks of deflation and falling asset prices loom large. It is not a permanent condition for us, but we need to see this “once in a century” type event play out. Certainly with the upcoming elections in November, which may prove volatile, this is a good time to stay patient and conservative.

Please let me know if you have any questions or comments by visiting our website at

Peter J. Falker, CFA


Monday, August 16, 2010

General Motors IPO—A Financial Opinion

General Motors has been making a good recovery and has some great new cars, with the possible exception of the Chevy Volt (see NY Times article below). However, from my financial point of view, it is ridiculous to take the company public right now. This move is political, not financial, and is related to the coming mid-term elections, not the financial viability of General Motors.

For those readers who have not read my previous posts calling for and commenting on the General Motors bankruptcy, over the last several years, please take a look at what I had to say on the subject in March 2006: and June 2009: .

Of course, when the bankruptcy finally occurred, several constructive things were enabled, including a restructuring (sort of) of the dealer network and pension/healthcare obligations, as well as the renegotiation of union contracts. Of course, no lender could have been expected, under such dire circumstances, to provide debtor in possession (DIP) financing, as is the norm for Chapter 11 bankruptcies, which proceed through the courts to reorganization, with new shareholders etc. Instead, the U.S. Government invested $50 billion and received a 60% equity position and the Canadian government invested $10.5 billion and received 12.5%. We know the U.S. government had a loan outstanding of about $20 billion, before the bankruptcy, and it’s unclear to me what became of that loan. Earlier this year, the company, with an announcement that made it sound like they were repaying the government’s entire investment, repaid $6.7 billion. Perhaps I’m missing something here, but the remainder of that loan does not seem to appear on the company’s most recent balance sheet, so it is presumably part of shareholders’ equity.

What is quite clear, however, is that, after announcing earnings of $2.6 billion and free cash flow of $3.8 billion, for the six months ended June 30, 2010, General Motors’ balance sheet shows total cash and marketable securities of $33 billion and total shareholders’ equity of $23 billion. So, what happened to the other $37.5 billion of the U.S. and Canadian governments’ roughly $60.5 billion in capital investments in the last year? One can only assume that these new capital investments, like all other capital invested in General Motors historically, have been dissipated.

And this company, with its ongoing record of capital destruction says it’s going to launch an IPO to repay the government? Remember, if they repay the government, they will not retain the proceeds from the offering. They will have only the cash they have right now, plus future cash flows, to operate the company going forward.

Indeed, on August 5th, the New York Times reported GM CEO Ed Whitacre saying: “We want the government out, period….We don’t want to be known as Government Motors.” The Times went on to say, “Through its sponsorship of the automaker’s bankruptcy last summer — including more than $50 billion in loans — the Treasury Department holds about 61 percent of G.M. Analysts have been expecting G.M. to sell part of its shares during the initial offering, but Mr. Whitacre said the company anticipated selling them all at once.”

Really? Do you suppose he is talking about the whole $60.5 billion or just the $23 billion that’s left? Let’s take a look at how that would work. The nation’s big underwriters (at least who’s left) are supposedly vying for the privilege of selling the new GM IPO (read vying for the big underwriting fee to be paid from the proceeds). So, Goldman Sachs, JP Morgan Chase, Morgan Stanley etc. would take GM’s executives on a worldwide road show to hype the company’s terrific products (some really are but not the Chevy Volt yet; see below) and how they are making a big profit, while still being propped up by the US and Canadian governments’ $60.5 billion (or what’s left of it).

Here’s a NY Times article on problems with the Chevy Volt:

If GM succeeds in raising equity capital (and they probably will to some extent), these new investors will be committing capital to equity, which carries the highest risk on the very risky balance sheet of a company that still appears to be destroying capital investments. To clarify my point, consider this: Would these same investors be willing to buy the long-term debt of General Motors, i.e. 20 year bonds with a legal promise to pay and a fixed interest rate? Very unlikely, because these investors are not planning to stick around to find out how GM eventually works out. What will likely happen, assuming the hype is strong enough and the talking heads bob around enough when the IPO occurs, is that the original investors will engage in the “greater fool” syndrome, flipping the stock to the next fool and the next fool, and so on, until someone holds the stock for the long term and takes all the risk of loss. There has been a recent lesson in this regard, with the Tesla Motors IPO, several months ago. The stock initially jumped, allowing the original fools to flip their stock to the greater fools. However, in this instance, the next fools in the series didn’t appear and the stock tanked. Perhaps that will happen here, as well.

Please don’t misunderstand me here. I believe that GM is definitely on the mend, with many good new products and a much-needed cultural change underway. However, in my opinion, it is too soon for the company to be selling stock to the public. For all intents and purposes, the company is technically bankrupt, still relying on the government to prop it up. If it could really stand on its own, the company should be able to access the bond market and borrow substantial amounts of money for its day-to-day operations, with the government’s equity ownership essentially serving as collateral. That is clearly not the case and apparently not what the government wants. They want a political solution, before the mid-term elections. That, unfortunately, could do a great disservice to the taxpayers, the equity markets and the company itself. We have heard, in just the last few days, from a financially astute, potential GM customer, who has decided against buying a new GM product for fear of the company’s failure to survive the government’s current manipulation of their financial situation.

Finally, there has been a very significant announcement, while I was writing this blog post. The Chairman and CEO of GM, Ed Whitacre, has unexpectedly resigned as CEO, effective September 1st , and from the board effective at year end. He is to be replaced by Daniel Akerson, who has been CEO of one failed company (XO Communications) and one relatively unsuccessful company (Nextel); hardly the credentials necessary to run GM, especially not in the midst of a critical IPO.

Question: Why would Ed Whitacre (or any CEO) suddenly resign right at the beginning of one of the biggest IPOs in history, unless there is something wrong? Answer: There probably is.

Stay tuned.

Jack Falker

August 16th, 2010

Thursday, May 27, 2010

And Now for Some Good News.....

For everyone who follows this blog, you know we have continually set forth the fundamental economic problems that burden the global economy. Excessive leverage and the uncomfortable consequences of reducing that leverage top the list. We have studied similar events in history to learn what could go wrong, as well as what could go right. We have stayed conservative since 2008, with a healthy cash position. Our stock and bond holdings have done very well during the recovery phase, surpassing our expectations.

Remember, our number one focus for the past year has been simple: invest conservatively to preserve capital, allowing for investment at a better time and price. After a relentless and unprecedented “bull” market for the last 14 months, investors are finally appreciating risk again. We welcome this change.

An appreciation for risk is exactly what allowed us to buy investment-grade corporate bonds in late 2008 and early 2009 at yields-to-maturity ranging from 8% to 12%. An appreciation for risk is what allows us to buy EVA companies with 3% to 5% dividend yields at reasonable prices. An appreciation for risk benefits the patient and conservative investor.

If people now question everything from whether markets are “rigged” to complete Armageddon in the global economy, then that is a change for the better. It is a shift in investor psychology that we have been expecting for some time. Without a healthy dose of skepticism, conscientious investors have no chance. Attention to risk does not spell disaster. It opens up opportunity.

Could markets go lower? Yes. Could we have market instability from “machine” trading? Yes. Do we face challenges from Europe, an over-indebted Japan, a bubble in China, persistent deficits and higher taxes at home? Yes. Those are issues we study every single day. They matter greatly to us and have kept us cautious. We factor them into the prices we are willing to pay. But there are solutions to each problem that are difficult but not catastrophic. The issues are clearly on the table and voted on every day in the market. Beyond those solutions we have a fundamental belief in the “going-concern”.

“Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.”

-Warren Buffett, Shareholder Letter, 2007

Households will always seek to maximize wealth and consumption, making the most of the resources available. Behavior won’t always be rational or predictable, but markets allow for our society to proceed in the most efficient way possible. Mistakes are made and corrected, confidence will rise and fall, and capital will be misallocated only to be reallocated. Politics and power will interfere, but society will continually pursue a better outcome. There is opportunity to invest for that future. If we didn’t believe in that, we would resign our role as investment managers to live on a farm near a reliable source of water and grow our own food.

Every doomsayer or perma-bear I know of at least acknowledges the going-concern concept and the fact that difficult issues can and will be resolved. In valuation analysis it is often called “terminal value”. That is an oxymoron because it actually represents continuing value. It measures what an asset is worth into perpetuity. While we don’t know exactly how the issues of today will be resolved and we expect it to be uncomfortable at times, markets need to simultaneously appreciate both risk and going concern.

For several months now risk has been underappreciated. It is indeed good to see assets start to re-price, even if our holdings are somewhat negatively affected. Since the market surpassed our expectations last year, it does not surprise us to see some of those gains retraced.

What is important is that we are here to take advantage of better prices as they develop. We have been prepared for a change in market character.

Expect us to maneuver by trimming certain positions into rallies and making investments in core EVA holdings at lower prices. Protecting capital is still our main priority today in an uncertain world, but our long-term goal is to make money and generate wealth for our clients. We are encouraged to see that goal come into focus. Don’t get me wrong, we can be as bearish as anyone; it is in our nature to be conservative. Much of what we are dealing with is slow to develop, requires patience, and a watchful eye. Just give us good value at a price that appreciates risk, and we can do more than just wait. That is good news.

Peter J. Falker, CFA

For more information about our business, please visit our website at:

Tuesday, May 11, 2010

Living in the Land of Oz

All those who said Greece did not matter (I guess it has something to do with its economy being only the size of Massachusetts) can finally face the truth that it matters by roughly $1 Trillion. I guess $1 Trillion is not what it used to be, especially when central banks can print money without limit to be administered by generous, bailout-minded custodians of taxpayer money. They must save their only son (the banking system) from the cruel realities of life on the street. Who’s looking out for the rest of us? I think we can only help ourselves.

From reading and listening to many market experts today, last week’s sell-off was supposedly an overreaction anyway. The 1,000 point drop was a “glitch” (actually it is a “yet to be discovered glitch”). The market simply corrected last week to set up the next leg higher. Greece really didn’t matter after all.

Actually, there is a grain of truth to thinking that Greece doesn’t matter. French and German bank exposure to the debt of weak Euro-zone economies is all that really matters. Pure and simple, this is a bank bailout by the European Union, with self-imposed rules being broken to maintain the status-quo. The IMF, funded largely by the U.S. taxpayer, is providing 33% of the money involved ($330 billion!). In an unprecedented move, the European Central Bank has announced it began buying an unspecified amount of debt of European countries. It will provide this money, as ECB President Jean-Claude Trichet remarked, “to re-establish a more normal functioning of the market in order to be sure that we have an appropriate monetary-policy transmission.”

“More normal functioning” depends entirely on your point of view. It is becoming the norm to bail out irresponsible and negligent behavior. The money provided by the ECB didn’t exist yesterday. The ECB isn’t a money making, high return on capital enterprise. They simply own a printing press. There is a certain gullibility required for people to believe in this magic. If it was Procter & Gamble, Clorox, Cisco, Microsoft, or Berkshire Hathaway making this type of investment, we might entertain it as a shrewd, well-reasoned move by a disciplined, value-creating business. But that is not the case. In fact, left to the market to decide, it is a very bad investment. Just last week, two-year Greek bonds were yielding 15%. Only someone with a printing press would make that bet.

I know the EU, the ECB, the Federal Reserve, and the U.S. Treasury are worried. They fear that a moment like last Thursdays “glitch” was actually real. After stumbling for weeks with words of confidence, the EU finally orchestrated a “Sunday Save”, taking a page from the U.S. crisis playbook. Greek riots and truth-seeking markets seemed enough to push the EU to extreme measures. Weekend elections in Germany indicate real political divisions over the European bailout. So, the time to act is now, before markets and democracies impose real discipline. Monday, we went from “Euro-phobic” to “Euro-phoric” (clever…my words) due to the bailout’s absolute size. Who doesn’t love free money? I understand the need for liquidity in a credit crunch, but what we are dealing with here is real, lending-based insolvency in the banking system.

Sometimes it feels like we live in the Land of Oz, with some lunatic calling the shots behind a curtain. Democracy and capitalism, however, reveal the truth, even if they take us on a long, winding, yellow-brick road. Indeed, that road might someday be made of gold. If we eventually find comfort in what Keynes called the “barbarous relic”, it would be an attempt to prevent us from acting likewise. If central bankers and legislators want to maintain order without returning to some type of money based on metal, they need to act in line with free market principles and remove the specter of continual bailouts.

The curtain has been pulled back. The Wizard has been revealed. The hot air balloon is on its way. Everyone must think for themselves, and be courageous and willing to take responsibility for their actions. That is what we do every day as fiduciaries. This is our livelihood and we invest our own capital alongside our clients. The companies we invest in must create value and we look to protect capital from the risks inherent in markets.

There is no magic (or bailout) in that.

Peter J. Falker, CFA

May 11, 2010

Friday, May 07, 2010

Why We Don't Panic

Yesterday the Dow Jones Industrial Average dropped nearly 1,000 points intraday. The market ended the day down roughly 350 points. It is still unclear what directly caused the freefall. The New York Stock Exchange said this morning that they could not identify an error, but certainly something or somebody created an automatic and overwhelming response from computer generated trading.

Hopefully, this event will receive a tremendous amount of scrutiny from traders, regulators, and exchanges. Most of the downturn was corrected quickly. The market went down 700 points in 15 minutes then recovered 600 points in the following 20 minutes. The exchanges have decided to cancel many of the trades that occurred in that time frame. We had no orders present in the market when this occurred. When buying or selling, our orders are small and incremental and manually entered by us. We never have open or standing orders in the market that would fill automatically.

Regardless of the technical aspects of the sell-off, stocks began moving lower over the past week. The last several days have seen rising market volatility and a rally in U.S. Treasury Bonds, indicating a correction with a concurrent flight to safety. This comes as little surprise to us as markets will continue to confront the consequences of global over-indebtedness and economic imbalances. As written in this blog many times, deleveraging at all levels of society is a major theme for us in managing client portfolios today. The markets will ultimately deliver the verdict on how deleveraging takes its course, despite the efforts of interventionist government policies to manufacture a sustainable recovery. Currently, Europe is providing the best example of this circumstance and was a significant contributor to the momentum that got out of control yesterday.

“Show me a hero, and I will write you a tragedy.”

-F. Scott Fitzgerald

We have dual investment goals: generate wealth and protect capital. Our equity and bond holdings have performed very well since the market started recovering 14 months ago. Our bond holdings were mostly purchased in the midst of market panic in 2009 for very attractive yields-to-maturity. As stocks have recovered, we have shifted a significant portion of our equity holdings to conservative, high dividend paying companies that generate long-term wealth with consistently high returns on capital. These stocks achieve both investment goals simultaneously. Notably, however, we have also maintained a significant cash position, invested in the Schwab U.S. Treasury Money Market Fund.

Along with our bond holdings, this cash position contributes meaningfully to our goal of protecting capital. Even with a low yield, it provides a very important component of return. While it gives us flexibility to invest when opportunities appear, it gives us great comfort on days such as this. To be sure, while the market was down 9% yesterday afternoon, our cash position was down 0%. If a correction continues, that cash component will become more and more valuable both in its ability, not only to protect capital, but also for reinvestment at reasonable prices, upon which we intend to act.

Up to this point in the market recovery, we have been glad to let our bond and equity allocations do the heavy lifting of generating capital appreciation. Our cash position has not significantly hindered overall returns. Its relatively low yield has been inexpensive insurance to protect against a volatile backdrop no less severe than what was witnessed in the 1930s.

We are not trying to be heroes in this environment, chasing higher returns into a vortex of uncertainty. We have too much respect for the challenges of today to be cavalier in taking unnecessary risk with our clients’ capital. When confronted with low rates of return, investors often make the mistake of taking added risk. (A phenomenon we have witnessed repeatedly over the last 10 years.) Without compensation for that risk, losses occur suddenly and usually by surprise. Yesterday’s market action, reminiscent of late 2008, demonstrated clearly how a market shock might quickly undermine confidence when returns are low and risks are elevated. This environment is very different from the 25 years that preceded the collapse of the tech bubble.

Managing a portfolio that balances the goals of generating wealth and protecting capital will continue to serve our clients well as investors become more familiar with the changing character of markets.

If you have questions or comments, please contact us.

Peter J. Falker, CFA

Monday, March 22, 2010


Aside from grazing the subject in previous posts, I have refrained from directly addressing China and the inherent economic issues. We are by no means experts on China, and the implication of Chinese economic policy is not usually a factor in building our client portfolios. However, the macroeconomic (big issues) world we live in today, requires more thought on subjects like this than at any other time since we started managing investments. We have also been asked our opinion on China in many conversations with investors and friends. So here is my opinion, and I will try to keep this within the specific context of our investment principles. There are many issues that contribute to a well rounded analysis, but my focus here is on that of price.

The Divinity of Price

Our investment strategy, focused on EVA-producing businesses, favors markets that are generally unencumbered and free to translate value through price. The goods and services of the businesses we invest in should be priced to reflect the inputs of labor, capital investment (that includes the cost of capital), and any value that a business creates in excess of these inputs. That extra value is known to us as economic profit and is what ultimately drives capital allocation in the market. Investors will seek out those businesses that consistently deliver economic profit. Equally important is that investors abandon those that destroy value.

Of course, there are factors that interfere with an efficient pricing mechanism, such as uncertainty over changing tax policy and regulation, among many others. For the most part, however, the capital market allows for value-creators to be rewarded and value-destroyers to be punished. It differentiates the good and bad stuff, allowing for both success and failure. Obviously I could launch into a discussion here of the consequences of the bank and auto bailouts of 2008 and how that doesn’t fit this model at all, but I’m trying to stick to the subject here. We clearly understand and are troubled that free-market principles are quickly abandoned when the going gets tough. Stock market returns over the past 15 years and, in turn, our investment returns have been, at times, driven by the forces of market manipulation and intervention.

So, very simply, anytime a pricing mechanism is controlled or distorted, the ability to correctly translate value breaks down entirely. The history of global trade and economics is full of pricing distortions. The driving force is always political and self-serving. So let’s be clear about our politics. The U.S. is a market-based, democratic country legislated by Democrats, Republicans, and a few Libertarians, while China is a centrally-planned economy with a single party government run by the Communist Party of China (CPC).

I don’t have to go much further for you to understand my point, but it should be abundantly clear that the two ideologies approach economics and markets from very different points of view. However, tinkering with market prices is tempting for both. International trade utilizes a natural pricing mechanism in currency exchange rates. Those rates are meant to translate the value of inputs from one economy to the other. China’s policy of a fixed peg of the Renminbi to the dollar is simply a price control. Price controls obstruct free markets. China creates seemingly endless GDP growth, yet without a real price, they likely destroy value and hide losses.

The Yin Grows

Why do the Chinese engage in such overt market manipulation? Some might argue that the Chinese have gone a long way to accepting market principles. I just want to get right at the core of the issue here, knowing we can rationalize or qualify this endlessly. The Chinese are, by definition, Communists. The CPC explicitly uses Marxism as one of its guiding principles. After all, Marx literally wrote the book on communism. In the Communist Manifesto there are statements that reject free trade and free markets. Marx also recognized that capitalism does not tolerate over-capacity. Persistent over-capacity drives returns below the cost of capital to the point of loss. Capitalism and free markets thrive on allowing failure so capital is redirected away from non-productive uses. China is the poster child of over-capacity in today’s world, building vacant cities in anticipation of future growth (Read this article in FT about Chenggong. See this video about Ordos City).

The wealth of the working class in China is suppressed and controlled by an overwhelmingly dominant single party political system, for the (supposed) eventual benefit of the whole. In the short-term, the benefits are disproportionately endowed on exporting industries and state-owned enterprises. The working class absorbs the short-term economic loss for the benefit of increasing total employment. By pressing continually on with investment in more and more capacity, China slowly transfers the means of production away from other countries. On the global stage, this is a power play, leveraging off an economic model of large trade surpluses to gain economic influence in the world.

The Yang Shrinks

The U.S. fell into the trap, with little pause or consideration of the consequences. Lured by a price too good to pass up, the U.S. has repeatedly justified manufacturing and consumption decisions. We fooled ourselves, living in an economy where price supposedly reflects value and aggregates all inputs, we rationalized that China just has access to more resources, more people, enjoying comparative advantages. With unemployment at low levels in the U.S. for many years, largely because asset prices and lending were supported by loose monetary policy, we hardly noticed the growing consequences. (Thanks to our own price fixers at the Federal Reserve – for a better look at that I recommend reading William Fleckenstein’s book “Greenspan’s Bubbles”).

Here we sit with 17% under/unemployment, structurally impaired from years of misallocated capital. Small businesses have little access to capital and banks are not increasing lending. Consumers have pulled back and everyone is yelling about deficits and healthcare. (By the way, the next great misallocation of capital is well underway in healthcare. It is by far the fastest growing component of consumption expenditures AND employment). I am at least encouraged that the political debate in this country is raging. People are paying attention. The fix may well be in on our side of the equation, with much work left to be done.

Yin Must Equal Yang

Welcome to the consequence phase. Too little too late for debate on the subject of currency manipulation, in my mind. The die is cast and we now find ourselves at the end of the debt rope. In order to run persistent trade deficits while maintaining high levels of employment, we have been borrowing in the pursuit of prosperity. How convenient for the Chinese to have been the natural source for much of that credit. Not convenient at all really. It is by design. They seem to have bought into the story as well. As hedge fund manager Hugh Hendry describes it, it’s as if Bernie Madoff was in charge of U.S. GDP accounting and China was the largest investor. The worst thing then for China is a derailment of the U.S. growth story as promised, especially in the form of a banking crisis. As the U.S. hits the debt ceiling, no longer able to borrow excessively as markets deny a further misallocation of capital, growth is short-circuited. China (and other surplus countries like Germany in Europe) must naturally face the consequences as well.

Bubble Hunting

Is China a bubble? I’ve read many who think so, such as Jim Chanos and Hugh Hendry, and they sound very compelling (read Chanos’ thoughts, read Hendry’s thoughts). But I don’t analyze China for investment purposes, have never been there, and I don’t have good insight on the numbers. What I can say, is that manipulating price prevents the market from purging losses. This type of price fixing is meant to rig a country for GDP growth and employment, not value creation. That is similar to how we ended up with the Dot Com and housing bubbles, as the price of money was set by the Federal Reserve to prevent the loss of jobs and GDP growth. In the end, we destroyed value, eventually reflected in falling asset prices. If China is in a bubble of some kind, without free market mechanisms, they may well blow hot air longer than we expect.

China Is As China Does

Financial headlines are ablaze that China must float the Renminbi now. No one seemed to care much until it all went wrong. It’s gone wrong, but there is no value in blaming China. We have been willing participants believing that prices reflected value. Now we confront the circumstances of having reached our borrowing limits and looking for retribution. Retribution, according to many in Congress, comes in the form of trade barriers. So, in essence, instead of manipulating price, we suspend pricing entirely. Let’s only hope this stays within the bounds of a diplomatic resolution. (Follow this link to find Taiwan on Google Maps).

My belief is that China holds the Renminbi peg (or close to it) beyond any pressure applied from the U.S. That circumstance will only serve to enforce the necessary process of deleveraging and the incipient deflationary forces in the U.S. With or without trade barriers, the U.S. must reign in debt and start saving more. Any radical adjustments in policy at this point would likely spark greater uncertainty and exacerbate that process.

This continues to favor our aversion to general equity market risk and keeps us close to “dollar” assets. Within equities, that requires larger holdings in defensive stocks such as consumer staples and very select utilities that pay above market dividend yields. We have continued to hold the high quality corporate bonds we purchased in late 2008 and early 2009. We also hold a fairly high cash position that protects against adverse market reactions. It also gives us flexibility to exploit investment opportunities that will be present as market volatility is likely to continue.

Fighting Words?

One last, rather well known quote from Communism’s founding father. Whether this is relevant or perhaps even prophetic, we might need to reconcile what it means in today’s world.

Freeman and slave, patrician and plebian, lord and serf, guild-master and journeyman, in a word, oppressor and oppressed, stood in constant opposition to one another, carried on an uninterrupted, now hidden, now open fight, a fight that each time ended, either in a revolutionary reconstitution of society at large, or in the common ruin of the contending classes.”

-Karl Marx, The Communist Manifesto, 1848

Consider this as the China story continues to unfold on the global stage.

Peter J. Falker, CFA

March 22, 2010

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