It may come as a surprise to some that when the market’s performance is expressed in the opposite of infinitely dilutable paper, we are currently just barely 15% higher than the generational S&P low of 666. As the chart below demonstrates, the S&P expressed in gold is plunging, and has dropped 22% from its 2010 highs, down 18% from the beginning of the year, and just 15% higher than March 5, 2009. As Russia and GLD have been demonstrating so aptly over the past 5 months, gold is not dilutable, and can not be contaminated with various Greek sovereign bond holdings. It is, in summary, pure, and is immune from that strain of 100% lethal, and printerborne, Central Banking syphilis where one’s paper rots off. Which is why the Dow may easily pass 36,000. The issue is that at or about that time, the Dow to Gold ratio will be 1. Note also, the downward channel in the SPX/Gold index: each day this channel is not broken, is another day that Bernanke pops a few extra Ambien.
The wonderful Miguel Barbosa of Simoleon Sense has interviewed Joe Calandro, Jr., author of Applied Value Investing. The interview is first class. Joe Calandro, Jr. is an interesting guy. Deep value? Check. Activist investing? He’s for it. Austrian School of Economics? Check. I think I just wet myself.
Here’s Joe’s take on value:
Q. Can you give me an example of some of your best investments?
A. In the book I profile a value pattern that I call “base case value” which is simply net asset value reconciling with the earnings power value. Firms exhibiting that pattern, which sell at reasonable margins of safety have proved highly profitable to me. In the book, I show examples of this type of investment.
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“Value investing” in general has 3 core principles:
(1) The circle of competence, which essentially relates to an information advantage and holds that you will do better if you stick to what you know more about than others.
(2) The principle of conservatism. You will have greater faith in valuations if you prepare them conservatively.
(3) The margin of safety. You should only invest if there is a price-to-value gap: when the gap disappears you exit the position.
Here’s Joe on activist investing:
Q. You’re primarily in the corporate sector now; in your book you touch upon the failure of corporate M&A groups to apply value investing. Why do you think this is the case? What is your take on activist value investors?
A. That’s a good question and I don’t have a definitive answer for it. My take on it is that Corporate America hasn’t been trained in Graham and Dodd. For example, if you get away from Columbia and some of the other top schools you really don’t have courses of study based on Graham and Dodd. I think this lack of education carries over to practice. If educational institutions aren’t teaching something, then executives are going to have a difficult time applying it. And if they do try to apply it, their employees and boards may not understand it. Hopefully, my book will help to rectify this over time.
Regarding activist investors, I think every investor should be active. If you allocate money to a security (either equity or debt) you have the responsibility of becoming involved in the respective firm because, as Benjamin Graham noted, you invested in a business, not in a piece of paper or a financial device. This is real money in real businesses so there is a responsibility that comes with investing.
And Joe’s view on economics:
Q. Can you give us a tour of the major insights you obtained from the Austrian School of Economics.
A. I have two big academic regrets: I did not study Graham and Dodd or Austrian economics until I was in my mid 30’s. One of the major theories of Austrian economics is its business cycle theory. Just the other day (11/6/2009), that theory was mentioned in the WSJ by Mark Spitznagel, who is Nassim Taleb’s partner, in his article “The Man Who Predicted the Depression.” As you know, Taleb has also spoken highly of Austrian economics as have other successful traders/practitioners such as Victor Sperandeo, Peter Schiff and Bill Bonner.
Austrian economics finds success with practitioners because, I think, Austrian economists are truly economists; they do not try to be applied mathematicians. Therefore, Austrians tend to see economics for what it is; namely, a discipline built around general principles that can be applied broadly to economic phenomena. As a result, Austrian economics is generally very useful in areas such as the business cycle and the consequences of government intervention, which are very pertinent topics today.
The Dow:gold ratio is not everyone’s cup of tea. Paul Kedorosky likens it to measuring yo-yos in meerkats, but says it’s “semi-useful.” I agree. Several semi-useful observations that can be made from the chart include:
Gold has outperformed the DJIA from the late 1990s to the present. In the late 1990s the Dow was more expensive in gold than it had ever been in the preceding 100 years.
In 2009, the gold trade is getting long in the tooth. Most of the really big gains in gold have already been made. It’s no longer obviously cheap relative to equities, however…
…it’s probably not over yet. The Dow:gold ratio has traditionally bottomed at a point significantly lower than we have seen this time around. This might suggest that it still has a ways to fall before it reaches the nadir. For the bottom to come in, either gold has to go up, equities have to come down, or some combination of both has to occur. My guess is the latter, however, this is not the only view out there. For example, in the Buttonwood’s notebook column of the Economist, Buttonwood asks, “Is gold the next bubble?“
WHAT are the preconditions for a bubble? Perhaps there are four: easy credit conditions, a significant trend-breaking event, the lack of plausible valuation measures and an appealing story.
Gold fulfils most of these conditions. One can argue about the credit conditions; lending is still weak but crucially interest rates are low. That helps given that gold has no yield; in effect, the opportunity cost of holding gold has disappeared. The event that changed minds was the credit crunch, which caused a partial loss of faith in banks. Gold has no valuation issues (no yield or earnings); since people hold it as a store of value, it can be worth whatever they want it to be worth. And it has a plausible backstory; spendthrift governments are monetising their deficits like the Weimar Republic before them.
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…whereas one can say, based on historic valuation measures, that Wall Street is currently 40% overvalued, one can make no such bold statement on gold.The next stage of a bubble would be broad-based public interest.
One thing clear to me from the chart is that buying equities from the late 1990s to the present was like running up the down escalator. It was fun, but it wasn’t the easiest way to get to the top. Standing still on the up escalator was an easier ride. This was the point of my Buffett on gold post last week. The change in the Dow:gold ratio for the period 1964 to 1979 makes it clear why Buffett was bested by gold over that period. The change in the ratio for the period from the early 1980s through to the late 1990s, combined with Buffett’s otherworldly ability to identify undervalued equities, also explains the lollapalooza gains made by Berkshire Hathaway during that period. It might also suggest that at some stage in the near future equities will again be the up escalator, but not quite yet, for the reasons below.
In an inflationary environment a business must keep increasing the price of its goods or services just to keep its margins static, and any reinvestment in plant and machinery must be undertaken at increasingly higher prices. If it can’t increase its prices or it doesn’t earn enough to keep up with its maintenance capital expenditure, then it will shrink and risks falling behind any competitor that can. In other words, it has to run up the down escalator, and if it can’t run faster than the escalator, then it’s going backwards. Businesses with no pricing power and low returns-on-equity will therefore suffer in an inflationary environment. While it is true that a business with pricing power and high return-on-equity is better able to protect itself somewhat from inflation, it is not true that inflation is good for this business either. Since I (and, I suspect, most investors) can’t prospectively pick one from the other, perhaps stepping onto the up escalator in such times is not such a bad idea. All gold does is sit there, yes, but it can’t be printed, so it tends to appreciate against the dollar as the dollar is debauched.
Has the dollar been debauched? The Austrian economist in me thinks so. Einhorn, John Paulson, Rogers and Buffett’s commentary on US fiscal and monetary policy can’t all be wrong. Keeping interest rates too low for too long and printing too much money – what Buffett describes as “Greenback emissions” – will result in inflation measurable in the CPI in the not too distant future. (As an aside, I think there is inflation now, but because it’s not running through the CPI yet it doesn’t exist according to the orthodox view, which also happens to be the one in power, and on both sides of politics, for that matter).
What can we deduce from the foregoing? If gold does as it has done in past cycles, it should do well for the foreseeable future. That has to be tempered by the fact that the gold price has run a long way, both in dollar terms and in comparison to equities (as measured against the DJIA). Gold could have a big reversal – in the mid-1970s the DJIA rallied significantly against gold before sinking to its long-term bottom – before it continues onto historical highs. In this regard, Jim Rogers’ recent commentary is instructive [via The Globe and Mail]:
Jim Rogers: I don’t ever like to buy something making all time highs however I’m not selling my gold. Gold is going to go much higher in the course of the bull market. Doesn’t mean it can’t go down 20 per cent next year but during the course of the bull market it is going to go much higher it is certainly not a bubble yet.
Jim you are typically a contrarian investor. If everyone is buying, shouldn’t you be selling?
Jim Rogers : Yes, I should be selling at the top, but I don’t think this is the top. Gold, if you adjust it for its old highs, adjust it for inflation back in 1980, gold should be over $2000 an ounce right now. In my view, in this bull market in commodities gold will make all new highs adjust for inflation.
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When will gold hit 2k?
Jim Rogers: I wish I was that smart. You should watch TheStreet.com. They know everything.
Warren Buffett’s position on gold is well known, if a little difficult to fathom. This is from Buffett’s appearance on CNBC’s Squawk Box on March 9, 2009, but could have been taken from any of his commentary over the last fifty years:
BECKY: OK. I want to get to a question that came from an investment club of seventh and eighth graders who invest $1 million in fake money every year. This is the Grizzell Middle School Investment Club in Dublin, Ohio, and the question is, where do you think gold will be in five years and should that be a part of value investing?
BUFFETT: I have no views as to where it will be, but the one thing I can tell you is it won’t do anything between now and then except look at you. Whereas, you know, Coca-Cola will be making money, and I think Wells Fargo will be making a lot of money and there will be a lot–and it’s a lot–it’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that. The idea of digging something up out of the ground, you know, in South Africa or someplace and then transporting it to the United States and putting into the ground, you know, in the Federal Reserve of New York, does not strike me as a terrific asset.
Then there’s this comment from Buffett on the relative performance of Berkshire Hathway book value and an ounce of gold over fifteen years in the 1979 letter to shareholders:
One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.
Fifteen years of blood, sweat and tears from the greatest investor in the world and he just breaks even with gold, which “just sits there and eats insurance and storage and a few things like that.” And still he recommends avoiding gold.
For tis the sport to have the enginer
Hoist with his owne petar.
By early 2006 the 49-year-old Mr. Paulson had reached his twilight years in accelerated Wall Street-career time. He had been eclipsed by a group of investors who had amassed huge fortunes in a few years. It was the fourth year of a spectacular surge in housing prices, the likes of which the nation never had seen. Everyone seemed to be making money hand over fist. Everyone but John Paulson.
“This is crazy,” Mr. Paulson said to Paolo Pellegrini, one of his analysts.
Paulson’s response was to have Pellegrini look at the long term returns on house prices:
The answer was in front of him: Housing prices had climbed a puny 1.4% annually between 1975 and 2000, after inflation. But they had soared over 7% in the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Mr. Pellegrini’s figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop likely would be brutal.
Paulson decided he wanted to bet that house prices would regress to the mean, but how to find the right instrument to allow him to do that:
By the spring, Mr. Paulson was convinced he had discovered the perfect trade. Insurance on risky home mortgages was trading at dirt-cheap prices. He would buy boatloads of credit-default swaps—or investments that served as insurance on risky mortgage debt. When housing hit the skids and homeowners defaulted on their mortgages, this insurance would rise in value—and Mr. Paulson would make a killing. If he could convince enough investors to back him, he could start a fund dedicated to this trade.
And then he stuck to his trade:
By the summer of 2006, Mr. Paulson had managed to raise $147 million, mostly from friends and family, to launch a fund. Soon, Josh Birnbaum, a top Goldman Sachs trader, began calling and asked to come by his office. Sitting across from Mr. Paulson, Mr. Pellegrini, and his top trader, Brad Rosenberg, Mr. Birnbaum got to the point.
Not only were Mr. Birnbaum’s clients eager to buy some of the mortgages that Paulson & Co. was betting against, but Mr. Birnbaum was, too. Mr. Birnbaum and his clients expected the mortgages, packaged as securities, to hold their value. “We’ve done the work and we don’t see them taking losses,” Mr. Birnbaum said.
After Mr. Birnbaum left, Mr. Rosenberg walked into Mr. Paulson’s office, a bit shaken. Mr. Paulson seemed unmoved. “Keep buying, Brad,” Mr. Paulson told Mr. Rosenberg.
What’s Paulson’s new big idea? Hint: It’s got distinctly Austrian tones:
By the middle of 2009, a record one in 10 Americans was delinquent or in foreclosure on their mortgages. U.S. housing prices had fallen more than 30% from their 2006 peak. In cities such as Miami, Phoenix, and Las Vegas, real-estate values dropped more than 40%. Several million people lost their homes. And more than 30% of U.S. home owners held mortgages that were underwater, or greater than the value of their houses, the highest level in 75 years.
As Mr. Paulson and others at his office discussed how much was being spent by the United States and other nations to rescue areas of the economy crippled by the financial collapse, he discovered his next targets, certain they were as doomed to collapse as subprime mortgages once had been: the U.S. dollar and other major currencies.
Mr. Paulson made a calculation: The supply of dollars had expanded by 120% over several months. That surely would lead to a drop in its value, and an eventual surge in inflation. “What’s the only asset that will hold value? It’s got to be gold,” Mr. Paulson argued.
Paulson & Co. had never dabbled in gold, and had no currency experts. He was also one of many warming to gold investments, worrying some investors. Some investors withdrew money from the fund, pushing his assets down to $28 billion or so.
Mr. Paulson acknowledged that his was a straightforward argument, but he paid the critics little heed.
“Three or four years from now, people will ask why they didn’t buy gold earlier,” Mr. Paulson said.
He purchased billions of dollars of gold investments. Betting against the dollar would be his new trade.
It is interesting to see a few well-respected investors on the same side of this trade. Einhorn made his views on gold known in his speech to the Value Investing Congress.
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.
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.
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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:
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.
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.
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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.
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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.
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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.
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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.
Greenbackd 