The Oldest Arrangement?

How do people deal with their student debt?

Source: St. Louis Fed

Student debt is soaring. The cost of college is skyrocketing, but in our knowledge-based economy, education is more important than ever to financial success. Some people think a college degree is little more than signaling: the degree on your resume tells a prospective employer that you are intelligent and hard-working. But for someone looking for work, that’s beside the point. If you don’t have a diploma, many potential employers won’t even bother looking at your resume.

But a degree is incredibly expensive. The full cost for a BA at many private schools can be more than a quarter of a million dollars. And State Universities are expensive, too: four years at the University of New Hampshire costs more than $150 thousand for New Hampshire residents. It’s no wonder college debt is soaring.

So many students are resorting to the oldest profession to handle some of these newest financial pressures. The dating site SeekingArrangements.com is designed to connect “Sugar Babies” with “Sugar Daddies/Mommas.” In other words, young people are selling their bodies to help them pay off their student loans. The site claims to have 4.5 million active members, and lists a phone number with a Las Vegas area code (naturally) for press inquiries.

In the past, students would talk of working their way through college. With college costs out of control, we shouldn’t be surprised if being a “working student” takes on a whole new meaning.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Triumph of Engineering

How did Google beat Yahoo?

Source: Bloomberg

Ten years ago we didn’t know what would happen. Google had just gone public, while Yahoo had been around a while. Both companies had a core search engine, and both were set on expanding their services.

Now Google is a $500 billion behemoth, while Yahoo is about to be relegated to the dustbin of history. How did Google win the competition for hearts, minds, and clicks? A lot has to do with the way they engineered their approach to data storage and management. From the start, Yahoo used third-party vendors to handle its file sharing. NetApp was their go-to system. At first, this seemed reasonable. They could add or subtract services just by adding or taking away NetApp modules.

Google took a different approach, designing its own information infrastructure. They built their file system to be inherently flexible and scalable, simplifying and accelerating their roll-out of new products. As a result, while Yahoo engineers were reengineering their data interface with each new app, Google’s system could be quickly adapted when new services were adopted. This also allowed Google to use its computing power more efficiently. When servers weren’t busy on search they could be used to process email. Yahoo, on the other hand, had to deal with redundancies and inefficient connections all the time.

Photo: Matt Wade. Source: Wikipedia

This was a classic build vs. buy decision. Yahoo came quickly to the market by using pre-existing infrastructure. Google, on the other hand, spent three years building its own file system, but they began with the end in mind, structuring it for growth and flexibility.

From the outside, it was impossible to tell which company would win. Sometimes getting to the market first gives a company an insurmountable advantage. But more often, what matters is getting things right—if not the first time, eventually. Google understood that their data needs would be constantly growing and changing, so they needed an adaptive, flexible, efficient system. That’s what’s allowed them to add Gmail and Android and YouTube to their core search capability.

When you face a problem, try to visualize it completely, from as many angles as possible. Imagine the ideal approach—ignoring what’s been done before. Then you can evaluate what resources you have, what might need to be outsourced, and what you can do yourself. Above all, begin with the end in mind. You never know how far your idea might go.

Douglas R. Tengdin, CFA

Chief Investment Officer

Failing Upwards

What drives US markets?

Source: Bloomberg

Over the years the stock market in the US has generated significant real returns – better than most other markets around the world. Since 1994, US equity markets have returned 5.4% above inflation, while the rest of the world has averaged only 2.3%. Why?

One reason has to do with the way we treat failure. The US has a very liberal bankruptcy regime. When companies can’t pay their debts, we allow them to stay payments to their creditors and reorganize. Sometimes that means that the company continues, like the Chicago Tribune. That paper keeps coming out, despite going through Chapter 11 bankruptcy proceedings in 2007. By contrast, after Lehman Brothers collapsed, its assets were sold and the company was liquidated.

In both cases, managers were fired and unproductive assets were freed to be put to use in a more productive way. This includes buildings and equipment, but it especially includes people. When people are stuck working for “zombie companies” that have been propped up through subsidized loans, they can’t work to their fullest potential. Japan’s business sector is famous for having “company men” who draw a salary for doing nothing more than show up and read the paper. What a waste!

Failure isn’t truly failure if we learn from it and put our time and efforts to more productive use. That’s why the startup culture in Silicon Valley rewards folks who are on their third or fourth attempt. Winston Churchill put it best: “Success is not final, failure is not fatal: it is the courage to continue that counts.”

Douglas R. Tengdin, CFA

Chief Investment Officer

Euro Futures

Is the Eurozone dying?

Photo: Dave Meier. Source: Picography

It’s certainly facing tough times. Economically moribund, most Euro government bonds carry negative interest rates. Countries on the economic periphery still face crushing debt service. Unemployment remains above 10% — the same level it was shortly after the Great Recession. And soon Britain will vote to leave the EU. Who can blame them? Who wants to tie their economic future to a 20-ton anchor?

But bad as things are right now, they were significantly worse just two years ago. Unemployment was 12% and headed higher. Europe was in the middle of a double-dip recession, brought on by the central bank’s attempt to “normalize” interest rates prematurely in 2011. The Eurozone economy was shrinking by 1% per year, and had been since 2011. Now, their economy is growing, the Greek people voted to stay part of the Euro, and there is economic crisis pushing people out. Various groups might be better off by going alone, but getting there is a problem.

Eurozone unemployment. Source: Bloomberg

Absent some calamity, the Eurozone will likely continue in its present form: a monetary union with centralized regulation but most fiscal and political decisions made at the national level. The biggest threats facing Europe right now are the migration of millions of Syrians fleeing civil war and the rise of reactionary nationalist movements. Neither of these directly affects the UK, but any flare-ups over the next month will likely impact the Brexit vote.

There are lots of things to be worried about, globally, but there always are. The Euro created a unified market with over 300 million highly educated producers and consumers. It would be a mistake to bet against it.

Douglas R. Tengdin, CFA

Chief Investment Officer

Small Futures?

Are we all doomed?

Photo: Alton Thompson. Source: Wikipedia

A recent report by McKinsey and Co. discussed the long-term prospects for the stock and bond markets. Their contention was that after an era of stellar performance, returns are likely to be significantly lower over the next 20 years.

Source: McKinsey & Co

There’s nothing dramatically ground-breaking about these projections. After all, twenty years ago 10-year US Treasury Notes yielded 7%. Now they yield 1.8%. 10-year German bunds yielded 6.5%. Now they yield 0.2%. In the past, strong real economic growth driven by technological innovation and improved global trade was the source for above-average equity returns. Going forward, if economic growth remains sub-par, both equity and bond returns will be a lot lower.

German 10-year government bond yields. Source: Bloomberg

Practically, this means that people retiring in a few years shouldn’t expect a long series of double-digit returns to help them out. If they haven’t started saving, the should begin now. For younger folks, lower market levels during their earlier saving years will help them, in the long run. If you were investing all through the Financial Crisis, your best returns have come from the purchases you made in February and March of 2009, when we wondered if the global economy was headed for a depression.

But this is really a dog-bites-man story. Analysts have been warning us to expect lower returns for a while. Adapting to them means we need to save more and consume less. The highest returns over the long haul, will come from stocks, consistent with financial theory. Bonds are mainly useful as a source of stability, especially if the economy continues to grow slowly.

If returns turn out to be better than this, you’ll end up with a bigger portfolio than you expected. Stay diversified, watch your costs and your taxes, and be careful not to reach for yield. Above all, don’t panic.

Douglas R. Tengdin, CFA

Chief Investment Officer

Alpine Meadows

What comes to mind when you think of the Alps?

Photo: Kevin Connors. Source: Morguefile

Maybe it’s clear mountain lakes and crystal blue skies. Maybe it’s sun and snow and skiing. Or maybe it’s money?

A map of Europe scaled by per-capita GDP reveals an interesting tendency: the areas with the most mountainous topography tend to have higher incomes. Northern Italy, western Austria, southern Germany, and Switzerland are all significantly richer than other regions. This holds true despite differences in taxation, culture, transport, and trade policies. Why might this be?

Source: Eurostat

Many explanations have been offered—the tendency for mountainous areas to be left alone; the impact of global tourism; even the legacy of the Hapsburg Empire, remote though that may be. (Without Wiki I can’t recall the name of single Hapsburg leader.)

What jumps to mind when I see this map is the connection with Switzerland. What’s distinctive about the Swiss? Switzerland has fiercely guarded its independence and neutrality. It was never a great manufacturing center, but over the centuries their safe-haven status has helped them amass a large base of capital. That money had to be employed productively. So the regions that had the greatest contact with Swiss bankers and banking institutions have had more access to ready sources of capital and finance. It also didn’t hurt that Switzerland has been a self-governing coalition of small states from the time of William Tell.

Statue of William Tell in Altdorf. Source: Wikipedia

As our bureaucrats and politicians try to sort out too-big-to-fail banks and banking regulations, it’s worth asking what’s made Switzerland so stable for several centuries. Finance is real. It’s a mistake to treat it as something extraneous to the economy.

Douglas R. Tengdin, CFA

Chief Investment Officer

Book ‘Em

Why do we love old books?

Photo: Diane Hope. Source: Morguefile

There’s something romantic to “old book smell.” It’s a kind of earthy, musty aroma of old leather and paper. Maybe the smell invokes trips to the library when you were a child. It’s quite attractive to many people. There are even high-end perfumes that try to mimic it.

Paper products release distinctive odors as they break down, notably lignin, which produces a vanilla-like scent as it decomposes. Various presses use different sources of paper which have particular characteristics. My old paperback copies of Lord of the Rings have a wonderful smell of birch or pine to them. It’s even possible to date a volume by smelling it. Scientists have identified dozens of volatile organic compounds produced by old paper.

It’s one reason I hope e-books never wholly replace traditional paper books. Yes, I can easily adjust the font size on my Kindle as my eyes get older, and yes, I can access and carry hundreds of volumes in a device lighter than a sweater. But a glass-and-plastic reader doesn’t entice me the way an old volume does. It can’t exude the ambiance of the family library, even if they infuse lignin and rosin into the simulated leather cover.

Photo: Gabor. Source: Morguefile

Our world gets more digitized and more accessible every day. It’s important, though, to remember what makes it truly humane. For me, old books will always be part of that picture.

Douglas R. Tengdin, CFA

Chief Investment Officer

Getting Going

How do you get started investing?

Photo: Tyler Main. Source: USMC

I got involved with investing via a different route. I had studied computer modeling in college in the early ‘80s. While looking for a job, I met with a bank manager who had a computer model for the bank’s earnings and balance sheet, but didn’t have anyone that could run the model. Tentatively, he hired me to implement the computer simulation. I got the analytic software to work much faster than expected, so he put me onto different tasks. I quickly learned how important investments are on a bank’s balance sheet—how they can be used to help a bank match its assets to its liabilities.

Essentially, I came to investing by studying liabilities. And that’s not a bad approach. The reason we invest is to meet future financial needs—our future liabilities. For example, at some point, most of us want to retire. We’ll need a source of income to live on. That future demand is a liability, so we save and invest now in order to meet that need. The amount of time we have until we need the money will help determine how much risk we can take—how much volatility we can put up with in our portfolios.

Every investor is different. We all have unique needs, wants, and dreams. We also have varying resources: our jobs, skills, and relationships. These combine to create a distinctive asset/liability structure—our extended personal or family balance sheet. Your investments are just part of this picture, and the part you probably have the most control over. That’s why investments are like clothes—there’s no “one size fits all.” They have to be cut and fit to match the unique size and shape of your individual balance sheet. (It’s also why I’m skeptical that robots will turn out to be very good tailors. But that’s a different discussion.)

Tailor’s shop. Photo: Wolfgang Sauber. Source: Wikipedia

The first rule of investing is to “know yourself.” Before we buy a stock or think about asset allocation, we need to understand what we own and what we owe: our assets and liabilities. Only then can we match our investments to our lives—and have portfolios that fit.

Douglas R. Tengdin, CFA

Chief Investment Officer

Brexit Blues

What is “Brexit”?

River Thames. Source: Wikipedia

“Brexit” refers to the potential withdrawal of the UK from the European Union. They’re voting on the possibility on June 23rd of this year. The UK isn’t part of the Euro – the British Pound is still their currency. But it is part of the EU, and has been part of that or its predecessor, the EEC, since 1973. Membership in the EU has certain pluses and minuses. It improves trade, makes investment easier, and reduces the cost of most items. On the other hand, it requires large membership fees, puts the Brussels in charge of many restrictive labor and environmental rules, and has cost some Britons their jobs. The campaigning on this issue has been intense.

Photo: Dean Molyneaux. Source: Wikipedia

If Britain votes to leave the EU, it will be another step in the dissolution of many economic and political deals that have tied the world closer over the years. It would make “Grexit”–the potential exit of Greece from the Euro–more likely. Scotland and Wales might reconsider leaving the UK. The UK would have to renegotiate a host of trade deals with Europe and the US, and the terms would likely be more restrictive. A more risk-averse investment climate would likely drive the US dollar higher and US interest rates lower. This, in turn, could push China to devalue the Yuan. In short, global markets could be quite volatile.

Brexit, Grexit, and the rise of nationalist and nativist tensions in the US and around the world are symptoms of a general unhappiness with the pro-trade and pro-globalization order that has grown since the fall of the Soviet Union. Improvements in global commerce have led to stronger economic growth, but many people’s lives have been disrupted in the process.

The UK has reconsidered ties with Europe several times before. Each time, they have voted overwhelmingly to stay close to the Continent. Let’s hope they do so again.

Douglas R. Tengdin, CFA

Chief Investment Officer

Stock Market Values (Part 4)

How do you value a company when there are no earnings?

Photo: Mary R Vogt. Source: Morguefile

Is it just a case of irrational exuberance? Not necessarily. Traditional discounted cash flow analysis is a useful tool when it comes to evaluating financial assets, but it has its limitations. One aspect of investing that DCF analysis ignores is management’s flexibility. They can delay bringing a product to market, or expand its production to meet an unexpected surge in demand, or shift how their facilities are used—perhaps to produce a different kind of product. This kind of flexibility has real value.

To capture this value, we use option-pricing methods to supplement traditional valuation. An option is an asset that can go up, but is limited to the down-side. If management possesses a patent on a new drug, that patent has value even though it’s not producing cash right now. The upside may be huge, while the downside is limited to the cost of bringing the medicine to the marketplace.

Call option pricing. Source: Wikipedia

This is also why many tech companies seem to persistently carry such high valuations. The market is putting a high value of their potential growth, and the flexibility management has to pursue different approaches to their business. Putting a value on this kind of asset—management flexibility—is difficult, but it can be done. It depends on the cost of exercising the flexibility, the potential upside a change could realize, the amount of time management has to make the decision, and how volatile conditions are. The more volatile things are, the more these options have value. These values can all be quantified in a pricing model.

Black-Scholes Option Pricing Formula. Source: Wikipedia

In practice, this involves a lot of assumptions about stock prices and strike prices and market volatility run through an analytical model with decision points and normal distributions. Additionally, the real world will insert complexities that our models can’t accommodate. Nevertheless, options methodology is essential for understanding why some money-losing companies still have high market values, and why some profitable companies seem so cheap. Today, it seems, the market is putting a lot of value on the options that internet-media companies like Amazon and Netflix possess.

It’s not necessarily irrational just because you don’t understand it. Sometimes, what is unseen is more important that what is seen. It’s all in the options.

Douglas R. Tengdin, CFA

Chief Investment Officer