“In recent years, holding cash is so completely out of favor that it has become the ultimate contrarian investment.” —Seth Klarman
“There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.” —Charles Kindleberger
“It’s as if people used the invention of seatbelts as an opportunity to take up drunk driving. Psychologists call this ‘risk compensation.’ The entire point of the CDS was to create a margin of safety that would let banks take more risks. As with safety belts and dangerous drivers, innocent bystanders were among the casualties.” —Tim Harford
“… With notably rare exceptions, Germany remained largely at peace with its neighbors during the 20th century … With notably rare exceptions, Alan Greenspan has been right about everything … With notably rare exceptions, Russian roulette is a fun, safe game for all the family to play.” —Comments on Crooked Timber blog
2013
ANNUAL REPORT
_______________________________________________________
For further information, contact Gary Sieber at (574) 293-2077(574) 293-2077 or via email at gary@mcmadvisors.com
MARTIN CAPITAL MANAGEMENT, LLC
2013 ANNUAL REPORT
TABLE OF CONTENTS
Total Account Composite Performance……………………………………………………… 2 S&P 500 Index and MCM Asset Allocation/Performance ..………………………………… 3 Letter to MCM Client
Performance Commentary …………………………………………………………. . 3 The ‘Unavoidables’: Death, Taxes … and Succession………………………….……. 4
Essential Traits of a Successor……………………………………………………….. 5
It Takes More Than Intelligence and a Good Track Record…….……………. 6
The Hard Truth About ‘Soft’ Traits……………………………………………6
A Preview: Recognizing and Avoiding Serious Risks…………………………. 7
Behavioral Economics and the Prerequisite of Fierce Independence………………….. 8
Market Prices Are More Volatile Than Intrinsic Values………………………. 8
The Folly of Forecasting…………………………………………………….. 10
The Hidden Motives Behind Profit Margins, Earnings, and Dividends………..………12
The Valuation Debate: Should Long-Term Investors Rely on Short-Term Earnings? ..16
Are ‘Fat Tails’ Yesterday’s Risk? ……………………………………………………. 17
Decision Making Without Forecasts and the Role of Optionality …………………… 21
A Foreordained Conclusion ………………………………………………………….23
Final Thoughts ……………………………………………………………………….. 24
Endnotes …………………………………………………………………………………… 25
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Total Account Composite Performance
In 2013, the annual return on MCM’s total account composite1 was 9.8% after fees. Since we began documenting performance history at the end of 1999, coinciding with the peak of the greatest bull market in financial assets in history, our compounded annual performance has been 5.3% compared with the S&P 500 Index’s 3.6%.
Annualized Growth Rate
MCM
MCM vs S&P 500:
MCM
Total
S&P
Relative
Compounded
Year
Equities *
Account *
500
Performance
Outperformance **
(1)
(2)
(1)-(2)
2000
30.4%
16.3%
-9.1%
25.4%
27.9%
2001
22.5%
14.8%
-11.9%
26.7%
66.7%
2002
-14.2%
-8.0%
-22.1%
14.1%
96.9%
2003
33.4%
22.3%
28.7%
-6.4%
87.2%
2004
4.3%
3.5%
10.9%
-7.4%
74.7%
2005
-0.3%
-0.3%
4.9%
-5.2%
66.1%
2006
4.8%
2.0%
15.8%
-13.8%
46.3%
2007
1.5%
2.9%
5.5%
-2.6%
42.7%
2008
-20.2%
-7.0%
-37.0%
30.0%
110.7%
2009
57.6%
20.9%
26.5%
-5.6%
101.4%
2010
18.1%
1.3%
15.1%
-13.7%
77.4%
2011
-2.4%
-0.3%
2.1%
-2.4%
73.3%
2012
15.9%
1.0%
16.0%
-15.0%
50.8%
2013
46.7%
9.8%
32.4%
-22.6%
25.1%
* Net of fees
** Invested dollar with MCM relative to invested dollar in the S&P 500 since 12/31/99
Disclosures: The MCM Total Account composite includes consolidated portfolios greater than $1 million where MCM has been given full investment authority. The strategy seeks long-term growth through a combination of capital appreciation and income. The reported return includes interest and dividends but does not factor in taxes. Returns are net of fees. The S&P 500 is a market value weighted index consisting of 500 stocks chosen for market size, liquidity and industry group representation. The reported return is inclusive of dividends but exclusive of taxes and management fees.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.
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Letter to MCM Clients
Performance Commentary
To the Clients of Martin Capital Management:
The crux of our investment strategy over the last several years has been to serve as prudent stewards of your portfolios of marketable securities. We’ve tiptoed through a field of dreams under which we believe a few random landmines await the unwary. At great peril to career and business but little to your capital, we’ve invested to try to minimize wealth-threatening risks while most managers are attempting to maximize return. Proactive and precautionary investing, however, has come at a price in the short term.
Our equities rose 46% in 2013 compared with 32% for the S&P 500 Index. The MCM total account composite gain of 9.8% reveals the opportunity cost of forgoing equity investments for lack of an adequate margin of safety. That left us holding an average of 73.4% of the portfolio invested predominantly in short-term U.S. Treasury securities, which yielded 0.2%. The net cost of hedges was 0.7% of total assets.
We continue to view our choices as fairly straightforward: We can either accept the present as the best there is (or will be) as others have done, or we can prepare for the yet-unseen opportunities of tomorrow with the optionality that only liquidity provides. We can’t serve two masters—the present and the future—simultaneously.
Taking a slightly broader historical snapshot that includes the last five years, we share a dubious distinction with Berkshire Hathaway. Since Warren Buffett took the reins in 1965, Berkshire has never experienced a five-year period during which the increase in its book value was less than the S&P 500 Index, including dividends—that is, until 2013. Estimates are that the
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company’s book value at year end will have grown approximately 85% since 2008, whereas the S&P 500 returned 128%, including dividends. In the S&P’s five-year romp, Berkshire’s book value per share underperformed in all but one year, 2011, when the debt crisis in Europe unsettled markets. Buffett deadpanned as only he can, “We do better when the wind is in our face.”
Anticipating that Berkshire might not keep its five-year relative performance record intact, Buffett did not equivocate in last year’s chairman’s letter: “The one thing of which you can be certain: [We] will not change yardsticks.” Buffett—and we at MCM—provide the comparison as a way for investors to evaluate our performance against a low-cost S&P 500 Index fund. Looking forward, he said, “Charlie and I believe the gain in Berkshire’s intrinsic value (for which book value is a significantly understated proxy) [italics are Buffett’s] will over time likely surpass the S&P returns by a small margin.”
If we have any advantage over Berkshire, it’s that we have the maneuverability of a speedboat compared with the Berkshire battleship. And if we are even reasonably successful in emulating the best of what he believes—and we believe—Buffett has found in the persons of Todd Combs and Ted Weschler, the heirs apparent as managers of Berkshire’s $100 billion (and growing) portfolio of marketable securities, we would be disappointed if we didn’t outperform the S&P by a noticeable margin over the next market cycle. Aside from having the right people and the right incentives in place, it is critical for us to use our greater flexibility and optionality in managing risk and seizing opportunity if the capital markets only replicate in the future what they’ve done in the past—that is, that they fluctuate, sometimes to extremes.
The ‘Unavoidables’: Death, Taxes … and Succession
Admitting to the two certainties in life, death and taxes, Buffett (83) and Munger (90) have been both dutiful and forthcoming about plans to replace the irreplaceable. As for microscopic MCM, finding a successor for its youngish, 71-year-old founder is much simpler, but it has not proved to be easy.
In last year’s report, I wrote, “My overarching goal is to partner with an organization whose long-term, risk-adjusted investment record is as solid as (or ideally better than) our own. Of equal importance, it must be an organization whose forward-looking assessment of risks and returns is dependable enough that its long-term record will remain intact for years to come.”
Focused efforts in 2013 to find such a partner have yet to bear fruit, even with the help of several extraordinarily capable friends in high places in our industry. Although I had opportunities to meet a number of outstanding professionals and firms, there were none whose actions spoke as loudly as their words in avoiding serious risks that could diminish the luster of prior successes. The time was not ill-spent, however, for much introspection resulted. In order to strengthen ourselves internally, effective January 1 we implemented the first phase of a meritocracy-based investment management model that is patterned after Berkshire’s. Several key people at Berkshire provided both direction and encouragement, and I am deeply in their debt.
A Prussian general once astutely observed, “No plan survives first contact with the enemy.” (Or perhaps, with reality.) Like most businesses, we’ve implemented plans before that seemed to be well-conceived but didn’t survive the reality check. Ultimately, however, what matters is how quickly and effectively we adapt. Getting it right remains more important to us than getting it first.
In 2013, as the markets rose farther and farther out of reach, there was ample time for thinking about stewardship, about the management of wealth over generations. Since MCM will eventually manage my estate, most of which will be committed to Marsha’s and my private foundation, this report is dedicated to building an organization around the enduring precepts laid out in the three-paragraph block quote below from Warren Buffett. Theoretically, a private
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foundation has perpetual life, and thus it mirrors my attitude toward the stewardship of your wealth. If well-managed, wealth will serve the intentions of its creators for generations to come. Because our circumstances, aspirations, and concerns are at least directionally similar, I expect what I’m thinking is what you’re thinking: What kind of person should you and I be looking for to oversee our marketable securities portfolios in good times and bad?
Please note the emphasis on person rather than institution, unless the institution carries the cultural DNA of a highly principled leader.2 Ayn Rand left no doubt that “…man’s mind is the root of all the goods produced and of all the wealth that has ever existed on earth.”3 In times like the present, Rand’s warnings of “looters and parasites” seem particularly apropos. As for the parasites, they are crawling out of identity-challenged institutions everywhere, like the legion of cookie-cutter mortgage bankers stamped out in the early 2000s with P. T. Barnum’s famous dictum watermarked on their diplomas. The old admonition is as relevant as it is disregarded during today’s desperate gamble for return: “Don’t confuse brains with a bull market.”4
Beyond the proactive steps taken above, I am searching for a younger person who will succeed me as MCM’s chief investment officer when the need arises. Picking the right person(s) will not be easy. All investment choices involve trade-offs, cryptically conveyed in the old country & western song title, “You Can’t Have Your Kate and Edith Too.”
By avoiding traumatic market declines that frequently fan the fires of fear and other wealth-destroying emotions, the upside is often truncated, and opportunities, some very real and others illusory, are forgone. Amidst all the noise and clamor, wealth inexorably migrates toward those who are its worthy masters—and irrevocably away from those who are intellectually or temperamentally no match for their money. With those thoughts in mind, our want ad for a successor (and yours in evaluating the stewards of your wealth) reads, in part, as Warren Buffett observed in 2007:
Essential Traits of a Successor
It’s not hard, of course, to find smart people, among them individuals who have impressive investment records. But there is far more to successful long-term investing than brains and performance that has recently been good.
Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.
Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior [are] vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.5
Finally, this person would also be my likely successor as majority owner of MCM. While many duties can be delegated, there is one that cannot: maintaining the culture of honesty and integrity that includes unconditionally subordinating the needs of the firm’s owners and employees to those of our clients. We are in a service profession and serving ourselves must be a byproduct of first selflessly serving our clients. The priorities cannot be reversed.
What follows are three thumbnail sketches of my interpretation of what Buffett meant.
* * *
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It Takes More Than Intelligence and a Good Track Record …
You never know who’s swimming naked … until the tide goes out. And the discovery can come as quite a shock to both the observer and the observed. Legg Mason investment manager Bill Miller, notably, got caught skinny-dipping during the financial crisis. In the “horse race” of relative-return investing, Miller’s name became synonymous with Secretariat on his way to the Triple Crown. Well-liked and highly regarded, Miller gained fame and fortune by accomplishing the remarkable feat of beating the return of the S&P 500 Index for 15 consecutive years, from the start of 1991 through 2005. Once the string was broken, he may have become desperate in attempting to get back on the bandwagon. In 2008, however, the tide ebbed and exposed a portfolio dominated by companies in the financial sector. Bill Miller’s legacy now is the stuff of nightmares for stewards of wealth.
Compound interest is a harsh taskmaster. Because of its simple but frequently misunderstood mathematics, a single significant loss with all the chips on the table can wipe out years of successes. Interestingly, compounding is much kinder and gentler if one sits out a hand or two, but that’s not what gamblers do—most conspicuously those with the hot hand.
The Hard Truth About ‘Soft’ Traits
Temperament, as I think Buffett would define it, is a catchall word. No doubt it’s rooted in how he sees the world and how he makes decisions. Buffett seems to have an uncanny knack for avoiding those activities that interfere with rational decision making and embracing those that do. My two favorite biographies of Buffett (with very different perspectives)—the first written by Roger Lowenstein and the second by Alice Schroeder6—go some distance in allowing the actions of the world’s greatest investor to define his temperament. A third effort comes from author Carol Loomis, who had the advantage of a close and long-standing relationship with Buffett. Her book,
Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, is as near as we’re likely to get to an autobiographical assessment of what temperament really means to the Oracle of Omaha. As a synthesis, words or phrases that come to mind would include equanimity, imperturbability, focus, logic, and uncompromising rationality.
Emotional stability, from one who has read much of what has been written about and by Warren Buffett, starts with the capacity to compartmentalize. Schroeder reveals a side of Buffett rarely evident in his activities as a businessman and investor. He is fallible as a person, she observes—no different in his humanity from the rest of us mere mortals. In a book written several years ago, Jason Zweig7 goes so far as to characterize Buffett as a borderline sociopath, one who is “inversely emotional”—a person who actually feels better the lower prices fall and worse the higher they rise. Zweig’s psychological interpretation is the basis for the famous Buffett aphorism, “I’m fearful when others are greedy, and greedy when others are fearful.”
From my personal experience, such contrarianism is an acquired taste. Once you are habituated, the world looks quite different, and you look like an alien to the world! In the depth of Buffett’s understanding of human and institutional behavior, it is clear that he is a student of the “immutable proclivities of man,”8 and the collective bipolar capacity to muscle markets and individual stocks to extremes, far from what they are actually worth. By keeping his head when most of those around him are losing theirs, Buffett has demonstrated time and again the capacity to acquire assets for far less than their actual worth. When assessing the so-called “soft” traits, one would be well-advised to study those characteristics common to great players of bridge, one of Buffett’s favorite pastimes.
The importance of fierce independence becomes evident as one encounters the truth about the folly of forecasts, about those who make them and then have the audacity to take actions based on them. When one is armed with such knowledge, the capacity to make up one’s own mind—to
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have the courage of one’s convictions, to stay the course, to eschew the crowd, and to find other lower-risk ways of advancing the portfolio ball—moves quickly to the forefront of desired character traits.
A Preview: Recognizing and Avoiding Serious Risks
The final and most challenging task is finding someone “genetically programmed to recognize and avoid serious risks, including those never before encountered.” When Buffett wrote that passage in the spring of 2007 it was, with the benefit of hindsight, prophetic: The markets (mostly the securitized debt markets, but with the equity markets not far behind) were doing “extraordinary, even bizarre, things,” and the perils that lurked in the widely embraced investment strategies were not spotted by the (risk) “models commonly employed today by financial institutions.”9
At the Berkshire Hathaway annual meeting in May 2007, I put the question to Warren and Charlie about whether the job requirement of recognizing serious risks was also a warning in disguise.10 Beyond his oblique answer, I have reason to believe that both of them thought serious risks existed—but deemed them not to be so clear and present a danger as to require significant portfolio actions. During the Q&A session in May 2009, Carol Loomis queried Buffett on the performance of the four unidentified managers-in-waiting during the crisis. Warren responded that none had outperformed the S&P. While nothing much has been said since, those managers disappeared, and Todd Combs and Ted Weschler arrived on the scene in 2010 and 2011, respectively. Both men appear to have what Buffett is looking for in terms of genetic programming, as well as the humility to avoid falling victim to whatever left Bill Miller sans swimsuit in 2008.
Fast-forward to January 2014. There appear to be serious risks extant, including some with which investors have little or no familiarity. Despite the Three Stooges slapstick antics of the Washington protagonists, the ad hoc rescue of the financial system was a political and, most likely, economic necessity.11 The liquidity crisis was addressed forthrightly, but beneath it lay a more intransigent solvency problem, one more effectively addressed in bankruptcy courts than by the central bank, which had neither mandate nor authority. By long overplaying its hand once the liquidity emergency subsided, the Fed extended the moral-hazard shield, and Congress did the same by enacting the proportionately benign Dodd-Frank legislation, thereby protecting bankers and other miscreants from facing the full consequences of their actions.
As second-generation Gordon Gecko clones feigned repentance on Wall Street, old vices quickly returned. The Fed and Congress may have unintentionally fomented a risk culture similar to that of the late 1920s, with asset prices skyrocketing while the economy advanced haltingly. Three noteworthy risks have thus emerged:
The first, and most contentious, is the overvaluation of risk assets.
The second, the systemic fragility of the financial intermediation mechanism, is the least understood because of its opaque complexity.
The third, advances in technology that have outstripped humanity’s capacity to manage them safely (e.g., computer coding upon which our businesses, our utilities, and indeed our culture rely—but has been proven susceptible to amateur hacking and/or professional or government cyber-attack), increases the likelihood of catastrophic failures not directly related to the capital markets but from the fallout and shockwaves that could reach them.
These thumbnail sketches of the personal character traits Buffett considers imperative not only serve as a useful guide for succession planning at MCM, they also open up a much broader discussion of issues critical to successful long-term investment strategy. That discussion follows.
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Behavioral Economics and the Prerequisite of Fierce Independence
Market Prices Are More Volatile Than Intrinsic Values
Buffett’s insistence that his successor understand human and institutional behavior will likely challenge some deeply held convictions. In the dogma of modern finance, the title of this section is received with the same antipathy as when Galileo had the gall to argue that the earth revolved around the sun, not vice versa. In the 17th century, however, authorities dealt with such apostasy more directly. The Roman Catholic inquisition found Galileo “vehemently suspect of heresy” and sentenced him to house arrest for the remainder of his life. The matter of whether investors are essentially rational or not remains unsettled. The Nobel Prize committee recently added to the confusion, reaching a split decision in awarding its coveted prize in economics for 2013. A founding proponent of efficient markets, University of Chicago’s Eugene Fama, and Yale’s Robert Shiller, a pioneer in behavioral economics at the other extreme, shared the scrambled eggs.
The difference in thought between these two men is anything but insignificant, nor is it purely academic. What hangs in the balance in terms of consequences might make it appear that Galileo got off easy. To contest the efficient-markets crowd’s thesis that investors are not completely rational beings is to imply that markets are not the omniscient, intimidating monoliths to which so many pay homage—the efficient melting pot of all generally earnest and enlightened opinions, with the good canceling out the bad and the truth percolating through to an explicit, minute-by-minute value for the sacrosanct Dow or S&P 500 “index.” It’s heretical to think that investors are instead prone to fits of varying degrees of euphoria and depression, with such emotional forces causing much greater fluctuations in asset prices than would be warranted by the “fundamentals” (expected growth and stability of earnings, dividends, shareholders’ equity, and so on).
Fama and Shiller both delivered their Nobel acceptance lectures on December 8 in Stockholm. Fama went first, which allowed Shiller,12 the heretic, to go on the offensive with his very first slide: “Speculative Asset Prices.” According to Fama, bubbles, the inference of the slide, can’t exist because everything that can be known about a security is already embedded in its price, the expression of the rational interplay between buyer and seller.
Shiller argued conversely, paraphrasing the great British economist John Maynard Keynes in the same way as author Mark Buchanan by saying,
markets resembled nothing so much as a beauty contest in which participants aim to choose not the most beautiful entrant, but the one they think most others will choose as the most beautiful. Everyone, ultimately, must guess what others will guess about what others will guess.13
Thus, Shiller implied, the market devolves into a high-stakes game of outwitting others. Adding another behavioral dimension to the debate, Jeremy Grantham, the idiosyncratic
head of $150 billion asset management firm GMO, attempted to quantify the relative volatility of market prices and did so by forthrightly reflecting on an institutional imperative within our own profession. In the firm’s Q2 2012 letter,14 Grantham argues that the conduct of institutions, which control 70% of assets, is driven primarily by attempts to minimize career risk—that is, the threat of losing one’s job. Going back to the well and paraphrasing Keynes, perhaps a little loosely, Grantham concludes: “You must therefore never, ever be wrong on your own.”
Accordingly, the great majority of investors keep close tabs on their fellows, not straying far from the fold. The result is herding and, if agitated, occasional stampeding, which periodically
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drives prices far above or below “fair” value. Grantham contends that a combination of growth in GDP and “fair value” for the stock market is remarkably stable, with the annual change within 1% of its long-term trend. By stunning contrast, he notes that the market’s price—reflecting the emotional swings of the fickle institutional herd—is within 19% of its long-term trend (two-thirds of the time)! That is to say, stock prices are 19 times more volatile than the underlying fundamentals would warrant most of the time. Grantham, citing Shiller’s data, makes a rather compelling case that herd behavior has almost nothing to do with rational price discovery.
In what I might term the Madoff effect, it is in our nature to want to believe. With all our presumed intelligence and powers of discrimination, we can rationalize almost anything to keep our life tied together into a coherent narrative. The adaptive mechanism, cognitive dissonance, makes mincemeat out of logic and facts. The reality that Madoff’s Ponzi scheme was destined to implode was never in doubt, but the timing was. Ultimately the short-term becomes the long-term, and we all profess shock and disbelief. The oft-repeated palliative, “This time is different,” which inevitably runs aground on the shoals of reality, has nonetheless been a constant throughout history because we really want to believe that this time is different.
Hyman Minsky (1919–96), to whom I often refer with unabashed admiration, was an economist who was ahead of the times. He saw the fatal flaw of equilibrium theory undergirding the rational expectations revolution long before it became obvious, conspicuously in the late 1990s and perhaps more subtly today. As it relates to market prices diverging from fundamentals, he observed that certain individuals are naturally more speculatively inclined than others. While some people or firms tend to think and act more cautiously, trying to scrutinize fundamentals and investing for the long term, others are more speculative and jump more aggressively onto what they believe to be profitable trends.
Moreover, market economies are self-propelling and self-referring systems strongly driven by perceptions and expectations that result in explosive, amplifying “feedbacks” that financier George Soros once coined “reflexivity.” In this state of mind, people judge the values of things not in absolute terms but in comparison with other things, or in relative terms. Caught up in the crowd, individuals’ biases tend to coalesce—and markets, as examples of crowds, are likely to exhibit this commonality. But there’s another factor that should actually make the reliability of crowds and markets much worse. Whether in fashion, language, or investment choices, people tend to copy one another. According to Mark Buchanan,
As some recent experiments have shown, this can make committees, crowds—and especially markets—very unwise indeed. … The experimental results show clearly that social influence destroys the wisdom of crowds in several ways. … Social influence creates a truly unpleasant combination of stupidity and increased confidence.15
Flashing back to the beauty-contest analogy, I begin with a microcosm. During the August 2007 “quant meltdown,” with which few readers are likely familiar, Cliff Asness, the mathematical whiz at AQR, wrote about how the beauty-contest strategy worked brilliantly until it became too popular—or, in the industry’s vernacular, “too crowded,” with disaster ensuing shortly thereafter. Successful strategies sow the seeds of their own demise. No strategy can emerge as the winner, because if it were perceived as such, and everyone started using it, eventually those in the minority will overwhelm the majority, apparent stability will give way to acute instability, and the majority will eventually collapse of its own weight. Once everyone’s aboard, to whom will the first seller, who gets a whiff of smoke in the theater of the absurd, sell?
As I began writing this annual letter, the “strategy” that seemed to be driving many portfolio decisions in the ever-levitating markets—from the largest institutions to the smallest retail
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investors—was predicated on the belief that prices will continue to rise because of the tailwind of seemingly perpetual easy money. Its beguiling beauty is in its simplicity, like the Madoff mania.16 Dovish Janet Yellen is only fanning the flames. Moreover, as one who admits to focusing only on reported earnings, she has publicly removed any doubt that she’s worried that the market is overvalued. No one, of course, knows when the illusion of stability gives way to its opposite. When the trade becomes crowded and a tipping point is reached, many physicists (but seemingly few economists) have a pretty good idea of what happens next.
The Folly of Forecasting
In his just-released second book, former Fed Chairman Alan Greenspan—“The Maestro”— makes a statement so prophetically and manifestly preposterous for a man of his station that I had to read it multiple times: “Even repeated forecasting failure will not deter the unachievable pursuit of prescience, because our nature demands it.”17 So much for Einstein’s definition of insanity and Margaret Heffernan’s condemnation of “willful blindness.”18 Greenspan, whose vanity attenuates the greatness of a man endowed with many gifts, may more justly deserve the title of poster child than maestro. He exhibits the hubris and fatal conceit that stems from having assumed more power than any man is truly capable of harnessing. With the caveats encompassed in this paragraph, however, I do consider the book a worthy read.
Whatever the reason (perhaps it’s our “nature,” as Greenspan suggests), the temptation to look to a leader to fix our problems and foresee the future runs deep. Humankind’s willingness to turn down the one-way street of government solutions or, of particular interest to us, central bank solutions to problems of their own creation is not something Thomas Jefferson would have encouraged. Of course, a leader doesn’t have to solve every problem or anticipate every eventuality alone. Good leaders surround themselves with expert advisers, seeking out the smartest specialists with the deepest insights into the problems of the day. As Greenspan and Ben Bernanke bore witness—and no doubt Janet Yellen will in her time—even deep expertise is not enough to solve today’s complex problems.19 Not one to sugarcoat, Nassim Taleb lays his cards on the table face up:
Theory should stay independent from practice and vice versa—and we should not extract academic economists from their campuses and put them in positions of decision making. Economics is not a science and should not be there to advise policy.20
Empirical psychologist Daniel Kahneman21 attempts to explain the foibles of forecasting in his highly regarded book, Thinking, Fast and Slow. Chapter 6 is aptly titled “It’s Not the Experts’ Fault—The World Is Difficult.” His main point is not simply that people who attempt to predict the future make many errors; that should be obvious to even the casual observer.22 It is that errors of prediction are inevitable because the world is unpredictable. A second equally critical lesson, evident from his self-critical research, is that highly subjective confidence, which Greenspan exuded, is not to be trusted as an indicator of accuracy.
In reflecting on the repeated failure of a forecasting experiment that he performed while in the Israeli army, Kahneman was circumspect.
What happened was remarkable. The global evidence of our previous failure should have shaken our confidence in our judgments of the candidates, but it did not. It should also have caused us to moderate our predictions, but it did not. We knew as a general fact that our predictions were little better than random guesses, but we continued to feel and act as if each of our specific predictions was valid.23
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Interestingly, Greenspan quotes Kahneman on seven occasions in The Map and the Territory: Risk, Human Nature, and the Future of Forecasting, the most paradoxical of which was: “We also tend to exaggerate our ability to forecast the future, which fosters optimistic overconfidence. In terms of its consequences for decisions, the optimistic bias may well be the most significant of the cognitive biases.”24
The Federal Reserve System, born in acrimony 100 years ago, is, in terms of potential domestic economic and social consequences, one of the most potentially disruptive ongoing case studies of forecasting failures in recent history. Former Fed Chairman Ben Bernanke came into office with the prelude of having taken a supporting role in numerous forecasting miscues and subsequent misguided actions during Alan Greenspan’s long tenure as chairman from 1987 to 2006. These errors are unintentionally revealed in Greenspan’s book and redressed as a series of late-life epiphanies. Nonetheless, his appointed successor did not realize at the time of his elevation from obscurity that his inheritance was to preside over the greatest financial debacle since the Great Depression.
Given the tone, texture, and directionality of his post-appointment speeches, along with the main thrust of his doctoral studies years earlier, Bernanke’s blindness to the oncoming crisis should have been proof positive that “it takes more than deep expertise to solve today’s complex problems.” And yet it wasn’t. The accolades are rolling in for Ben Bernanke just like they did eight years ago this month for Alan Greenspan. Within two years, the financial crisis made a mockery of Greenspan and his forecasts. The true test of a monetary policy regime’s efficacy is not how it begins … but how it ends. What will be Mr. Bernanke’s epitaph?
Policymakers have unwittingly failed to distinguish a temporary reduction in risk taking from a permanent one. The need for structural change renders the effect from the stimulus temporary at best; when the stimulus ends, the structural problems remain, and once again the economy ratchets back risk taking to compensate.
Meanwhile, government intervention distorts the allocation of resources and slows the transition to sustainable solutions. The stimulus exhausts precious resources, scares off productive risk taking, leaves structural problems unresolved, and accumulates a mountain of debt in its wake. If taxpayers four years ago failed to realize that the stimulus would ring up such a huge price tag without producing permanent results, they soon will. The most insidious mistakes are the ones you don’t even realize you’re making. They are things you do on purpose—but with unintended consequences because your mental model of the world is wrong.25
* * *
Long before the unintended consequences appear, the intended consequences are not even happening according to plan. If the Fed’s stated dual goal of full employment and price stability is to be believed, there seems to be a long and increasingly tenuous lag between actions and results.
Since the recession ended in June 2009, 95% of the gains in income from the Fed’s largess accrued to the wealthiest 1% of Americans, the largest gulf since the Roaring ’20s. The top 1% earned more than 19% of household income last year, the biggest share since 1928, and the wealthiest 10% captured a record 48.2% of annual household income.
Many investors (MCM clients among them) realized gains on financial assets before the top capital gains rate jumped from 15% to 20% in 2013. Those gains are included in income. The president’s recent State of the Union address focused on income inequality, a populist euphemism for income redistribution. He’ll be facing the “blood out of a turnip” conundrum. According to the IRS, the top 2% of earners—those who just had their marginal tax rates raised from 35% to 39.6%—already pay 50% of all income taxes.
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There’s something more socially noxious going on below the surface, another consequence that ties into Ayn Rand’s Atlas Shrugged reference to “looters,” governments who take by force of law from the producers, in order to give to the non-producers. President Obama either has not studied Rand or dismisses this aspect of her philosophy out of hand. There are only losers in the redistribution lottery, an assertion supported by abundant anecdotal evidence. Modern-day state lotteries clearly exist to tax the millions for whom impossibly infinitesimal probability is a sufficient basis for hope and action. The spoils that remain after the states’ rake and overhead costs are distributed to the “winners,” those who have yet to discover that unearned money rarely buys anything but grief.26 It doesn’t stop there. Moral drift is seductive. The Atlantic, for example, recently reported that in 1974 only 3% of retiring members of Congress became lobbyists. Today, 50% of senators and 42% of representatives do.27 Virtually every reader has an opinion on the subject, including how to fix the problem—assuming, of course, that it is a problem that can be fixed.28
The prices of financial assets have been the prime beneficiary as the discount rate applied to estimated future cash flows was intentionally driven to record lows. Many consumers of this report may be among that 1% of wealthiest Americans mentioned above.29 If there’s any doubt as to why most of that money has not trickled down, particularly in the multiplier form of investment spending, it is that many in the 1% (including yours truly) think it’s all an illusion. Contemplative members of the 1% are not so naïve as to accept the thesis of the financial alchemists, that permanent wealth has been created. As oft-quoted, brilliant, and clear-thinking Jim Grant observes,
The clear and present risk of the stock market is we’re living … in a hall of mirrors because the Fed’s accommodative policy is distorting the calculations by which the market has been traditionally valued. … The Fed can change how things look. It can’t change the way things are.30
The Hidden Motives Behind Profit Margins, Earnings, and Dividends
One of principal arguments in support of the current level of stock prices is that a new plateau in profit margins has been reached. The counterargument is that they will mean-revert.
Few doubt that several factors have contributed to the overall increase in profit margins. First, the cost of borrowing money to fund assets of both non-financial and financial companies has been declining for several decades, and even more sharply since 2008 because of the Fed’s ongoing zero-bound, short-term interest rate policy and the series of QE programs. Second, since the stuttering recovery officially began in the summer of 2009, the cost of labor per unit of output has fallen, at least in part due to wage stagnation. Only under depression conditions can they be expected to become permanent.
Rather than inundating you at this point with confusing acronyms and indecipherable statistics, an appeal will be made to your common sense, particularly as it relates to what’s behind the numbers: the incentives that often motivate behaviors. Economist Steven Levitt is well-known as the co-author of the best-seller, Freakonomics.31 Levitt’s singular genius is not economics as you and I know it. Rather, he has distilled the dismal science to its most primal purpose, which he describes as: “Explaining how people get what they want.” Read on with the following framework in mind:
“Incentives are the cornerstone of modern life”
“Conventional wisdom is often wrong”
“Dramatic effects often have distant, even subtle, causes”
“Experts use their informational advantage to serve their own agenda.”32
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If we are uncertain about the veracity of “the numbers,” and getting them wrong might reduce our margin of safety, perhaps we’ll find clues by tracing them to their behavioral origins. Let’s begin by asking ourselves who are the nominal owners of most of the largest corporations in America— and then asking how those owners have changed over the years. In 1950, 92% of all U.S. stocks were in the hands of individual investors. Since then, there’s been a vast migration of ownership. Today, institutions control roughly 70% of U.S. stocks while individuals hold only 30%.33 Contemporaneously, from 7% in the 1950s and 1960s, stock-related compensation as a percentage of the typical executive’s total compensation jumped to 47% during the 1990s. Through the middle of the last decade, it had risen further to 60%.34 In these evolutionary developments, causation is the basis for correlation.
For simplicity’s sake, let’s assume that the 60% receiving stock-based compensation are affiliated with mostly mature, large, financial and non-financial corporations over which professional boards preside. They, in turn, hire professional managers (or did I reverse the order?). The way institutions view their ownership duties and responsibilities is at one end of a continuum, and at the other is the owner/operator of a smaller business. In terms of the actual operating business itself, the institution, one step removed, has no “skin in the game,” no personal risk—upside but no downside. The owner/operator is keener about risks because he owns the downside. Not only does he have skin in the game, his soul is in it too.
It doesn’t take a leap of logic or imagination to deduce the behaviors of most professional managers, given the incentives under which they operate, as well as the comparatively short timeframe during which they typically have to establish their worth.
So, with that prelude, let’s get directly to profit margins—profits divided by revenues. Profits are a residual; they are what’s left after all expenses have been deducted from revenues. This is where the plot thickens, and incentives begin to creep into the picture. Holding everything else constant, ceteris paribus, higher profit margins = higher profits = higher stock price = higher stock-based compensation.
It begins with revenues, units sold times price. For many non-commodity businesses with differentiated products, there can be the short-term choice of price gouging to maximize margins— at the risk of a declining market share and eventually declining margins over the longer term.
Below the revenue line, not all expenses are created equal under the financial accounting rules for SEC-registered companies—i.e., GAAP (generally accepted accounting principles). Another way for a professional manager to increase profit margins is to reduce expenses. Because not all expenses involve an expenditure of cash (e.g., depreciation, amortization, and the write-down of assets), and all expenditures don’t represent an equal amount of immediate expense (e.g., purchase of fixed assets, acquisitions, R&D spending), there’s wiggle room within the accounting standards because of the difference between cash and accrual accounting (and between financial and tax accounting). Thinking back to Steven Levitt’s first insight about “the cornerstone of modern life,” the professional manager’s stock-based compensation incentivizes him to maximize reported profits in order to “get what he wants” whereas, in the same vein, the owner/operator is usually most interested in minimizing taxable income because the tax bill is paid out of his pocket.
So let’s look at a couple of practical ways that professional managers can enhance (or at least not depress) profit margins in the short run. One obvious place is to reduce capital expenditures. Besides possible upfront expenses related to building and equipping a new manufacturing, wholesaling, or retail facility, non-cash depreciation and interest expense will likely reduce earnings long (often years) before the project carries its own weight as new fixed investment theoretically raises output and, with state-of-the-art production technology, potentially lowers manufacturing costs. The argument that consumer demand is currently weak holds little water for long-term
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projects—unless the professional managers (or owner/operators for that matter) believe that demand will remain lethargic for an extended period of time. That’s a more troubling consideration, outside the realm of this discussion. In any event, since 2008 the proportion of cash flow invested in capital assets is the lowest on record.35 Either way, it’s a no-win situation. It makes little