The Myth of the Steady State

Everyone’s waiting for things to get back to normal. The problem is, no one knows what normal looks like.

In August of ‘07, the wheels started to come off the bus. That’s when a year’s worth of real-estate price declines began to tell on the sub-prime mortgage market. First Bear Stearns’ hedge fund blew up. Then sub-prime originators began to fail. Then prime-based originators, and you know the rest.

Now that we’re in a recovery, people are debating what the “new normal” will look like. But for now, we’re in an inventory-rebound. That’s not normal.

But what was normal before the crisis? The run-up to the housing bubble wasn’t normal. Prior to that, we had the escalation and execution of the Iraq war. Prior to that, we had the inflation and pricking of the internet bubble. Prior to that … you see what I mean?

Some say the market is an evolutionary mechanism, always adapting to new conditions. But to me it seems more like quantum physics, with jump conditions and measurement failures and uncertainty principles. And like quantum mechanics, the market frequently violates some of the most elegant mathematical models. As Einstein said, if you want elegance, go see a tailor.

I don’t believe in a past, present, or future economic equilibrium. The market we see is the market we have. The trick is to prepare for the next market, without going broke.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Competition and Monoply

Why do competitors try to become monopolists?

Most business people enjoy competing. They know the thrill that comes from fighting for critical new business. They also know that competing keeps them sharp and helps them improve what they do, because if they don’t serve their customers someone else will. So competition leads to happy customers and vigorous companies. So why do they want to become monopolists?

If they can eliminate their competition, they secure a larger market and higher revenues. With no pricing pressures, they can set prices in line with their costs. And a monopolist can cut some significant expenses: marketing, recruiting, even some production costs.

But once the competition is gone, there is less external focus on the customer and more internal focus on the bureaucracy. Monopolists talk; competitors act.

It’s human nature to want to sleep late and quit early. And monopolistic rents help a company’s short-term bottom line. But that’s not good for customers and it’s not good for business. Competition keeps us honest by keeping us accountable. Monopolistic businesses may seem safe, but in the long run, it’s competitive companies and industries that offer the best growth.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Buy Back Blues

Why do companies buy back their shares?

It’s a fair question. A reasonably profitable company will generate excess cash, often more than it can use to grow. What should it do with it?

Companies have three options: hold it, pay it via dividends, or buy back shares. In the absence of taxes, investors should be indifferent. Money earned is money earned, no matter how the company distributes it. The financial impact of each approach is the same.

While holding excess cash might encourage management to do something stupid, and tax policies formerly favored buybacks over dividends, such is not the case now. So why do companies keep buying back their shares? Often management believes their shares are undervalued. Share buybacks can indicate confidence in the future; but they can also disguise mediocre performance by artificially enhancing financial ratios.

Some have suggested that share buybacks counteract the dilution due to employee stock option plans. This is a canard. If an option program dilutes shareholders, buybacks don’t counter this. They may disguise the dilution, but they don’t reverse it.

While share buybacks don’t create economic value for investors, they do send a signal. But the intelligent investor has to discern whether the signal conveys information, or is just a smoke screen.

Douglas R. Tengdin, CFA
Chief Investment Officer
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15 Minutes

Meredith Whitney and Nouriel Roubini now say the panic is over. Should we care?

These two analysts are now enjoying their 15 minutes of fame as two who correctly foresaw the financial issues surrounding toxic assets, excessive leverage, and unsustainable consumer spending. The Brown University graduate and New York University professor are both admittedly very smart. But do we need to jump at everything they say?

Every market is different. In the late ‘90s Henry Blodgett and Mary Meeker understood how the internet was changing retail and business dynamics. In the late ‘80s it was Abby Joseph Cohen. These people see something different about the current economy and get one big market call right. But it doesn’t really serve investors to name anyone as a market oracle.

These people make a correct short-term prediction and the media showers them with laurels. Nouriel Roubini gets to show off those natty suits. But when the moment passed, did the Abby Cohens and Mary Meekers of the world see it coming? Not really. They kept riding their own personal express until it went off the tracks.

Most traders know that only half of their market calls turn out to be right. They try to set things up so that their good trades pay off more than their bad trades lose. But when the media darlings start to believe their own press clippings, other investors get persuaded that Roubini and Whitney have it all figured out. And no one has it all figured out.

We don’t know what the future holds. The best we can do is keep questioning and maintain our disciplines.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Loser’s Game

Has investing become a loser’s game?

When we watch top sports performances we often watch winners: The hundred-mile-an-hour fastball, the service ace in tennis, the 300-yard drive in golf. Winning elite-level sports competition is a winner’s game: you win by hitting winners. But your average hacker wins in sports by not losing: getting the tennis ball back over the net, hitting the golf ball down the middle of the fairway, getting the baseball into play.

In investing, some aspects are clearly loser’s games. Bond investing gives you a defined income stream and your principal back after a specific period of time. If the issuer defaults, you have trouble. Otherwise, boring is good. Clearly, the way to win in bonds is by not buying a losing issue.

Similarly in stocks, the way to outperform over the past year was to avoid issues like Citibank, Bank of America, and GE that lost 50 to 80 percent. While many losing stocks have come back, those issuer have stayed at depressed levels.

Other crises saw a similar pattern. By avoiding EMC during the dot-com bust or Enron and Worldcom in the middle of the decade, an investor could beat the general market. Avoiding losers adds as much value or more than picking winners.

Two things these losers had in common: they were all big, and they were so excessively complex that even their own managers had a hard time understanding them. Maybe winning at the loser’s game isn’t so complicated.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Simplicity, simplicity, simplicity

Could our financial problems have stemmed from too much complexity?

In banking, there are four or five ways to measure capital and about a dozen ways to classify assets. In insurance there is likewise a complex web of reserve calculations and investment silos. And everyone in finance is subject to an alphabet soup of regulators. Is the solution to our problem adding one more layer of calculation and regulation?

Having regulators compete with one another can be good on one level—it encourages each regime to do its best—but it can lead to regulatory capture, where the SEC lawyer is just punching his ticket before he moves on to become the compliance chief of a multi-billion dollar hedge fund. How quick might he be to shut down an offender?

Thoreau wrote, “Simplify, simplify. Our life is frittered away by detail.” A rational regulatory regime with clear simple rules—like a simple leverage ratio: assets over capital—might not be optimal, but it would be transparent. If the assets could be yours, they are yours, and count as leverage. A simple, uniform corporate tax rate brought in more revenue in Ireland per corporation than did a higher rate with more exemptions in Italy. That’s the power—and freedom—of simplicity.

In finance, there’s a lot of room to simplify. But it’s hard to get the balance right. As Einstein said, “Everything should be made as simple as possible, but no simpler.”

Douglas R. Tengdin, CFA
Chief Investment Officer
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The New Puritans

H. L. Mencken once quipped that a Puritan is a person who is afraid that someone, somewhere, is having a good time.

Well, we have a new Puritan class in our midst, and they’re not obsessing about personal good times. They’re worried about economic good times. They’re convinced that the average American has under-saved and overspent for decades, and now we have a bill to pay. The “New Normal” of this view has the savings rate rising to 10%, the economy running at 2%, and all of us wearing hair shirts.

The New Puritans are convinced that we need to atone for our economic sins. A higher savings rate is only for starters. They point to President Obama’s tire tariff as the first skirmish in a new trade war. They point to plans for financial reform as a sign of new re-regulation. They think these long-term trends of deleveraging, deglobalization, and reregulation will give our economy arthritic joints and make us all move slower.

But economics is not a morality play. Analysis shows that the “housing wealth effect” was really the employment impact of a construction boom. So a housing bust, while affecting employment, shouldn’t result in a permanently higher savings rate. The other aspects of the “new normal” seem equally cyclical.

Don’t panic. The world hasn’t ended or even changed that much. While galling to some, the dynamic American economy will still keep consumers happy.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Ratings Game

Is it free speech? Or a legal opinion?

That’s the question being asked about credit agency reports. During the sub-prime bubble, Moody’s and S&P offered opinions about the bonds’ credit quality. The idea that if you pool a lot of delinquent borrowers buying McMansions with nothing down together and you can create a Aaa bond is ludicrous now, but it didn’t seem so then So now some folks want to take it out of their hides. In the past, the agencies have argued that what they say is “just an opinion,” and protected under the first amendment. That’s silly. Agency opinions carry the force of law and define what many can invest in. There ought to be some accountability.

While it seems ridiculous to liken a Aaa rating to an editorial cartoon, I can see the wisdom in not bankrupting the agencies by blaming them for the banking crisis. We’ve lost, what, some $2 trillion, and these companies are worth about $15 billion. Not very much to offer – and for that we’d cripple an industry that we need.

No, the point is to define the rules going forward. Credit rating agencies are fiduciaries, and should be held to a fiduciary standard. But like fiduciaries, they should be protected from Monday-morning quarterbacks. In the meantime, there’s one rule that always holds: let the buyer beware.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Ultimate Resource

Is Africa calling?

Since late last year, the South Africa market has been on a tear. The shares have almost doubled from their bottom at year-end, and they’re only 25% below their all-time high. Over the last 5-years it’s returned about 15% per year, a testament to the power of globalization.

But isn’t Africa just a resource play? Are oil and diamonds and tourism the sum-total of the African economy? And aren’t disease, civil strife, and corruption real threats to stability?

That’s only part of the story. Sure, as global commodities have gotten expensive the resources in the continent have become more valuable. But something deeper is at work. South Africa has solid infrastructure and a tradition of rigorous accountancy. But the real transformation is in some of the frontier markets that are just beginning to develop their natural resources—places like Botswana, Uganda, and Ghana. These countries are stable politically and are will soon become oil exporters.

While the resource development is crucial in the short term, the real growth opportunity comes from development of human capital. African entrepreneurship is just entering its earliest stages. The continent has been plagued by racism, paternalism, and corruption. Independence movements of the past were unfortunately tied to wrongheaded economic policies. But much of Africa has moved beyond that.

Ever since Vasco de Gama sailed around the Cape of Good Hope, Africa has attracted attention. Let’s hope this new wave of interest results in some real growth.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Property Values

I thought we were headed for a commercial property abyss.

That’s what all the bear hunters were saying. “Residential property was the first shoe. Commercial property will be the second.” And when General Growth Properties declared bankruptcy last year it only fueled those fears.

But a funny thing happened on the way to the funeral. The corpse just didn’t show up.

The largest mall owner in America, Simon Property Group, is looking to buy a bunch of General Growth’s real-estate out of bankruptcy. Simon already owns almost 400 properties with 300 million square feet. While their revenues are down with the recession, management believes that a lot of these retail properties have some value. So they’re looking to fill out their portfolio.

This fits in with something I’ve mentioned before. When corporations vote with their treasury funds, it’s significant. Some bears think that commercial real estate is ready to collapse because the American consumer is in retreat. But it doesn’t look that way from this news. If a collapse were coming, you’d expect Simon to squirrel away its cash, not spend it on acquisitions.

But if commercial property is finding a bottom, just as residential property has, then the banks aren’t ready to collapse in a Banking Crisis 2.0. And if that’s the case, they’ve got plenty of capital. Companies will be able to borrow, and the U.S. should be back in business.

Douglas R. Tengdin, CFA
Chief Investment Officer
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