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Tom “Net Quick” Evans

Posted in About, Activist Investors, Greenbackd, Liquidation Value, Stocks, tagged , , on October 29, 2009| 4 Comments »

Following my Simoleon Sense interview with Miguel Barbosa, I’ve had a few requests for a post on Tom Evans. Here it is, hacked together like Frankenstein’s monster from all the public information I could track down:

Thomas Mellon Evans was a one of the first modern corporate raiders, taking Graham’s net current asset analysis and using it to wreak havoc on the gray flannel suits of the 40s and 50s. He’s not particularly well-known today, but he waged numerous takeover battles using tactics that are forerunners of those employed by many of the takeover artists of the 1980s and the activists of the 1990s and 2000s. Proxy battles? Check. Greenmail? Check. Liquidations? Check.

Born September 8, 1920 in Pittsburgh, and orphaned at the age of 11, Evans grew up poor. Despite his famous middle name (his grandmother’s first cousin was Andrew Mellon), he began his financial career at the bottom. After graduating from Yale University in 1931 in the teeth of the Great Depression, he landed a $100-a-month clerk’s job at Gulf Oil.

While his friends headed out in the evening, Evans would stay home reading balance sheets and looking for promising companies: those he could he could buy for less than the assets were worth in liquidation. Evans found such companies by calculating their “net quick assets,” the long forgotten name for “net current assets.” His friends teased him about his obsession and gave him a nickname: “Net Quick” Evans. From the 1944 Time Magazine article, Young Tom Evans:

With only some fatherly advice from Gulf’s Board Chairman, W. L. Mellon, Tom Evans made his way alone. For six years he saved money, like an Alger hero; and played the stockmarket, unlike an Alger hero. Thus he collected $10,000. He wanted to find and buy a family-owned business that had gone to pot. In the down-at-the-heels H. K. Porter Co., in Pittsburgh’s slummy Lawrenceville section, he found it. Once a No. 1 builder of industrial locomotives, Porter Co. was down to 40 workers.

Tom Evans bought up Porter bonds at 10 to 15 cents on the dollar, reorganized the company under 77B, and became president at 28.

From then on, Evan was the chief terror of the sleepy boardrooms of the era, much like Icahn would be 30 years later. As a connoisseur of deep value on the balance sheet, one has to admire his methods (From the New York Times obituary, Thomas Evans, 86, a Takeover Expert, Dies):

‘He was never really an operator; he was a financial guy — a balance sheet buyer,” one of his sons, Robert Sheldon Evans, told Forbes magazine in 1995. ”He would buy something for less than book value and figure the worst that could happen was he would liquidate it and come out O.K. What he didn’t want to do was lose money on the deal. If he knew his downside was covered, then he figured the upside would probably take care of itself.

”It was a very shrewd policy in the 50’s and 60’s, when there were highly inefficient markets: buying undervalued assets, running them for cash and selling off pieces. The 80’s leveraged buyout guys were just taking a lot of his deals to their logical extension.”

The book The White Sharks of Wall Street: Thomas Mellon Evans and the Original Corporate Raiders by Diana B. Henriques is an excellent biography on Evans. More than that, it describes many of the battles for corporate control in the 40s, 50s and 60s. In contradistinction to the takeover battles of the 80s, the dogfights in the 40s, 50s, and 60s were largely proxy fights, and in as much, should be familiar to today’s “activist investors.” James B. Stewart’s Let’s make a deal, his review of Henriques’ book, does it justice:

There are surely few phenomena more remarkable in American business than the periodic ability of cash-poor but swashbuckling newcomers, using little or none of their own money, to seize control of some of the country’s most valuable corporations. In its most recent, frenzied incarnation, dot-com entrepreneurs have exchanged stock in companies with few tangible assets and even fewer profits for control of established, profitable companies. Fifteen years ago, the currency was junk bonds rather than inflated stock. And before that, it was bank loans using a target’s assets as collateral.

Wall Street greets each wave of takeovers as the dawning of a new era. But the proposition that nothing has fundamentally changed is convincingly set forth in ”The White Sharks of Wall Street,” an engaging and thorough history of early corporate takeovers by Diana B. Henriques, a financial reporter for The New York Times. Her central character is Thomas Mellon Evans, who surfaces in what seems like nearly every trendsetting corporate battle from 1945 until his retirement in 1984, and whose tactics remain essential to practitioners of corporate warfare. Junk bonds? Greenmail? Scorched earth? Evans had been there long before investment bankers coined a catchy vocabulary to describe the maneuvers of people like T. Boone Pickens, Carl Icahn and Saul Steinberg.

Though Evans seems to have escaped the widespread public resentment and envy the others generated, and Henriques’s portrait is carefully nonjudgmental, it is difficult for a reader to work up much sympathy for him. He was ruthless, bad-tempered, usually indifferent to workers and communities. He repeatedly displayed what appears to be a criminal disregard for the antitrust laws (though he was never prosecuted). He divorced two wives (the second later committed suicide), and both times a replacement was conspicuously at hand long before any legal proceedings had begun. He betrayed two of his own sons in his quest for corporate dominance and wealth.

…

Yet as a deal maker Evans displayed a natural audacity and genius. In 1935, 24 years old and lacking any money to speak of, he decided he wanted to gain control of Pittsburgh’s struggling H. K. Porter Company, a manufacturer of steam locomotives. Inspired by a Fortune magazine account of Floyd Odlum, who became rich by using borrowed securities as collateral for loans to buy undervalued stock, Evans borrowed shares from a Mellon mentor, took out a loan and invested in Gulf Oil stock, then a Mellon enterprise. When Gulf’s stock rose handsomely as the nation emerged from the Depression, Evans used his profits to buy Porter bonds, then selling for a small fraction of their face value. When Porter finally had to declare bankruptcy and was reorganized, Evans, as the largest creditor, traded his bonds for equity and became the largest shareholder. Porter, essentially acquired for junk bonds, would be Evans’s vehicle for most of his life.

I highly recommend The White Sharks of Wall Street: Thomas Mellon Evans and the Original Corporate Raiders by Diana B. Henriques for fans of deep value and activist investment.

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A way a lone a last a loved a long the riverrun

Posted in About, Activist Investors, Greenbackd, Liquidation Value, Stocks, tagged , , on October 28, 2009| 6 Comments »

We’ve just completed an interview with Miguel Barbosa of the wonderful Simoleon Sense. Go there now, and get trapped in an endless loop as you are recirculated back here and so on.

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Iconic Value vs Glamour research receives an update

Posted in About, Greenbackd, Stocks, Value Investment, tagged , , , on October 23, 2009| 12 Comments »

In a new paper Value vs Glamour: A Global Phenomenon (via SSRN)  The Brandes Institute updates the landmark 1994 study by Josef Lakonishok, Andrei Shleifer, and Robert Vishny investigating the performance of value stocks relative to that of glamour securities in the United States over a 26-year period. Lakonishok, Shleifer, and Vishny found that value stocks tended to outperform glamour stocks by wide margins, but their earlier research did not include the glamour-driven markets of the late 1990s and early 2000s. The paper asks, “What effect might this period have on their conclusions?” To answer that question, The Brandes Institute updated the research through to June 2008, examining the comparative performance of value and glamour over a 40-year period, and extending the scope of the initial study to include non-U.S. markets, to determine whether the value premium is evident worldwide.

The research focuses on our favorite indicator, price-to-book value, but also includes price-to-cash flow, price-to-earnings, sales growth over the preceding five years and combinations of the foregoing. Here is The Brandes Institute’s discussion on price-to-book:

Lakonishok, Shleifer, and Vishny on price-to-book

The Brandes Institute  hewed closely to Lakonishok, Shleifer, and Vishny’s methods, described on page 3 of the paper:

First, the sample of companies as of April 30, 1968 was divided into deciles based on one of the criteria above. Second, the aggregate performance of each decile was tracked for each of the next five years on each April 30. Finally, the first and second steps were repeated for each April 30 from 1969 to 1989.

We start with the price-to-book criterion as an example. First, all stocks traded on the NYSE and AMEX as of April 30, 1968 were sorted into deciles based on their price-to-book ratios on that date. Stocks with the highers P/B ratios were grouped in decile 1. For each consecutive decile, P/B ratios decreased; this cuilminated in stocks with the lowest P/B values forming decile 10.

In essence, this process created 10 separate portfolios, each with an inception date of April 30, 1968. The lower deciles, which consisted of higher-P/B stocks, represented glamour portfolios. In contrast, the higher deciles – those filled with lower-P/B stocks – represented value portfolios.

From there, annual performance of deciles 1 through 10 was tracked over the subsequent five years. Additionally, new 10-decile sets were constructed based on the combined NYSE/AMEX sample as of April 30, 1969, and every subsequent April 30 through 1989. For each of these new sets, decile-by-decile performance was recorded for the five yeras after the inception date. After completing this process, the researchers had created 22 sets of P/B deciles, and tracked five years of decile-by-decile performance for each one. Next, [Lakonishok, Shleifer, and Vishny] averaged the performance data across these 22 decile-sets to compare value and glamour.

As the chart below indicates, [Lakonishok, Shleifer, and Vishny] found that performance for glamour stocks was outpaced by performance for their value counterparts. For instance, 5-year returns for decile 1 – those stocks with the highest P/B ratios – averaged an annualized 9.3%, while returns for the low-P/B decile 10 averaged 19.8%. These annualized figures are equivalent to cumulative rates of return of 56.0% and 146.2%, respectively.

Value Glamour 1

[Lakonishok, Shleifer, and Vishny] repeated this analysis for deciles based on price-to-cash flow, price-to-earnings, and sales growth. The trio found that, for each of these value/glamour criteria, value stocks outperformed glamour stocks by wide margins. Additionally, value bested glamour in experiments with groups sorted by select pairings of P/B, P/CF, P/E, and sales growth.

The Brandes Institute update

The Brandes Institute sought to extend and update Lakonishok, Shleifer, and Vishny’s findings. They replicated the results of the Lakonishok, Shleifer, and Vishny study to validate their methodology. When they were satisfied that there was sufficient parity between their results and Lakonishok, Shleifer, and Vishny’s findings “to validate our methodology as a functional approximation of the [Lakonishok, Shleifer, and Vishny] framework,” they adjusted the sample in three ways: First, they included stocks listed on the NASDAQ domiciled in the US. Second, they excluded the smalles 50% of all companies in the sample. Finally, they divided the remaining companies into small capitalization (70% of the group by number) and large capitalization (30% of the group by number):

To expand upon [Lakonishok, Shleifer, and Vishny’s] findings we begin with our adjusted sample, which now includes data through 2008. Specifically, we added decile-sets formed on April 30, 1990 through April 30, 2003 and incorporated their performance into our analysis. This increased our sample size from 22 sets of deciles to 36. In addition, the end of the period covered by our performance calculations extended from April 30, 1994 to April 30, 2008.

Exhibit 3 compares average annualized performance for U.S. stocks from the 1968 to 2008 period for deciles based on price-to-book. Returns for deciles across the spectrum changed only slightly in the extended time frame from our replicated [Lakonishok, Shleifer, and Vishny’s] results. Most notably, the overall pattern of substantial value stock outperformance persisted. During the 1968 to 2008 period, performance for decile 1 glamour stocks averaged an annualized 6.9% vs. an average of 16.2% for the value stocks in decile 10. Respective cumulative performance equaled 39.6% and 111.9%.

Value Glamour 2

Set out below is the comparison of large cap and small cap performance:

Value Glamour 3The paper concludes that the value premium persists for the world’s developed markets in aggregate, and on an individual coutry basis. We believe it is more compelling evidence for value based investment, and, in particular, asset based value investment.

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Fickle is Einhorn

Posted in About, Austrian Economics, Greenbackd, Stocks, tagged , , on October 21, 2009| 3 Comments »

Rolfe Winkler of Reuters blog Contingent Capital has a great summary of David Einhorn’s talk to the Value Investing Congress. Despite what we say in the title, Einhorn is hardly fickle (we just couldn’t resist). If anything, he’s stubborn to a fault, so it is interesting that he’s changed his mind so dramatically about the influence of macro events on his traditional bottom-up investment style. In his speech (.pdf via Winkler’s blog), he sets out the rationale behind the change, what he perceives the current macro risks to be, and what he’s doing in response. Apologies in advance for the huge blocks of text. We believe that this is the most important factor influencing the market and the economy, and will be for the next 5-10 years. Ignore it at your peril.

Speaking of his change in attitude to secular macro trends, Einhorn said:

I want to revisit [Greenlight’s 2005 position in MDC Holdings, a homerbuilder] because the loss was not bad luck; it was bad analysis. I down played the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble. At the time, I wondered whether even if he were correct, would it be possible to convert such big picture macro-thinking into successful portfolio management? I thought this was particularly tricky since getting both the timing of big macro changes as well as the market’s recognition of them correct has proven at best a difficult proposition. Smart investors had been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right, there was no way to know when he would be right. This was an expensive error.

The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the longshort exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time.

What, according to Einhorn, is the secular macro trend most influencing the market and economy? The inflationary policies of the current administration:

Presently, Ben Bernanke and Tim Geithner have become the quintessential short-term decision makers. They explicitly “do whatever it takes” to “solve one problem at a time” and deal with the unintended consequences later. It is too soon for history to evaluate their work, because there hasn’t been time for the unintended consequences of the “do whatever it takes” decision-making to materialize.

…

Rather than deal with these simple problems with simple, obvious solutions, the official reform plans are complicated, convoluted and designed to only have the veneer of reform while mostly serving the special interests. The complications serve to reduce transparency, preventing the public at large from really seeing the overwhelming influence of the banks in shaping the new regulation.

In dealing with the continued weak economy, our leaders are so determined not to repeat the perceived mistakes of the 1930s that they are risking policies with possibly far worse consequences designed by the same people at the Fed who ran policy with the short term view that asset bubbles don’t matter because the fallout can be managed after they pop. That view created a disaster that required unprecedented intervention for which our leaders congratulated themselves for doing whatever it took to solve. With a sense of mission accomplished, the G-20 proclaimed “it worked.”

We are now being told that the most important thing is to not remove the fiscal and monetary support too soon. Christine Romer, a top advisor to the President, argues that we made a great mistake by withdrawing stimulus in 1937.

…

An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger. Although our leaders ought to make some serious choices, they appear too trapped in short-termism and special interests to make them. Taking no action is an action.

In the nearer-term the deficit on a cash basis is about $1.6 trillion or 11% of GDP. President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade. The American Enterprise Institute for Public Policy Research recently published a study that indicated that “by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.”

…

Further, the Federal Open Market Committee members may not recognize inflation when they see it, as looking at inflation solely through the prices of goods and services, while ignoring asset inflation, can lead to a repeat of the last policy error of holding rates too low for too long.

At the same time, the Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.

…

I believe there is a real possibility that the collapse of any of the major currencies could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.

I believe that the conventional view that government bonds should be “risk free” and tied to nominal GDP is at risk of changing. Periodically, high quality corporate bonds have traded at lower yields than sovereign debt. That could happen again.

His response has been to buy physical gold “as insurance against sovereign default(s).”

Now, the question for us as investors is how to manage some of these possible risks. Four years ago I spoke at this conference and said that I favored my Grandma Cookie’s investment style of investing in stocks like Nike, IBM, McDonalds and Walgreens over my Grandpa Ben’s style of buying gold bullion and gold stocks. He feared the economic ruin of our country through a paper money and deficit driven hyper inflation. I explained how Grandma Cookie had been right for the last thirty years and would probably be right for the next thirty as well. I subscribed to Warren Buffett’s old criticism that gold just sits there with no yield and viewed gold’s long-term value as difficult to assess.

However, the recent crisis has changed my view. The question can be flipped: how does one know what the dollar is worth given that dollars can be created out of thin air or dropped from helicopters? Just because something hasn’t happened, doesn’t mean it won’t. Yes, we should continue to buy stocks in great companies, but there is room for Grandpa Ben’s view as well.

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

A few weeks ago, the Office of Inspector General called out the Treasury Department for misrepresenting the position of the banks last fall. The Treasury’s response was an unapologetic expression that amounted to saying that at that point “doing whatever it takes” meant pulling a Colonel Jessup: “YOU CAN’T HANDLE THE TRUTH!” At least we know what we are dealing with.

When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

…

For years, the discussion has been that our deficit spending will pass the costs onto “our grandchildren.” I believe that this is no longer the case and that the consequences will be seen during the lifetime of the leaders who have pursued short-term popularity over our solvency. The recent economic crisis and our response has brought forward the eventual reconciliation into a window that is near enough that it makes sense for investors to buy some insurance to protect themselves from a possible systemic event. To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable.

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Brains or a bull market?

Posted in About, Greenbackd, Value Investment, tagged on October 20, 2009| 1 Comment »

The old Wall Street saw, variously attributed to Warren Buffett or Humphrey B. Neill, author of the Art of Contrary Thinking, goes, “Never confuse genius with a bull market.” With that in mind, we present to you the performance of the Wilshire 5000 Equal Weight Index, which is one of the broadest measures of the stock market.

For the month of September the Wilshire 5000 Equal Weight Index was up 15.8% and for the last quarter to September 30 it was up 36.0%.  You can see for yourself at the Wilshire Index Calculator (it’s a little clunky – you’ll need to select “Wilshire 5000 Equal Weight” in the “Broad/Style” box and set the date to September 30 2009). Year to date the index is up a whopping 83.02%. From March through September, the average stock is up 113.1%. If we take the Wilshire 4500 Equal Weight Index, which excludes the top 500 stocks by market capitalization of the 5000 Equal Weight Index, the return is +120% from March to September 2009. Sobering.

Hat tip Bo.

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The Austrians were right

Posted in About, Greenbackd, Stocks, tagged , on October 19, 2009| 13 Comments »

You may be familiar with the “Peter Schiff was right” Internet meme that’s been doing the rounds for a year or so. If you are not, the meme is a montage of Peter’s appearances on various business television shows between 2006 and 2007. In each clip he is alone in arguing that the US stands at the precipice of a collapse and is roundly derided by the other participants and the anchor. One such example is set out below:

Peter was indeed right about the ensuing collapse. What’s more, he was right for the right reasons, as opposed to the “permabears” who are right the way a stopped clock is right twice a day (ordinarily we’d include Nouriel Rubini in this club, but won’t do so on this occasion for reasons which will shortly become obvious). Is Peter clairvoyant? No. He’s a disciple of the Austrian School of Economics (about which we came out of the closet a few weeks back). Given Schiff’s prescience and well-known adherence to Austrian economics, one might think that the Austrian School deserves a second look, especially so given that the Keynesian orthodoxy completely missed the crash. One such paper seeks to do just that, but with a wider lense that doesn’t presuppose the conclusion.

In No One Saw This Coming: Understanding Financial Crisis Through Accounting Models (.pdf) Dirk J Bezemer of Groningen University takes a scholarly look at which macroeconomic models helped anticipate the credit crisis and economic recession and which did not. Says Bezemer:

The credit crisis and ensuing recession may be viewed as a ‘natural experiment’ in the validity of economic models. Those models that failed to foresee something this momentous may need changing in one way or another. And the change is likely to come from those models (if they exist) which did lead their users to anticipate instability. The plan of this paper, therefore, is to document such anticipations, to identify the underlying models, to compare them to models in use by official forecasters and policy makers, and to draw out the implications.

There are two broad ideas in the paper most interesting to us: The first is Bezemer’s documentation of the “sense of surprise at the credit crisis among academics and policymakers,” which gave rise to the erroneous view that “no one saw this coming”. The second “is a careful survey – applying a number of selection criteria – of those professional and academic analysts who did ‘see it coming’, and who issued public predictions of financial instability induced by falling real estate prices and leading to recession.”

“No-one saw this coming”

Bezemer makes the arguement that the view that it was impossible to know that a crash was imminent has gone unchallenged and unexamined by the mainstream press and academia:

The view that “[n]o one foresaw the volume of the current avalanche” appears justified by a lack of discussion, in the academic and policy press, of the possibility that financial globalization harboured significant risks, or that the US real estate market and its derivative products were in dangerous waters. Wellink (2009) quoted a 2006 IMF report on the global real estate boom asserting that there was “little evidence (..) to suggest that the expected or likely market corrections in the period ahead would lead to crises of systemic proportions”. On the contrary, those developments now seen as culprits of the crisis were until recently lauded by policy makers, academics, and the business community.

…

These assessments by the experts carried over to a popular view, enunciated in the mass media, that the recessionary impacts of the credit crisis came out of the blue. USA Today in December 2006 reported on the fall in house prices that had just started that summer, “the good news is that far more economists are in the optimist camp than the pessimist camp. Although a handful are predicting the economy will slide into a housing-led recession next year, the majority anticipate the economy will continue to grow” (Hagenbauch 2006). Kaletsky (2008) wrote in the Financial Times of “those who failed to foresee the gravity of this crisis – a group that includes Mr King, Mr Brown, Alistair Darling, Alan Greenspan and almost every leading economist and financier in the world.”

The surprise at this gravity was proportionate to the optimism beforehand. Greenspan (2008) in his October 2008 testimony before the Committee of Government Oversight and Reform professed to “shocked disbelief” while watching his “whole intellectual edifice collapse in the summer of [2007]”. Das (2008) conceded that contrary to his earlier view of financial globalization ‘eliminating’ credit risks, in fact “[p]artial blame for the fall 2008 meltdown of the global financial market does justly go to globalization.” The typical pattern was one of optimism shortly before and surprise shortly after the start of the crisis.

The common elements of the alternative view

Bezemer notes that, despite the foregoing, there was an “alternative, less sanguine interpretation of financial developments” and it was “not confined to the inevitable fringe of bearish financial commentators.” Bezemer is mindful that among those expressing the alternative view, the lucky guesses must be distinguished from the insightful predictions. Here he discusses the problem and his methodology for doing so:

A major concern in collecting these data must be the ‘stopped clock syndrome’. A stopped clock is correct twice a day, and the mere existence of predictions is not informative on the theoretical validity of such predictions since, in financial market parlance, ‘every bear has his day’. Elementary statistical reasoning suggests that given a large number of commentators with varying views on some topic, it will be possible to find any prediction on that topic, at any point in time. With a large number of bloggers and pundits continuously making random guesses, erroneous predictions will be made and quickly assigned to oblivion, while correct guesses will be magnified and repeated after the fact. This in itself is no indication of their validity, but only of confirmation bias.

In distinguishing the lucky shots from insightful predictions, the randomness of guesses is a feature to be exploited. Random guesses are supported by all sorts of reasoning (if at all), and will have little theory in common. Conversely, for a set of correct predictions to attain ex post credibility, it is additionally required that they are supported by a common theoretical framework. This study, then, looks to identify a set of predictions which are not only ex post correct but also rest on a common theoretical understanding. This will help identify the elements of a valid analytical approach to financial stability, and get into focus the contrast with conventional models.

In collecting these cases in an extensive search of the relevant literature, four selection criteria were applied. Only analysts were included who provide some account on how they arrived at their conclusions. Second, the analysts included went beyond predicting a real estate crisis, also making the link to real-sector recessionary implications, including an analytical account of those links. Third, the actual prediction must have been made by the analyst and available in the public domain, rather than being asserted by others. Finally, the prediction had to have some timing attached to it. Applying these criteria led to the exclusion of a number of (often high profile) candidates – as detailed in the Appendix – so that the final selection is truly the result of critical scrutiny.

The twelve analysts described there – the number is entirely an outcome of the selection criteria – commented on the US, UK, Australian, Danish and global conditions in housing, finance and the broader economy. All except one are (or were) analysts and commentators of global fame. They are a mixed company of academics, government advisers, consultants, investors, stock market commentators and one graduate student, often combining these roles. Already between 2000 and 2006 they warned specifically about a housingled recession within years, going against the general mood and official assessment, and well before most observers turned critical from late 2007. Together they belie the notion that ’no one saw this coming’, or that those who did were either professional doomsayers or lucky guessers.

So who were those analysts able to make an accurate and cogent prediction? Here’s the table:

No One Saw This Coming Table 1

What are the common elements of these analysts?

A broadly shared element of analysis is the distinction between financial wealth and real assets. Several of the commentators (Schiff and Richebächer) adhere to the ‘Austrian School’ in economics, which means that they emphasize savings, production (not consumption) and real capital formation as the basis of sustainable economic growth. Richebächer (2006a:4) warns against ““wealth creation” though soaring asset prices” and sharply distinguishes this from “saving and investment…” (where investment is in real-sector, not financial assets). Likewise Shiller (2003) warns that our infatuation with the stock market (financial wealth) is fuelling volatility and distracting us from more the durable economic prospect of building up real assets. Hudson (2006a) comments on the unsustainable “growth of net worth through capital gains”.

A concern with debt as the counterpart of financial wealth follows naturally. “The great trouble for the future is that the credit bubble has its other side in exponential debt growth” writes Richebächer (2006b:1). Madsen from 2003 worried that Danes were living on borrowed time because of the mortgage debt which “had never been greater in our economic history”. Godley in 2006 published a paper titled Debt and Lending: A Cri de Coeur where he demonstrated the US economy’s dependence on debt growth. He argued it would plunge the US into a “sustained growth recession … somewhere before 2010” (Godley and Zezza, 2006:3). Schiff points to the low savings rate of the United States as its worst malady, citing the transformation from being the world’s largest creditor nation in the 1970s to the largest debtor nation by the year 2000. Hudson (2006a) emphasized the same ambiguous potential of house price ‘wealth’ already in the title of his Saving, Asset-Price Inflation, and Debt-Induced Deflation, where he identified the ‘large debt overhead – and the savings that form the balance-sheet counterpart to it’ as the ‘anomaly of today’s [US] economy’. He warned that ‘[r]ising debt-service payments will further divert income from new consumer spending. Taken together, these factors will further shrink the “real” economy, drive down those already declining real wages, and push our debt-ridden economy into Japan-style stagnation or worse.” (Hudson 2006b). Janszen (2009) wrote that “US households and businesses, and the government itself, had since 1980 built up too much debt. The rate of increase in debt was unsustainable… Huge imbalances in the US and global economy developed for over 30 years. Now they are rebalancing, as many non-mainstream economists have warned was certain to happen sooner or later.” Keen (2006) wrote that the debt-to-GDP ratio in Australia (then 147 per cent) “will exceed 160 per cent of GDP by the end of 2007. We simply can’t keep borrowing at that rate. We have to not merely stop the rise in debt, but reverse it. Unfortunately, long before we manage to do so, the economy will be in a recession.”

Of the analysts holding the “alternative, less sanguine” view, most were from the Austrian School. It would be nice if a few more Keynesians had Greenspan’s “shocked disbelief” while watching his “whole intellectual edifice collapse in the summer of [2007]”. We’re not holding our breath. While we don’t necessarily agree with all of Bezemer’s conclusions, the paper is superbly written and an engaging read.

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Grahamites, meet Ludwig von Mises

Posted in About, Greenbackd, Stocks, Value Investment, tagged , on October 2, 2009| 5 Comments »

Dr. Chris Leithner has prepared a paper for the von Mises Institute, Ludwig von Mises, Meet Benjamin Graham: Value Investing from an Austrian Point of View, in which he argues that Grahamite value investors and economists from the Austrian School hold “compatible views about a range of fundamental economic and financial phenomena” and Austrian economics should therefore be compelling to value investors “because it subsumes real economic and financial events within justifiable laws of human action.”

This paper shows that value investors and Austrians hold compatible views not only about the price and value, but also about other vital economic and financial phenomena. These include risk and arbitrage; capital and entrepreneurship; and time-preference and interest. Indeed, with respect to these matters each group may have more in common with the other than each has with the mainstream of its respective field.

While we’ve never explicitly said so on this site, many of you will have guessed that we subscribe to the Austrian School of economics. We know that view is unpopular with some of our readers, but we ask that you read Leithner’s paper before inveighing in the comments or the mail bag. Leithner is the principal of Leithner & Company, a private investment company based in Brisbane, Australia, and a strict adherent to the “traditional “value” approach to investment pioneered by Benjamin Graham and adapted by his colleagues Warren Buffett, Thomas Knapp and Walter Schloss.” His paper is a tour de force on both Grahamite value investment and Austrian economics, and describes our views with a clarity that escapes us.

Set out below are some important excerpts from Leithner’s paper. The first describes the Austrian view of the operation of markets and its rejection of Efficient Market Theory, which is relevant given the discussion in the comments on Jim Hodge’s guest post several weeks ago:

A deep chasm separates the theory of entrepreneurial discovery from the mainstream model of perfect competition. To mainstream economists, the decisions to buy and sell in the market are mere mathematical derivations. A decision, in other words, is “made” by a “given” model, probability distribution and data. The mainstream model thus eliminates the real-life, flesh-and-blood decision-maker – the heart of the Austrian economics and value investing – from the market. Market automatons do not err; accordingly, it is unthinkable that an opportunity for pure profit is not instantly noticed and grasped. The mainstream economist, goes the revealing joke, does not take the $10 banknote lying on the floor because he believes that if it were really there then somebody would already have grabbed it.

In sharp contrast, Austrians recognise that decisions are taken by real people whose plans are imperfectly clear, indistinctly ranked, often internally-inconsistent and always subject to change. Further, at any given moment a market participant will be largely unaware of other market participants’ present and future plans. It is participation in the market that makes buyers and sellers a bit more knowledgeable about their own plans and slightly less unaware of others’ plans. Market participants will inevitably make mistakes; further, it is probable that they will not automatically notice them. Accordingly, it is not just possible – it is typical – that opportunities for gain (“pure profit”) appear but are not instantly detected. Recognising the obvious – namely that he has possibly been the first to notice it – the Austrian will therefore take the $10 note inadvertently dropped on the floor and ignored by his mainstream colleague. An “Austrian” act of entrepreneurial discovery, then, occurs when a market participant seeks and finds what others have overlooked.

…

It is important to emphasise that this discovery, like Buffett’s and Graham’s many others, did not derive from information that other buyers and sellers could not possess. These acts of entrepreneurial discovery stemmed from the alert analysis of publicly available information and the superior detection of opportunities that others had simply overlooked. On numerous occasions, Graham and his students and followers have found promising places to look and have been the first, in effect, to detect the piles of notes that others have disregarded and left lying on the floor. Anybody, for example, could have bought parts of American Express, The Washington Post, GEICO (whose enormous potential Graham was the first to find) and Coca-Cola when Mr Buffett did; but few saw what he saw, ignored the irrelevancies and reasoned so clearly. Instead, most were distracted by myriad worries – and economic and financial fallacies – and so very few followed Buffett’s lead.

In this second excerpt, Leithner discusses the Grahamite approach to investment in an uncertain world (as it ever is), and why Grahamites pay no heed to mainstream economists’ forecasts about macroeconomic aggregates such as inflation, exchange rates, joblessness, trade and budget deficits and the like:

Grahamites recognise that the future is inherently uncertain. That is to say, there is no probability distribution and there are no data that can “model” it. The future is not radically uncertain, in the sense that Ludwig Lachmann maintained, but it is largely so. Like many Austrians, Grahamites accept that one can know some things (such as historical data, relationships of cause and effect and hence the laws of economics), and therefore that to some extent the past does project into the future. Grahamites do not agree, in other words, that anything can happen; but they are acutely aware – because they have learnt from unpleasant personal experience – that the unexpected can and often does happen. They also acknowledge that forecasting the future is the job of entrepreneurs, not economists or bureaucrats, and therefore that the entrepreneur-investor-forecaster must be cautious and humble.

…

Market timers, commentators and mainstream economists, then, cannot foresee economic events and developments with any useful degree of accuracy. And even if they could, the aggregate phenomena upon which they fixate are typically of little interest to Grahamites. Hence value investors ignore analysts, economists and others who claim that they possess clear crystal balls. But Grahamite investors do not ignore the future per se. Quite the contrary: they plan not by making particular predictions about what will happen but by considering general scenarios – particularly pessimistic scenarios – of what might conceivably happen. They then structure their actions and investments in order to reduce the risk of permanent loss of capital in the event that undesirable eventsand developments actually occur.

Grahamites also recognise that if markets tend towards but never attain a state of equilibrium, and if profit-seeking entrepreneurs constitute the “oil” that enables the market mechanism to operate and adapt so smoothly, then over time particularly talented and shrewd and lucky entrepreneurs will tend, more often than not and relatively consistently, to accumulate capital. Less successful entrepreneurs, on the other hand, will consistently lose some – and eventually all – of their capital. It is for this reason that Grahamites search incessantly for businesses that possess consistently solid and relatively stable track records, and the demonstrated ability to surmount a variety of unexpected changes and vicissitudes.

In this final excerpt, Leithner discusses the calculation of desired rates of return, and the relationship to firm value:

On what bases, then, do Grahamites reason towards an assessment of a given security’s value? First, they assess the structure of the underlying firm’s capital and the stability of its earnings. Second, they ascertain their time preference (i.e., the extent to which they are prepared forego consumption today in order to consume more in the future) and thus their desired rate of return. Although value investors have never used the term “time preference,” embedded within the Grahamite approach to the valuation of securities is a notion of time preference and interest that is compatible with Austrian understandings of these concepts.

…

What is an appropriate payback period? The answer depends upon one’s time preference; and that, in turn, will vary from one investor to another. But a few general points can be made. First, a shorter payback period (i.e., a higher rate of return) is preferable to a longer one (i.e., lower rate of return). This is because the longer the time required in order to recoup an investment, the riskier that investment becomes. The longer the payback period, the more a decision to invest depends upon the veracity of its underlying assumptions, i.e., the more imperative it becomes that those assumptions correspond to reality. With each additional year of waiting, the chances increase that unforseen or uncontrollable factors – a recession, a decrease of the purchasing power of the currency, new competition, the loss of key contracts, employees and other innumerable and perhaps unimaginable factors – will decrease (or halt the rate of increase of) the size of the yearly coupon and hence prolong further the payback period.

…

Second, a high natural rate of interest implies a large required rate of return and a more stringent hurdle for potential investments to surmount. For example, a natural rate of 12-15% (which Leithner & Co. uses to conduct its investment operations) and a constant stream of coupons imply a payback period of 6-8 years. By that criterion, both the Telstra stock’s and the Commonwealth bond’s payback period is unacceptably long; and by this absolute, more challenging – and, to mainstream investors, virtually unknown – yardstick, neither of these securities are compelling. Since the late 1990s, in other words, wide swaths of the investment universe (i.e., most equities, bonds and real estate) have been unacceptably dear; and the five-year investment results of most mainstream investors confirm the sad consequences of buying securities at inflated prices.

Leithner’s paper is superb,and well worth reading. His explication of the concept of “capital goods” and capital, and the relationship to firm value should not be missed.

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A classic contrarian indicator re-emerges: The BusinessWeek cover

Posted in About, Greenbackd, Stocks, tagged on October 2, 2009| 3 Comments »

BusinessWeek aims to keep its impeccable market forecasting record intact (via BusinessInsider):

Business Week Cover

This is the seventh sign of the apocalypse.

Disclosure: Long tinned food and shot-gun shells.

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Hedge Fund Activism and Shareholder Value Summit

Posted in About, Activist Investors, Catalysts, Greenbackd, Value Investment, tagged , , on September 18, 2009| Leave a Comment »

We’ll be in San Diego next week for the Hedge Fund Activism and Shareholder Value Summit. If you’re going too, and you’d like to catch up, we’d love to hear from you. You can reach us at greenbackd [at] gmail [dot] com.

We’ll be posting intermittently next week, but we’ll be back to our regular schedule starting from Monday, 28 September. Hopefully we’ll have some new insights to share.

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Open invitation for guest posts

Posted in About, Catalysts, Greenbackd on August 26, 2009| 3 Comments »

We’ve received some great investment ideas on this blog from our readers, and it seems a shame that they remain hidden in the comments of other posts (See, for example, Shake&Bake’s take on LDIS or Sop81_1’s analysis of EDCI). To that end, we’re extending an open invitation to anyone who wishes to submit a post for publication. The only requirement is that it be within the remit of Greenbackd, which is say that it is an undervalued asset situation with a catalyst. Email your idea to greenbackd [at] gmail [dot] com.

We have our first guest post for Friday from Wes Gray. We hope it’s the first of many.

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