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Table of Content

006

Biggs on Finance, Economics, and the Stock Market

Go to chapter

016

The Little Book of Market Wizards

Go to chapter

025

Inside the House of Money, Second Edition

Go to chapter

030

The Invisible Hands

Go to chapter

042

Right on the Money

Go to chapter

053

The Little Book of Venture Capital Investing

Go to chapter

065

Emerging Markets in an Upside Down World

Go to chapter

076

Code Red

Go to chapter

88

The Warren Buffett Way, Third Edition

Go to chapter

101

The Essays of Warren Buffet, Fourth Edition

Go to chapter

111

The Road to Recovery

Go to chapter

122

The Manual of Ideas

Go to chapter

Barton Biggs Section 1A: market History and the Long View Jack D. Schwager Chapter 1: Failure is Not Predictive

Steven Drobny Chapter 1: An Introduction to Global Macro Hedge Funds Steven Drobny Chapter 1: Rethinking Real money Doug Casey Chapter 1: Doug Casey on Bernanke Louis C. Gerken Chapter 1: An Historic Overview of Venture Capitalism

Jerome Booth Chapter 1: Globalisation and the Current Global Economy John Mauldin & Jonathan Tepper Chapter 1: The Great Experiment Robert G. Hagstrom Chapter 1: A Five Sigma Event - The World’s Greatest Investor Lawrence A. Cunningham Chapter 1: Corporate Finance

Andrew Smithers Introduction and Chapter 2: Why the Recovery Has Been So Weak John Mihaljevic Chapter 1: A Highly Personal Endeavour Some of these chapters are from advance uncorrected first proofs and are subject to change. All information and references must be checked against final bound books.

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Biggs on Finance, Economics, and the Stock Market Barton’s Market Chronicles from the Morgan Stanley Years Barton Biggs 978-1-118-57230-6 • Hardback • 432 pages • April 2014

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Section 1A: Market History and the Long View

In Search of History and a Word Processor That Works April 23, 1985

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ast week, I said I would write this week about the crucial allocation between stocks and bonds that is on everybody’s mind. After spending three hours or so writing on this subject on Sunday, the ultimate word processor nightmare occurred, and, on the print command, my entire text was erased. It’s too late to attempt to rewrite this week what was lost so, instead, let me summarize some conclusions. In making asset allocation decisions, I use both mathematical tools and subjective judgment. Nunzio Tartaglia’s Analytical Systems Group has developed a variety of quantitative models for comparing stocks, bonds, and short-term investments, and I use a Present Value Model and the Ford Dividend Discount Model. In addition, straight risk/reward analysis of stocks, bonds, and bills is helpful. Next week, I will report on the status of each of these systems, all of which, incidentally, say that bonds are more attractive than stocks right now.

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However, I place more emphasis on judgment considerations, because valuation models are just snapshots of the present’s relative value relationships. These models have no predictive powers.Yet, financial asset prices have a lot of the future in them; in other words, they incorporate discounting mechanisms.Valuation models are like X-rays; they do not in and of themselves evaluate a patient’s future health, but they help the doctor to do so. It may sound corny, but I believe the investor should heed the lessons of history, because the past replays, and one ignores its lessons at one’s peril. The present always seems different from the past, but human nature doesn’t change, and the patterns of fear and greed repeat. The cycles of economic history, particularly the ebb and flow of inflation, and the pattern of the relative performance of asset categories recurs. I am convinced that the past really is the key to the future. We have done a great deal of work in collecting and ordering statistics. We found that it is very difficult to determine the exact year (much less the quarter) in which a particular era began or ended, and it is often difficult to fairly represent the performance of different assets. Messing around in the yellowing, dry pages of old manuals trying to reconstruct the past into an orderly framework is a good way to learn that even economic history is extremely complicated. I think our work indicates that you want to be in bonds and commercial paper in deflationary times and in stocks in periods of price stability, disinflation, and moderate inflation. In times of rapid or accelerating inflation, real estate, precious metals, and equities provide positive real returns. But generalizations must be viewed with caution because performance varies considerably relative to the initial valuation of the asset in question. In other words, if the asset entered the period overvalued, its relative performance suffered. A recent example is equities in the latest inflationary era. After a long bull market, stocks were overpriced by all historical and psychological benchmarks as inflation began to accelerate; thus they failed as an inflation hedge. Knowing the record of history is not enough. The investor must be able to determine the present valuation of each asset relative to other assets and to its own valuation cycle.

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Kondratieff and the Long Cycle June 25, 1985

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believe that although knowledge increases, the world progresses, and technology advances, human behavior unfortunately remains the same. This is certainly true in the cycles of emotion in the stock market, and it has always seemed to me that it also should be valid in economic patterns.Thus I have been intrigued with the idea of a long cycle in human events that in general terms recurs. History does not have to repeat itself, but because people don’t change, it does. Economics is really mostly about cycles. Economists like Wesley Mitchell, Simon Kuznets, and Joseph Schumpeter have written about both the conventional business cycle and longer, 10- or even 20-year Juglar cycles. I have been fascinated for years, however, with the supercycles described by a Russian government economist named Nikolai Kondratieff, who created the first five-year plan for Russian agriculture in 1920. In 1922, Kondratieff published “The Long Waves in Economic Life,” which describes a recurring 50- to 60-year economic cycle driven by the ebb and flow of innovation and capital investment, and that had social implications. In many ways, Kondratieff ’s writings are an explanation of history. The commissars were not amused, however, when they realized that their agricultural economist’s theory argued that the downturns in capitalist economies were not attributable to inherent defects within the system but were self-correcting. He was put on trial and sentenced to Siberia, where he spent the rest of his life breaking big stones into little ones. It is believed he died in the 1930s. His papers were generally ignored until the last decade or so, when the work of Professor Jay Forrester of the Sloane School at MIT attracted attention.

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The idea of long cycles in human economic history goes back to biblical times. The Old Testament tells of 50-year jubilees, in which slaves were freed and debts were forgiven. Gibbon’s Decline and Fall of the Roman Empire gives evidence of a 50-year cycle of war and inflation, and a 54-year cycle can be found in the history of agricultural prices going as far back as the Mayans in Central America in 1260. Even primitive economies seemed to become overextended in a regular, more or less half-century cycle. Wealth in terms of land, slaves, and debt would become concentrated, and a purge to revitalize was almost part of the order of nature. Each cycle, as the accompanying chart shows, is characterized by four distinct phases. First there is a long growth era (27 years on average) culminating in an inflationary peak. Then comes a 1- or 2-year primary depression, which is followed by a plateau of 5 to 10 years. The last phase is a secondary depression and 15 or more years of stagnation. The precise timing of each cycle is different, but the broad outline is eerily similar. Kondratieff identified three 54-year cycles: 1790 to 1843, 1843 to 1896, and 1896 to the early l940s. His charts and papers, which relate to England, the United States, and France, analyze commodity prices, interest rates, and wages. Actually, Kondratieff identified rather than analyzed. Professor Forrester and his Systems Dynamics Group believe the waves can be explained by capital investment. During growth phases, demand is imposed on the capital goods industries by both the consumer goods area Kondratieff ’s Long Wave (Annual Averages, Ratio Scale)

120 100 80

Sharply rising prices corresponding to War of 1812

Sharply rising prices Sharply rising prices corresponding to Primary corresponding World War I Primary recession to Civil War recession after war after war “Era of Good Roaring 20s Feelings” after Reconstruction War of 1812 Secondary Secondary Secondary depression depression depression

Primary recession after war

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Sharply rising prices corresponding to Vietnam War Primary recession after war

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The long wave, a composite of business conditions in the world capitalist economy, based on studies by Nikolai Kondratieff.

U.S. wholesale price index (100 = 1967)

Source: Richardson & Snyder, Publisher, NY/Paragraphics.

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and the capital goods sector itself. At the peak, a labor shortage drives wages up and encourages capital-intensive production, which puts even greater stress on the capital goods area. During the plateau phase, the capacity created during the growth period is not exploited, while a relative fall in labor costs encourages a shift back to greater use of labor, which further diminishes the need for new capital equipment. The stagnant phase is marked by a secondary depression and a rapid collapse of the capital goods sector. Accumulating physical depreciation then sets the stage for the next growth phase. In effect, as Forrester says, a major depression rebalances the economy, liquidates debt, and clears away accumulated excesses. Anyone who wants to get really immersed in the theory should contact Professor Forrester or, for the lighter version, buy The Long Wave Cycle by Julian Snyder, published by Richardson & Snyder, 25 Broad Street, New York. Another excellent article on the social and historical aspects of the Kondratieff cycle, including trough wars and peak wars, by Ronald Kaiser was published in the May–June 1979 issue of The Financial Analysts Journal. I think Forrester puts too much emphasis on innovation and capital investment and not enough on the human factor. Kaiser is more eclectic and even points out that every U.S. war has occurred either at the peak or the trough of a growth phase. In any case, whichever way you look at it, the “primary depression” was either in 1974 or in 1980 when, just as in 1920, the prices of commodities, land, and real assets reached incredible peaks. We are now in the plateau phase where the world, thinking the worst is past, enjoys a false, Indian-summer prosperity. Economic growth is slow. Deflationary pressures in commodity prices and real assets offset inflationary monetary and fiscal policies. Stock prices rise, speculation surges, and a financial panic and stock market bust usually terminate the phase. I am very struck by the similarities between the plateau stages of the past, and particularly the 1920s, with conditions today. For example, previous plateaus always began with major political scandal (the demise of the Federalist Party, the attempt to impeach President Andrew Johnson, the Teapot Dome–Harding scandal, and, this time, Watergate). Invariably, real estate and, particularly, land prices peak early in the plateau and then begin to decline (1820, 1875, and 1925). This time, farmland prices peaked right on schedule in 1980. Women’s rights movements are strong (Susan B. Anthony’s suffragette movement in 1890–1900, women’s suffrage in the 1920s, and the attempt to ratify the ERA today). Other characteristics include a political shift to the right and more stable, traditional behavior by the younger generation after a surge of political and social liberalism in the last decade of the growth phase. Financially, plateaus tend to be characterized by protectionism, usually in the form of tariffs (the 1816 tariffs, the Smoot-Hawley tariffs), a massive debt overhang (Germany’s war debt then and the LDC debt today), and increasing use of leverage and margin for speculation in financial asset bull markets. The very low margin requirements of the 1920s were certainly a factor in the Crash of 1929. I think the growing acceptance of options and even the Fed’s talk of eliminating margin requirements are 11


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very ominous signs, because plateaus often end with financial panics that precede the secondary depression and stagnation. Most economists deride the “long wave” theory as being in a league with astrology and argue that advances in economic theory, the much greater role of government in the economy, and international cooperation in the past half-century make the economic cycle much more controllable today. I devoutly hope they are right, but the similarities between past cycles and the present bother me a lot. I worry that we really are in a period comparable to the mid-1920s—maybe even as late as 1926 or 1927. We investors will see one more powerful bull market characterized by massive speculation that will end badly (the panic of 1819, the panic and bear market of 1873– 1879, the Crash of 1929). Most cycles in the past were not as severe as that of the 1930s, but they were depressions nevertheless. Some of the social and political aspects were not pleasant, including a trend toward witch-hunting, prejudice, and authoritarian government in other countries. The similarities of the Kondratieff cycle to the present may just be fascinating coincidences, but the historical record is compelling, and, as I said at the beginning, human nature doesn’t change much. Don’t become obsessed with the precise timing, but as events unfold over the next few years, be open-minded, and keep Dr. Kondratieff ’s long-wave pattern in mind.

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The Phony War January 2, 1991

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he present stalemate in the equity markets around the world reminds me of the time 50 years ago called the “phony war.” After the blitzkrieg in the spring and summer of 1939, when Hitler and his Panzers overran Eastern Europe, the Germans stopped and consolidated on the Western front. From September 1939 until May 1940, there were skirmishes at sea and in Scandinavia, but nothing much happened. A false calm, a tranquility, lulled many people into thinking that it was just one more border war in Europe, that it wasn’t different this time. They knew something threatening and savage, a product of past evils, was ranging loose in the world, but they still felt that, somehow, things would work out, that a world war could be avoided and that their lives wouldn’t change. W. H. Auden caught the mood best in his great poem, “September 1, 1939.” Today, it is not so much physical death (although that could happen in the Gulf ), but a lingering financial death that offends our night. To me there are, for the United States in particular, no credible reflationary levers left to reignite growth. The markets with their jaundiced, skeptical eye can’t be fooled by the old stimulative tricks of the Fed and the Treasury. Debt rather than savings has financed growth, and now the United States is at record levels of public and private debt relative to GNP. The piper must be paid. The movie of the 1980s must be run backwards. But I find people still think we are in just another cyclical correction in the economy, real estate, the banking system, the art market, and the financial services industry. One of the ancient and iron rules of forecasting is that events always take much longer to develop than expected, but once they begin, they occur much faster and go

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much farther than anticipated. So it was in the spring and summer of 1940, as Winston Churchill wrote in Their Finest Hour: Now at last, the slowly gathered, long pent-up fury of the storm broke upon us. Within a week the front in France, behind which we had been accustomed to dwell through the long years of the former war and the opening phase of this, was to be irretrievably broken. Within three weeks the long-famed French Army was to collapse in rout and ruin, and the British Army to be hurled into the sea with all its equipment lost. Within six weeks we were to find ourselves alone, almost disarmed with triumphant Germany and Italy at our throats, with the whole of Europe in Hitler’s power, and Japan glowering on the other side of the globe. I pray to God nothing like that happens to us, but, to me, the world, the markets now seem somewhat as they were then. It’s not just the deadline in the Gulf. It’s the banking system, real estate, and the Soviet Union, too. I can’t prove it, but I feel it’s the end of a supercycle of growth induced by debt, leverage, and asset inflation. At the same time, for years now, balance sheet liquidity has been declining. The Bank Credit Analyst expressed it well in its year-end review, which is well worth reading but which won’t make you sleep any better: “The ultimate implication of the supercycle is a decline in living standards. It can occur in an orderly or disorderly way, through deflation or inflation.” House prices, art, salaries, bonuses, stocks can’t keep going up forever. The average price of a home in California has risen from $24,680 in 1970 to $99,760 in 1980 and to $196,521 by the end of 1989. Charles Biderman, writing in Barron’s, points out that the mortgage payment required to pay debt service on the usual California new home amounts to 80 percent of the average income of a California family. As he puts it, all Californians believe they have inherited a divine right to make a killing in California real estate and are leveraged up to do it. The only trouble is that even home prices don’t go up forever. In the United Kingdom, for example, home prices peaked after the Napoleonic War in 1815 and then fell for a hundred years. Even in the United States in this century, they declined in real terms for 30 years in one stretch. Speaking of real estate and its condition, the best, most dispassionate analysis I have seen is Salomon’s December 1990 “Real Estate Market Review.” The writers anticipate that the Russell-NCREIF Index will report total returns of 2 percent in 1990 and minus 2 percent in 1991. After 1991, they believe returns will be dismal for a while because they assume that writedowns will be spread over “at least the next several years.” They expect that before this cycle is over, the capitalization rate for commodity real estate will trade through mortgage rates and that rates for trophy/franchise real estate will increase from 5–7 percent to 7–9 percent. They argue that there is a secular imbalance in the office, retail, and hotel sectors that will be exacerbated by the current recession and estimate that the United States has a 10-year visible supply of office space. Hotel occupancy rates, they say, will fall again in 1991. The industrial and 14


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apartment sectors will do relatively better because they are overbuilt only on a cyclical basis. The institutions that have lent billions in mortgages and home equity loans collateralized by high percentages of the current market value of residential real estate may be in for a financial blitzkrieg if job layoffs and falling house prices result in homeowners walking. As you might have guessed by now, I think stocks are still in a bear market. My asset allocation remains 20 percent cash, 40 percent equities, and 40 percent bonds. It’s not the end of the world. The good guys won 50 years ago, and they will win again. It just may take a while. Continues...

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The Little Book of Market Wizards Lessons from the Greatest Traders Jack D. Schwager 978-1-118-85869-1 • Hardback • 208 pages • March 2014

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Failure Is Not Predictive

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The Story of Bob Gibson

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On April 15, 1959, Bob Gibson played in his first major league game, coming in as a relief pitcher for the Cardinals as they trailed the Dodgers 3–0. Gibson gave up a home run to the very first batter he faced—an ignominy suffered by only 65 pitchers in the history of the game.1 In the next inning, Gibson gave up another home run. Gibson got a chance to redeem himself coming in as a relief pitcher

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the next evening, but again was hit hard by the Dodgers. Two nights later, Gibson was brought in against the Giants with two outs and two runners on in the eighth inning and promptly gave up a double. After that game, Gibson sat on the bench for a week, and then was sent back to the minors. It is hard to imagine a more demoralizing beginning. Despite his dismal start, Gibson ultimately went on to become one of the best pitchers in baseball history. He is widely considered among the top 20 pitchers of all time. Gibson played 17 seasons in the majors, winning 251 games, with 3,117 strikeouts and a 2.91 earned run average (ERA). In 1968, he posted an unbelievably low 1.12 ERA—the lowest such figure since 1914. He won two Cy Young awards, twice was named as the World Series most valuable player (MVP), played on nine All-Star teams, and was elected to the Baseball Hall of Fame in his first year of eligibility.

If at First You Fail One of the surprises I found in doing the Market Wizards books was how many of these spectacularly successful traders started with failure. Stories of wipeouts, or even multiple wipeouts, were not uncommon. Michael Marcus provided a classic example. Michael Marcus was enticed into trading futures when he was a junior in college. There he met John, a friend of a friend, who dangled the prospect of being able to double his

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money in two weeks by trading commodities. Marcus fell for the pitch, hired John as a trading adviser for $30 a week, and opened a futures account with the money he had scraped together in savings. Standing in the customer gallery of the brokerage firm, watching the clicking prices on the wall-size commodity board (this was back in the 1960s), Marcus quickly realized that his “adviser,” John, was clueless about trading. Marcus lost money on every trade. Then John came up with the idea that was “going to save the day.” The trade was buying August pork bellies and selling February pork bellies of the following year because the price spread between the two contracts was greater than the carrying charges (the total cost of taking delivery in the nearby contract, storing the commodity, and redelivering it in the forward contract). It seemed like a can’t-lose trade. After placing the trade, Marcus and John went to lunch. When they returned, Marcus was shocked to find that his account had been almost completely wiped out. (Marcus would later discover that August pork bellies were not deliverable against the February contract.) At that point, Marcus told John that he thought he knew as much as he did—which was nothing—and fired his adviser. Marcus then managed to rustle up another $500, which he lost as well. Unwilling to give up and accept failure, Marcus decided to cash in $3,000 from the life insurance left to him by his father, who had died when he was 15. He

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then started reading up on grains and making some winning trades. In 1970, he bought corn based on a recommendation in a newsletter he subscribed to. By sheer luck, 1970 was the year of the corn blight. By the end of that summer, Marcus had turned the $3,000 into $30,000. In the fall, Marcus started graduate school, but found himself so preoccupied by trading that he dropped out. He moved to New York, and when asked what he did for a living, he told people rather pompously that he was a “speculator.” In the spring of 1971, there was a theory around that the blight had wintered over and would infect the corn crop again. Marcus believed this theory as well, and he intended to capitalize on it. He borrowed $20,000 from his mother, adding it to his $30,000 account. He then used the entire $50,000 to buy the maximum number of corn and wheat contracts he could on margin. For a while, the market held steady because of the blight fears, but it didn’t go higher. Then one morning, there was a financial headline that read, “More Blight on the Floor of the Chicago Board of Trade Than in Midwest Cornfields.” The corn market opened sharply lower and fairly quickly moved to and locked limit down.2 Marcus stood by paralyzed, hoping the market would rebound, and watching it stay locked limit down. Given that his position had been heavily margined, he had no choice but to liquidate everything the next morning. By the time he

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was out, he had lost his entire $30,000 plus $12,000 of the $20,000 his mother had lent him.

• I would look up and say, “Am I really that stupid?” And I seemed to hear a clear answer saying, “No, you are not stupid. You just have to keep at it.” So I did. Michael Marcus

I asked Marcus whether with all these failures he ever thought of just giving up. Marcus replied, “I would sometimes think that maybe I ought to stop trading because it was very painful to keep losing. In Fiddler on the Roof, there is a scene where the lead looks up and talks to God. I would look up and say, ‘Am I really that stupid?’ And I seemed to hear a clear answer saying, ‘No, you are not stupid. You just have to keep at it.’ So I did.” He did, indeed. Eventually, it all clicked for Marcus. He had an amazing innate talent as a trader. Once he combined this inner skill with experience and risk management, he was astoundingly successful. He took a trading job at Commodities Corporation. The firm initially funded his account with $30,000, and several years later added another $100,000. In about 10 years’ time, Marcus turned those

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modest allocations into $80,000,000! And that was with the firm withdrawing as much as 30 percent of his profits in many years to pay the company’s burgeoning expenses.

“One-Lot” Persists Although many of the Market Wizards started off with some degree of failure, perhaps none reached the depth of despondency over their losses as did Tony Saliba. At the start of his career when he was a clerk on the floor, one of the traders staked him with $50,000. Saliba went long volatility spreads (option positions that gain if the market volatility increases). In the first two weeks, Saliba ran the account up to $75,000. He thought he was a genius. What he didn’t realize was that he was buying these options at very high premiums because his purchases followed a highly volatile period. The market then went sideways and the market volatility and option premiums collapsed. In six weeks Saliba had run the account down to only $15,000. Recounting this episode, Saliba said, “I was feeling suicidal. Do you remember the big DC-10 crash at O’Hare in May 1979, when all those people died? That was when I hit bottom.” “Was that a metaphor for your mood?” I asked. “Yes,” answered Saliba. “I would have exchanged places with one of those people in that plane on that day. I felt that bad. I thought, ‘This is it; I’ve ruined my life.’ . . . I felt like a failure.”

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Notwithstanding this dismal start, Saliba had one important thing going for him: persistence. After his disastrous beginning, he came close to quitting the world of trading, but ultimately decided to keep trying. He sought the advice of more experienced brokers. They taught Saliba the importance of discipline, doing homework, and a goal of consistent, moderate profitability, rather than trying to get rich quick. Saliba took these lessons to heart and switched from trading options in Teledyne, which was extremely volatile, to trading options in Boeing, which was a narrowrange market. When he did go back to trading Teledyne, his standard conservative order size led to ridicule by the other brokers and the sobriquet “One-Lot.” Once again, Saliba persisted, this time putting up with all the ribbing and not being goaded into departing from his cautious approach. Ultimately, the persistence and attention to risk control paid off. At one point, Saliba put together a streak of 70 consecutive months with profits in excess of $100,000.

Two Key Lessons There are two key lessons that can be drawn from this chapter. First, failure is not predictive. Even great traders often encounter failure—and even repeated failures—early in their careers. Failure at the start is the norm, even for those who ultimately become Market Wizards. As a related comment, the fact that most people who attempt trading fail at the beginning suggests that all novice traders should start

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The Little Book of Market Wizards

with small amounts of cash because they might as well pay less for their market education. Second, persistence is instrumental to success. Most people faced with the types of failures encountered by the traders detailed in this chapter would have given up and tried some other endeavor. It would have been easy for the traders in this chapter to have done the same. Were it not for their relentless persistence, many of the Market Wizards would never have discovered their ultimate potential.

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Inside the House of Money, Revised and Updated Top Hedge Fund Traders on Profiting in the Global Markets Steven Drobny 978-1-118-84328-4 • Hardback • 368 pages • March 2014

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C H A P TE R 1

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INTRODUCTION TO GLOBAL MACRO HEDGE FUNDS

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Joseph G. Nicholas Founder and Chairman of HFR Group

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he global macro approach to investing attempts to generate outsized positive returns by making leveraged bets on price movements in equity, currency, interest rate, and commodity markets. The macro part of the name derives from managers’ attempts to use macroeconomic principles to identify dislocations in asset prices, while the global part suggests that such dislocations are sought anywhere in the world. The global macro hedge fund strategy has the widest mandate of all hedge fund strategies whereby managers have the ability to take positions in any market or instrument. Managers usually look to take positions that have limited downside risk and potentially large rewards, opting for either a concentrated risk-taking approach or a more diversified portfolio style of money management. Global macro trades are classified as either outright directional, where a manager bets on discrete price movements, such as long U.S. dollar index or short Japanese bonds, or relative value, where two similar assets are paired

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IN SID E TH E H O U S E O F MO N E Y

on the long and short sides to exploit a perceived relative mispricing, such as long emerging European equities versus short U.S. equities, or long 29year German Bunds versus short 30-year German Bunds. A macro trader’s approach to finding profitable trades is classified as either discretionary, meaning managers’ subjective opinions of market conditions lead them to the trade, or systematic, meaning a quantitative or rule-based approach is taken. Profits are derived from correctly anticipating price trends and capturing spread moves. Generally, macro traders look for unusual price fluctuations that can be referred to as far-from-equilibrium conditions. If prices are believed to fall on a bell curve, it is only when prices move more than one standard deviation away from the mean that macro traders deem that market to present an opportunity. This usually happens when market participants’ perceptions differ widely from the actual state of underlying economic fundamentals, at which point a persistent price trend or spread move can develop. By correctly identifying when and where the market has swung furthest from equilibrium, a macro trader can profit by investing in that situation and then getting out once the imbalance has been corrected. Traditionally, timing is everything for macro traders. Because macro traders can produce significantly large gains or losses due to their use of leverage, they are often portrayed in the media as pure speculators. Many macro traders would argue that global macroeconomic issues and variables influence all investing strategies. In that sense, macro traders can utilize their wide mandate to their advantage by moving from market to market and opportunity to opportunity in order to generate the outsized returns expected from their investor base. Some global macro managers believe that profits can and should be derived from other, seemingly unrelated investment approaches such as equity long/short, investing in distressed securities, and various arbitrage strategies. Macro traders recognize that other investment styles can be profitable in some macro environments but not others. While many specialist strategies present liquidity issues for other, more limited investing styles in charge of substantial assets, macro managers can take advantage of these occasional opportunities by seamlessly moving capital into a variety of different investment styles when warranted. The famous global macro manager George Soros once said, “I don’t play the game by a particular set of rules; I look for changes in the rules of the game.”

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I NTR ODUCT ION T O GLOBAL MAC R O HE DG E F U ND S

SUMMARY Global macro traders are not limited to particular markets or products but are instead free of certain constraints that limit other hedge fund strategies. This allows for efficient allocation of risk capital globally to opportunities where the risk versus reward trade-off is particularly compelling. Whereas significant assets under management can prove an issue for some more focused investing styles, it is not a particular hindrance to global macro hedge funds given their flexibility and the depth and liquidity in the markets they trade. Although macro traders are often considered risky speculators due to the large swings in gains and losses that can occur from their leveraged directional bets, when viewed as a group, global macro hedge fund managers have produced superior riskadjusted returns over time. From January 1990 to December 2005, global macro hedge funds have posted an average annualized return of 15.62 percent, with an annualized standard deviation of 8.25 percent. Macro funds returned

HFRI Macro Index Growth of $1,000 $10,000 $9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 Initial

1990

1991

1992

1993

1994

1995

1996

1997

HFRI Macro Index

FIGURE 1.1

1998

1999

2000

2001

S&P 500 w/ dividends

Comparison of HFRI Macro Index with S&P 500

Source: HFR.

28

2002

2003

2004

2005


4

IN SID E T H E H O U S E O F MO N E Y

over 500 basis points more than the return generated by the S&P 500 index for the same period with more than 600 basis points less volatility. Global macro hedge funds also exhibit a low correlation to the general equity market. Since 1990, macro funds have returned a positive performance in 15 out of 16 years, with only 1994 posting a loss of 4.31 percent. (See Figure 1.1.) In light of the correlation, volatility, and return characteristics, global macro hedge fund strategies are a welcome addition to any portfolio.

29


The Invisible Hands, Revised and Updated Top Hedge Fund Traders on Bubbles, Crashes, and Real Money Steven Drobny 978-1-118-84300-0 • Hardback • 464 pages • March 2014

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Chapter 1

Rethinking Real Money

I. Why Real Money? Real money is a commonly used term in the financial markets to denote a fully funded, long-only traditional asset manager. Real money managers are often referred to as institutional investors. The term real money means the money is managed on an unlevered basis. This contrasts with hedge funds, which often manage money using borrowed funds or leverage. Real money funds can and often do employ leverage, but they normally attain leverage on a nonrecourse basis (e.g., investing as a limited partner in a fund that is levered). Examples of real money managers are public and private pension funds, university endowments, insurance company portfolios, foundations, family offices, sovereign wealth funds, and mutual funds. This book focuses on the mistakes made and lessons learned in 2008 and attempts to incite a dialogue about how to construct better portfolios in the real money world. For this reason, mutual funds

3

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REAL MONEY AND THE CRASH OF ‘08

will be excluded from the discussion, since they are usually managed under strict mandates and asset class restrictions, rather than as broad portfolios where asset allocation decisions dominate the investment process. Real money funds are important and worth analyzing because: (1) they are some of the largest pools of capital in the world; (2) they have a direct impact on the functioning of society; (3) they lost staggering amounts of money in 2008; and (4) in many cases, these funds are ultimately backstopped by the taxpayer if they fail to deliver their promises. Real money funds are in crisis and are “too big to fail.”

Size Real money funds comprise a majority of world’s managed assets, which totaled $62 trillion at the end of 2008. Within this grouping, pensions are by far the largest category, at $24 trillion, with U.S. pensions at $15 trillion, or almost one-quarter of total managed assets (see Figure 1.1).

35

32.8

Assets Under Management ($ trillion)

30

25

24

20

18.7

18.9

15

10

3.9

5

1.5 0

Pension Funds

Insurance Funds

Mutual Funds

SWFs

Hedge Funds

2.5 0.9 Private Equity

Figure 1.1 Global Fund Management Industry, End of 2008 SOURCE: IFSL estimates.

32

ETFs

Private Wealth


Rethinking Real Money

5

Impact on Society Much of real money exists to deliver the promise of future retirement benefits, to support education, to guarantee the payouts from insurance agreements, to support charitable activities, and even to back national interests. In short, real money is the foundation for many important aspects of modern society. Pensions form an important part of the fundamental social contract between workers and employers, both in the public and private sectors. Public pensions in particular help ensure that basic societal functions are populated by competent people. Some of these functions include: police officers, firemen, judges, sanitation workers, teachers, health workers, politicians, and soldiers, amongst many others. To give an example of how real money affects society, after the crash of 2008, Philadelphia city officials threatened to lay off workers and cut sanitation and public safety services unless they could delay pension contributions. Stories such as these will likely become much more prevalent over the next few years.

2008 Losses During the financial crisis, real money accounts suffered immense drawdowns. Pension funds globally saw their assets fall by almost 20 percent, while university endowments in the United States lost 26 percent on average. More surprisingly, because of the severity of investment losses, many institutions were forced to modify their operations to reflect a new reality: universities laid off staff, froze or cut salaries, issued debt, reduced financial aid, and suspended building projects; pensions increased employee and employer contributions, raised retirement ages, and cut benefits; charitable foundations canceled grants and delayed new programs; families curtailed spending and in many cases have been forced to sell assets. The severe losses in 2008 also exposed some fundamental flaws in how real money portfolios are managed. Portfolio construction methodologies failed to account for both worst-case scenarios and potential illiquidity. A primary lesson of this experience is that the pain of investment losses is not linear; there is a kink, after which point losses begin to force

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changes in behavior. As a result, short-term investment performance has consequences even for “long-term” investors.

Taxpayer Although all real money accounts are important to society in one way or another, pensions are the largest and arguably the most important. Well before the crisis of 2008, demographic challenges had been steadily putting pressure on pension systems in the developed world. Nevertheless, at the end of 2007, after an extended bull run for assets, many plans were fully funded, whereas at the end of 2008 most had become significantly underfunded. Although a university going bust or a charitable foundation closing down is tragic for those directly involved, the effect would be relatively isolated. On the other hand, a pension fund going bust has implications for taxpayers. In the United States, the taxpayer is the explicit backstop for public pension funds and the implicit backstop for corporate pension funds, the latter of which are guaranteed by the Pension Benefit Guaranty Corp. (PBGC), a federal agency. The PBGC is currently facing its own crisis, with a reported deficit of $33.5 billion at midyear 2009, a more than tripling of the $11 billion deficit reported at midyear 2008. The deficit is the largest in the agency’s 35-year history. More importantly, without confidence by workers that their benefits are intact, society breaks down. In Ohio, for instance, the teachers pension system reported that it could take 41 years for its investments to meet its liabilities to retirees based on actuarial assessments—and this was before 2008. During the 2008–2009 fiscal year, the pension fund lost 31 percent, prompting officials to claim that they would never be able to meet liabilities. Because of the inherent complexity and subjectivity associated with calculating the funding levels for pension funds, the true costs are often disguised in the near-term (see box on page 7). The shortfall associated with underfunded pensions can be made up by either investment performance or pension reform (i.e., changing the structure of the pension in some way). Yet pension reform amounts to fiscal tightening at a time when the global economy is weak and

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Rethinking Real Money

7

personal budgets are stretched. At the same time, these decisions are made by politicians, whose tenure in office does not compel them to make difficult, long-term decisions. Because voters do not opt for more tax or less benefits, the problems are often ignored, growing bigger by the day. Pensions loom as the next big financial crisis. But crises often bring about change. We now have new information, which raises many important questions about what to do going forward. In order to understand more clearly what happened in 2008 and be able to formulate a plan for where we go from here, it is worthwhile to examine a brief history of real money, focusing on the U.S. pension world because it is the largest pool of funds and the biggest risk to the taxpayers of the world’s largest economy.

Pension Funding Levels Pension plans have two primary elements: (1) the future benefit obligations earned through employee service; and (2) the plan assets available to meet the liabilities owed to the beneficiaries. The challenge in assessing the health of pension plans is that both future liabilities and returns are estimates. Since the payments to beneficiaries will be made far into the future, actuarial assumptions are required to estimate mortality rates, medical costs, and future salary increases. The future stream of assumed payments is discounted into a single present value estimate, whereby the discount rate is determined by reference to a benchmark yield. The higher the discount rate, the lower the benefit obligations. Very small changes in the discount rate have enormous real dollar implications for estimated funding levels. Likewise, the value of plan assets available in the future to meet the pension obligations is also an estimate. The future value calculation is a function of expected returns on plan assets. Expected long-term returns are often developed using historical or “assumed” rates of return. In sum, it’s a big guessing game.

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II. The Evolution of Real Money In the Beginning, There Were Bonds Although pensions have existed for hundreds of years, the current structure took shape after 1948. In that year, the U.S. National Labor Relations Board (NLRB) ruled that corporate pensions must be included in contract negotiations between employers and employees. Before the ruling, the amount of capital allocated to an employee pension scheme, if such a plan even existed, was at the employers’ discretion. This ruling defined how much a corporation must contribute to the employee pension plan annually, regardless of company performance and profits. As a result, money began to consistently move into pension funds, creating significant growth in assets and eventually leading to the large, powerful, professionally managed institutions that exist today (see Figure 1.2). At the time, pension assets were managed very conservatively; fixed interest on bonds was matched to meet fixed commitments to pensioners—simple asset/liability matching. Bonds were selected from preapproved “legal lists” of securities, and it was common to have a limit for equities. In 1949, public and private pension assets in the United 12000

Total Assets ($ billions)

10000

8000

6000

4000

2000

0

1950

1955

1960

1965

1970

1975

1980

1985

1990

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2005

Figure 1.2 Growth of US Public and Private Pension Fund Assets, 1950–2008 SOURCE: Federal Reserve Flow of Funds.

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Rethinking Real Money

9

States were $15.7 billion. The asset mix was roughly half in government bonds, and half in other fixed income and insurance company fixed annuity investment products. There was minimal exposure to equities.

Along Came Inflation By 1970, public and corporate pension fund assets in the United States reached $211.7 billion, the majority of which was concentrated in fixed income. Beginning with the 1973–1974 oil embargo, wave after wave of commodity price-induced inflation roiled fixed interest portfolios through the remainder of the decade. Nevertheless, assets continued to pour into pension funds because of strict commitments mandated on employers. At the end of the decade, U.S. pension funds had $649 billion in total assets, and the outperformance of equities versus bonds during the previous ten years did not go unnoticed by pension fund managers. While bond portfolios got destroyed, equities at least managed to preserve capital in real terms (see Figure 1.3). Panicked and weary pension fund managers began rethinking their portfolios, and the shift out of bonds 140%

Nominal Equity

120% 100%

Total Return (%)

80% Nominal Bonds

60% 40% 20% 0% 1969

Real Equity 1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

–20% Real Bonds –40%

Figure 1.3 U.S. Stocks and Bonds, 1970s SOURCE: Bloomberg; U.S. Bureau of Labor Statistics, http://www.bls.gov/CPI/; and Damodaran Online, http://pages.stern.nyu.edu/∼adamodar/.

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into stocks began in earnest. By 1980, corporate pensions had 45 percent of their assets in equities, while public pensions had 16 percent. In many cases, public plans were still capped as to how much equities they could own. The largest U.S. pension fund, the California Public Employees’ Retirement System (CalPERS), for example, had a maximum allocation to equities of 25 percent, which was eventually lifted in 1984.

The 60–40 Model and the Great Moderation Through the 1980s and 1990s, pensions continued to shift their assets out of bonds and into stocks, ultimately moving toward the now ubiquitous 60–40 policy portfolio (60 percent in stocks and 40 percent in bonds, often domestic only). The 60–40 model which became the standard benchmark by which to judge portfolio performance. The shift into stocks, and corresponding increase in risk, occurred in lock step with Federal Reserve Chairman Paul Volcker’s famous battle with inflation, which saw the fed funds rate peak at 20 percent in 1981. In 1980, the so-called “misery index”—unemployment plus inflation—peaked at 20 percent. As the excess pessimism of the 1970s gave way to excess optimism during the Reagan 1980s and euphoria during the technology revolution of the late 1990s, 60–40 pension portfolios performed well. The big decisions that investors faced at this time were whether to tweak the 60–40 allocation to, say, 65–35 or 55–45. In actuality, the market environment throughout the 1980s and 1990s rendered these decisions inconsequential as both stocks and bonds benefited greatly from falling inflation and declining interest rates. The environment later became known as the Great Moderation, and was summed up well in a 2004 speech by then–Federal Reserve Governor Ben Bernanke (see box). Bernanke on the Great Moderation The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no

38


Rethinking Real Money

11

consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s. SOURCE: Board of Governors of the Federal Reserve System, www.federalreserve.gov; February 20, 2004.

By 1998, U.S. pension assets totaled more than $6.9 trillion, 438 times the 1949 figure. Pensions were larger than the national debt and growing faster. Because of their immense buying power, pensions became powerful market players in terms of shareholder activism, governance, and reform (see Figure 1.4). 8000 7000

Equity ($ billions)

6000

Elephant in the room

5000 4000 3000 2000 1000 0 1950

1955

1960

1965

1970

1975

1980

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2005

Figure 1.4 Equity Assets Owned by US Public and Private Pensions, 1950–2008 SOURCE: Federal Reserve Flow of Funds.

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REAL MONEY AND THE CRASH OF ‘08

U.S. 10-yr. Bond Yields Inflation Equity PE

Percent (Inflation & Bond Yield)

14% 12%

35

30

25

10% 20 8% 15 6% 10

4%

5

2% 0% 1980

Price/Earnings (Equity)

16%

1985

1990

1995

0 2000

Figure 1.5 Interest Rates, Inflation and Equity Multiples, 1980–2000 SOURCE: Bloomberg; Federal Reserve System, http://www.federalreserve.gov/datadownload/; and U.S. Bureau of Labor Statistics, http://www.bls.gov/bls/.

For two decades, the trend in equity markets was almost straight up, producing an entire generation of real money investors conditioned to buy any dip and remain invested in equities for the long term. Academics such as Jeremy Siegel of the University of Pennsylvania and bank strategists such as Abbey Joseph Cohen of Goldman Sachs became cheerleaders for the idea of owning equities for the long term, while banks and consultants peddled the story. Pensions, other real money investors, and retail investors all made money in this environment. It was a wonderful time to be invested (see Figure 1.5).

The Dot-Com Crash As real money was becoming increasingly loaded up on equity risk in their 60–40 portfolios (stocks can be anywhere from 2 to 10 times riskier than bonds depending on what proxies are used), two decades of declining inflation and interest rates culminated in a technology-led stock market bubble that finally popped in March 2000. After the peak, global equity markets declined relentlessly year after year, finally bottoming in

40


Rethinking Real Money

1400

4500

Global equities cut in half

1200

MSCI Global

5000

MSCI Global NASDAQ

1000

4000 3500 3000

800

2500 2000

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Tech stocks fall 75%

400

NASDAQ

1600

13

1500 1000

200 0 1995

500 1996

1997

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0

Figure 1.6 MSCI Global and NASDAQ, 1995–2003 SOURCE: Bloomberg.

early 2003. Stocks generally lost half their value while in-vogue technology stocks dropped 75 percent from peak to trough (see Figure 1.6). Just as they had in the 1970s with bonds, real money managers became painfully aware of the equity concentration risk in their portfolios and began to look for a better, less risky approach. Pensions were facing serious underfunding issues and all investors were looking for new answers. Amidst the carnage, the two largest university endowments—Harvard and Yale—rode through the dot-com bust unscathed, causing many investors to explore what these large, sophisticated real money investors were up to (see Table 1.1). Table 1.1 Equity Returns versus Harvard and Yale Endowments Fiscal Year (July 1–June 30)

S&P500

MSCI Global

Harvard

Yale

2000 2001 2002 2003

7.3% −14.8% −18.0% 0.3%

11.0% −21.3% −16.3% −4.1%

32.2% −2.7% −0.5% 12.5%

41.0% 9.2% 0.7% 8.8%

SOURCE: Bloomberg and Mebane Faber, The Ivy Portfolio (Wiley).

41


Right on the Money Doug Casey on Economics, Investing, and the Ways of the Real World with Louis James Doug Casey 978-1-118-85622-2 • Hardback • 400 pages • March 2014

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Chapter 1

Doug Casey on Bernanke: Be Afraid, Be Very Afraid (Part One) December 8, 2010

Louis: Thanks for the link to the “historic” Ben Bernanke interview*. It was breathtaking to hear the man who didn’t see the crash of 2008 coming say he’s “100 percent confident” he can control the U.S. economy. What do you make of that—is it hubris or stupidity? * The following conversations were originally published online and were peppered with hyperlinks to additional material we believed readers would want to reach. In this print edition of Right on the Money, we’ve retained the hyperlinks in ghost fashion. You can follow any link that interests you by visiting www.rightonthemoneybook.com. There you’ll find all the online links that the book refers to, laid out conversation by conversation, just as they appear in the book.

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Doug: As 60 Minutes pointed out, it’s rare for a Fed chairman to give an interview; this was only Bernanke’s second—here’s a link to his first. It’s such an unusual thing that I think it’s a sign that the Powers That Be are really quite worried. As they should be. His last interview was at the height of the crisis in early 2009. L: Bernanke himself looked worried. I was amazed, actually, watching the interview, by just how nervous and stressed he appeared. He stuttered, his lip quivered continuously, and that pulsing vein on his forehead really stood out throughout the interview. He looked like he was flat-out lying and doubted anyone would believe him, but had no choice but to keep lying. It was almost like a cartoon of a liar caught red-handed. It’s a shocker that the Powers That Be would let such an interview be aired—it would seem to be the opposite of reassuring, to me. D: I know. It’d be nice to run that interview through a voice stress analyzer and see what it says. It’s a question of whether he’s a knave or a fool—neither answer is bullish for the U.S. economy. He’d be wonderful to play poker against. He’s not a skilled or enthusiastic liar, but he is certainly becoming more practiced at it, which is, of course, par for the course of being Fed chairman. That aside, the interview is really interesting, because there are several times in the interview when he really comes across as being scared and warning people: the way he stressed how close to the edge of a precipice the economy was, and how troubled it remains. L: Well, that was the reason given for the interview. He says the critics of his latest $600 billion shot in the economy’s arm don’t understand how serious things are, how dangerous the high unemployment rate is. D: Yes, of course he’d say that. You know my argument is that “doing something” is a mistake, if it’s based on incorrect economics. Everything they are doing is not just the wrong thing, it’s the opposite of the right thing. L: So, do you believe Bernanke was actually lying? Or was he just highly stressed, because he’s the one in the hot seat, and he knows that just because the Titanic didn’t sink the moment it hit the iceberg, that doesn’t mean it’s out of danger?

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5

D: Perhaps it’s a bit like Hitler in the bunker, who was under great stress, and really wasn’t lying when he insisted that the Third Reich could still win the war. In fact, I can’t wait to see if someone does one of those “Hitler in the bunker” spoofs, based on this interview. L: I wouldn’t be surprised to see one posted on YouTube tomorrow. Meantime, Jon Stewart skewers Bernanke admirably in a recent skit on his show. D: Actually, someone just did one of those “Hitler in the bunker” spoofs on manipulation of the silver market—which, incidentally, I don’t believe is a reality. But it mentions our redoubt at La Estancia de Cafayate. There’s a lot of very rich and colorful language, which some people won’t like, but it’s very funny. L: Warning to readers: That video is not family-friendly. So, lying aside, let’s look at some of the things he said. The first and foremost thing that jumps out at me is that he says the Fed is “not printing money” and that the Fed’s actions have no significant impact on money supply. How can he imagine they can inject liquidity into the economy, and that it won’t have any impact on money supply? D: I think he knows better than that. Look, what the Fed has been doing is buying securities. And the way they do that is to credit the account of the seller with dollars. So, of course it creates money. That’s why they call it “quantitative easing”—because they’re increasing the number of Federal Reserve units in circulation. I really love that term, QE, because it’s so cynically dishonest, like the whole monetary system itself. And it’s amazing that nobody even challenges it. They just accept it instead of calling it what it is—printing money. It’s Orwellian. In any event, creating more currency units by buying government bonds serves several purposes, from their point of view. It raises the prices of bonds, and therefore pushes interest rates down—and they want lower rates because it makes it easier to finance the staggering amount of debt out there that threatens to collapse the system. And they want more currency units out there because that makes people feel richer, consume more, and that props up preexisting economic conditions—which are actually unsustainable. The crash prompted them to buy toxic paper from banks for a while, to keep them from going under. Now they’re buying U.S. treasuries again, with the latest $600 billion.

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Bernanke is taking desperate measures to solve an acute problem. But their consequences will be disastrous—much, much more damaging than if he’d done nothing. Of course if he did nothing, the system would collapse through a deflation: bonds would default, banks would close. What will now happen is the currency itself is going to be destroyed, which is much worse. But since it’s put off a bit further in the future, that’s the course he’s taking. L: Agreed. In spite of what Bernanke says, whatever the sellers of the securities do with the new dollars deposited to their accounts—even if they leave them on deposit with the Fed because the Fed is now paying interest for excess reserves—it still frees up other money the sellers can now use for other purposes. And because of the fractional reserve system, there’s a multiplier effect on the added liquidity. Bernanke says that all he’s doing is keeping interest rates down to stimulate the economy, but the way he’s doing it adds to the money supply. D: Exactly. We’re beyond the time when you have to cut down trees to print up hundred dollar bills. It’s just a keystroke, now. But playing with the amount of currency doesn’t create new wealth—it actually makes real wealth creation much harder. So as the situation gets more serious in the months and years to come, you can expect ever more ad-hoc measures from the government. They’ll probably try capital controls, to keep people from transferring wealth outside the U.S. Those will be popular because only “unpatriotic” people would do such a thing, as well as rich people—and it’s now time to eat the rich. They’ll likely require all pension plans to buy a certain amount of government securities. They’ll have restrictions on the amount you can spend on foreign travel. They’ll probably even try price controls, like Nixon did in the early 1970s. They’ll increasingly limit what can be done with cash—like the new requirement that all transactions of any type above $600 must be reported on 1099s—because digital money is much easier to control. New government bureaucracies will be set up to enforce all these things, and many more. L: Scary. Does it mean anything for Bernanke to say that the $600 billion came from the Fed’s “own reserves”? Where would the Fed’s

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7

reserves come from, if not from electronic dollars newly created at the stroke of a computer key? D: No. That’s a cynical lie. I think what he was trying to stress was that the money was not coming directly from taxes. The Federal Reserve is a misnomer. There is no reserve, as there was in the days when the gold at Fort Knox backed the dollar. Now, the dollar isn’t backed by anything, so there’s nothing to reserve—they can and do create as many dollars as they want, as ledger entries, which they can and do use to pay banks and others, who can and do use them to pay others, and so forth. It’s not a “reserve,” and it’s not “federal.” Although the Fed is a creature of the government, it’s not, technically speaking, part of it. It’s really controlled by the large banks, who benefit primarily through “fractional reserve” banking. In the past, when banks were just ordinary businesses that warehoused money and acted as brokers for loans made with savings, keeping a fractional reserve was a fraudulent practice that would eventually result in bankruptcy, followed by criminal charges.The creation of central banks, like the Fed, facilitated it as common practice; in effect, debt became a form of money. This isn’t the forum to explain the subject in detail; I’ve done that in my books. But we’ve now reached the inevitable consequence of the system, which is a financial cataclysm. Bernanke is trying to forestall the inevitable, and in the process is making it worse. As Louis XV correctly observed, “Après moi, le déluge.” L: Deluge indeed. You can see the out of control growth of what they are doing in any M2 money supply chart. Ancha Casey [Doug’s wife]: Mfmmmf mmmfmf. L: Hi Ancha—I didn’t catch that. Ancha [Leaning closer to Doug’s mic]: Hi Lobo.That growth of money supply erodes purchasing power. One peso here in Argentina today is worth one trillionth—literally—of its value at the beginning of the twentieth century. D: Yes. It really amounts to an indirect form of taxation: As more dollars are created, they dilute the purchasing power of the dollars already in existence—though we call it inflation. The first organizations and people to get those dollars are able to spend them at their old

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RIGHT ON THE MONEY

value. And, of course, the government—which is not the country or the people, but a group with its own identity and interests—gets to spend as many as it wants on what it wants. And now the numbers are moving into the trillions. Obama may soon have to ask his science advisor what comes after “trillion.” It’s all a charade. L: Inflation is taxation through dilution. But most modern economists don’t think inflation is the result of excess at the printing press, so whether Bernanke is lying, or just doesn’t see the danger of what he’s doing, it doesn’t look good. D: That’s right. Most economists blame inflation on the butcher, the baker, or the candlestick maker raising their prices for other reasons than the loss of purchasing power of the currency. They attribute inflation to “greed” on the part of producers and workers. The problem is a totally fallacious basic theory of economics. Almost all the “economists” coming out of school today aren’t actually economists. An economist is someone who describes the way the world works. But these people—Bernanke being a perfect example—aren’t interested in describing the way it works. Rather, they want to prescribe the way they want it to work, and then get the state to enforce their views on society.The state, of course, welcomes such advice when it serves its agenda. Bernanke has a high IQ, but he’s just an uninteresting and unoriginal suit. He grew up with the reigning orthodoxy, got his PhD in it, taught it, and has been rewarded with the leadership of the world’s largest central bank. But he’s not an economist. He’s a political apologist. And, I suspect, he’s now a very confused and scared one. Perhaps he can see that the ridiculous theories he’s grown up believing in are more phony than a Federal Reserve note. But he doesn’t dare admit it. L: Maybe we could buy one of the thousands of mirrors in Mugabe’s house in Zimbabwe and send it to Bernanke, as a gift. To look at himself, and perhaps see where the problem lies. D: It won’t help. The fundamental problem we have is an unsound money system, and no amount of fiddling with it will make it work well over any extended period of time. All fiat currencies follow one of two paths. One is when they keep printing more money to keep the ball rolling, which is what Bernanke’s doing. Or they stop

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Doug Casey on Bernanke: Be Afraid, Be Very Afraid (Part One)

9

printing money, in which case banks go bust, insurance companies go bust, and all sorts of corporations go bust, throwing the economy into a catastrophic deflation. The latter is the better alternative, sad to say. There’s no painless way out of this, at this point. Bernanke is caught between the Scylla of deflation, which would liquidate the inefficient part of the economy, and the Charybdis of inflation. He’s chosen Charybdis—the whirlpool—which will take the whole economy down. L: Bernanke did specifically say in his interview that the Fed had to take action because there was a serious threat of deflation, which was the problem with the Great Depression. D: Bernanke is afraid of deflation, because at this late stage, it would be extremely dramatic and immediate. In a free-market economy, neither monetary inflation or deflation are realistic problems, because gold is used as money, and the supply typically rises by only a small amount every year—and it almost never declines. But deflation is actually a good thing. Deflation may cause some wealth to change ownership, as any change can, but deflation does not destroy wealth, as inflation does. And deflation can be a very good thing because when dollars are worth more over time, it encourages people to save—and one of our big problems is that nobody’s saving. People don’t save because today’s artificially low interest rates are beneath the actual inflation rate, so of course nobody wants to save. But the only way to become wealthy is to produce more than you consume and save the difference. Banks can’t make loans unless, first, there are savings.This makes deflation’s reward to savers a very important positive. L: Bernanke says that falling prices would lead to lower wages, which would send the whole economy into decline. D: That’s an old fallacy. If all prices fall, including the price of labor, so does the cost of living, and no one is worse off . The price of labor would have to fall faster than the price of food, rent, et cetera for people to be hurt, and it does not follow automatically that this would be the case. If the butcher doesn’t have to spend so much for bread, maybe he doesn’t have to charge the baker so much, and both might be able to put aside a little more to save up for new goods from the candlestick maker, or to invest, or to create new businesses, and hire more people, which could actually drive wages up.

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RIGHT ON THE MONEY

L: Wages may be influenced by inflation or deflation, but are not really set by them.What determines wages is productivity; how much value does the laborer create, and what can he or she trade for that value? D: Exactly. And you get increases in productivity from capital creation, which arises from saving and investment. What this all boils down to is that you can’t create wealth by printing money. That just debases wealth and distorts the economy. L: Seems hard to believe Bernanke can’t understand such a simple thing. D: Well, the whole system is so precarious at this point that it may be quite accurate to label the Fed’s actions as “panic.” [Bernanke] said several times in the interview that he had to act—“aggressively” and “proactively”—to save the system. But you can’t save a system that’s built on quicksand—a fiat currency. The whole thing ought to be flushed away, along with the whole crazy-quilt work of Keynsian economics that most students are educated in. It’s strange. It took the catastrophic collapse of the USSR and other socialist states to prove to all but the most dogmatic ideologues that Marxism was a sociopathic scam. It may take the collapse of the United States and the Western world to put the lie to Keynes. If so, then the sooner the better. L: A lot of people would go down with that ship. D: Yes.The whole business of the United States, its “consumer economy,” has really become banking and finance. Everyone is buying and selling and trading electronic ghosts in between institutions, derivatives piled on derivatives, all magnified by the fractional reserve system. Or they provide services to those who do, paid for with meaningless accounting fictions that go back to the banks to pay for maxed-out credit cards. Nobody’s thinking of actually producing things of value. The whole thing is a completely ridiculous house of financial cards. People have forgotten the basics of banking, which are that a bank was a place where you deposited real money—mostly gold. There were time deposits (savings) and demand deposits (checking). The banks paid you some small amount when you deposited savings for some agreed upon period of time, typically about 3 percent, and made money lending it out at 6 percent. And banks charged you a small fee for the service of keeping your demand deposits liquid and paying them out to you or to whomever you gave your bank notes,

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11

or checks. That was it; banking was and should be no more exotic than a pawn shop. But nobody believes this is the way things should be anymore; there’s no way back without hitting the reset button. That’s why I think the whole system has to—and will—collapse. L: So you’re not buying Bernanke’s line that they are simply lowering interest rates to stimulate economic growth? D: No. Aside from the fact that paying for this stimulation increases the money supply, stimulating growth through artificially low interest rates is the opposite of what they should be doing. It encourages debt and spending—living beyond your means, which is what the whole country has been doing for decades. They shouldn’t be in a position to do anything—the Fed should be abolished. But, if anything, they should be raising interest rates to encourage savings. That’s how wealth is accumulated, and wealth is what’s needed to invest in new businesses and technologies, not to mention keeping yourself alive. L: And unfortunately, in lowering rates to stimulate the economy, Bernanke is simply following the recipes of mainstream economists, so there seems to be little chance that he or anyone in power will realize the disastrous course they are on. D: The chances are Slim and None, and Slim’s out of town. The trouble with mainstream economics, the way it’s taught in most colleges today, is that it’s like sociology, or English literature, or gender studies: It’s based on theoretical castles built in the air—no reality whatsoever. And [this is] of negative value in the real world. But, fortunately, the education system we suffer with today will also likely be washed away in the deluge. L: That reminds me of the part of the interview in which Bernanke was asked if the Fed would be able to rein inflation in, should it appear. It was one of two questions he jumped on without hesitation, saying that inflation was not a problem. He could raise interest rates in 15 minutes, if necessary, and that would quash inflation. Made me wonder what planet he was living on, to imagine that after he’s gone down the path of Mugabe, simply raising interest rates would restore purchasing power to the dollar. Even in recent memory in the United States, we’ve had high inflation and high interest rates—we call it stagflation. How could he not know this?

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RIGHT ON THE MONEY

D: It just goes to show what a bad economist Bernanke is. The whole science of economics is not about seeing the immediate, direct, and obvious effects of any given economic policy—a smart six-year-old can do that. It’s about seeing the indirect, hidden, and long-term effects of that policy. If the Fed goes into the bond market and buys a trillion dollars’ worth of bonds, the short-term and fairly straightforward effect will be for bond prices to go up and interest rates to go down. But the indirect and delayed effects from the creation of a trillion more currency units are inflationary, and eventually it will force even the interest rates back up again, because people won’t lend unless they can charge a rate that will more than make up for the lost purchasing power of the inflated currency. L: The seen and the unseen. Is it possible that Professor Bernanke has never read Bastiat? D: [Laughs] Don’t make me laugh. That’s old-fashioned stuff, Lobo. The Great Depression disproved classical economics, don’t you know? Now we have new economics—all built on quicksand, as I say, and that means the whole house of cards is doomed.

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The Little Book of Venture Capital Investing Empowering Economic Growth and Investment Portfolios Louis C. Gerken 978-1-118-55198-1 • Hardback • 288 pages • February 2014

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t e r On

MA TE RI

AL

e

ap Ch

An Historic Overview of Venture Capitalism

PY RI G

HT

ED

Those who cannot remember the past are condemned to repeat it. —George Santayana

Why is an historical overview of VC important? Because

CO

history does in fact repeat itself, and a study of history allows us to frame an understanding of the present and the future. The players and the investment climate change, but the entrepreneur’s innate instinct to risk capital for a return is no different today from what it was when John D. Rockefeller became America’s first billionaire in 1900. When Andrew

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The Little Book of Venture Capital Investing

Carnegie joined forces with his childhood friend, Henry Phipps, to form Carnegie Steel in 1892, they were driven by the same conviction to improve the status quo as are the idealistic dream chasers of the twenty-first century. It was these early trailblazers who paved the way and developed the techniques that have laid the foundation for VC as we know it today. Arguably, historians will debate the nature of history and its usefulness. This includes using the discipline as a way of providing perspective on the problems and opportunities of the present. I believe it to be an important tool in providing a systematic account and window to the future. It is patently dishonest and irresponsible to perpetuate the popular mythology that those who created great wealth in America are to be despised and that there are no useful lessons to be learned from an objective, historical review of their contributions to the subject at hand. As John F. Kennedy said, “To state the facts frankly is not to despair the future nor indict the past. The prudent heir takes careful inventory of his legacies and gives a faithful accounting to those whom he owes an obligation of trust.�1

In the Beginning On Sunday, May 23, 1937, John Davison Rockefeller, Sr., died just 46 days short of his 98th birthday. He left behind what is arguably the single greatest fortune ever amassed by a

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single businessman. He began accumulating his wealth on September 26, 1855, when he became the 16-year-old assistant bookkeeper at Hewitt & Tuttle, a commission merchant and produce shipper in Cleveland, Ohio. Three years later, he left Hewitt and formed his own commission merchant house with his friend Maurice B. Clark, using money he had saved from his $25 monthly salary and $1,000 borrowed from his father at 10 percent interest. It was during this initial period of managing a business, struggling week to week to make weekly payroll, that he discovered his innate abilities to quickly size up an opportunity, evaluate the risk-reward, and negotiate a path forward. By December 1862, Clark & Rockefeller was a going concern, making more than $17,000 annually and occupying four contiguous warehouses on River Street. That same year, the partners invested $4,000 of company profits with a chemist named Samuel Andrews. Andrews had developed a cost-effective method for distilling kerosene from crude oil. The partners built the Excelsior Oil Works and commercialized this process, providing a cheap and efficient means of lighting to the masses. Rockefeller was able to buy out Clark in 1865 by borrowing funds based solely upon his business reputation. He went full-time into the oil business, building another refinery called the Standard Works. On January 10, 1870, the partnership with Andrews was dissolved and replaced by a

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The Little Book of Venture Capital Investing

joint-stock firm named Standard Oil Company (Ohio). Sales of stock generated $1 million in capital and Standard oil controlled 10 percent of the nation’s petroleum refining business.2 This business model served for many years as a fairly standard template for how businesses or ventures were formed and financed or capitalized. Business founders would use their own money and whatever money they could borrow from family, friends, and anyone else who would listen to their ideas for a new or improved business. The people who invested the early money usually did so based upon the founder’s ability to sell them on the capability of the idea to solve a problem or provide a much needed service for which the public would clamor. This became known as seed capital and was usually less than $1 million. It was risky at best and often required early investors to wait until the enterprise was a profitable, going concern before they could realize a return on their investments. If a founder came up with a very good idea, he could sometimes gain financing from an angel investor. These were often wealthy individuals who would invest their own money into the enterprise in exchange for either some form of convertible debt, such as a 10-year bond which could be converted into stock or cash upon maturity, or in the form of a percentage of ownership of the new company or equity. As all wealthy people quickly discover, the image of Scrooge McDuck romping and rolling around in his

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[5]

private vault on piles of gold coins and bags of currency is only true in the make-believe world of comic books. Wealth will be depleted over time if not put to work. Taxes, inflation, expenses, and frivolous spending have caused more than a few lottery winners to end up in financial straits within a very few years. Enough stories abound about spoiled, entitled trust fund beneficiaries who completely squander their inheritances that there is an ageless proverb that says “there’s but three generations from shirt sleeves to shirt sleeves.” Money must be put to work by being invested, either in expanding one’s own business or in someone else’s venture.

The Roots of Venture Capital Carnegie Steel Company was sold to the United States Steel Corporation in 1901 for $480 million, of which about half went to founder Andrew Carnegie. The second-largest shareholder was Carnegie’s partner, Henry Phipps. In 1907, Phipps formed Bessemer Trust as a private family office to manage his fortune. Four years later, he transferred $4 million in stocks and bonds to each of his five children and Bessemer Venture Partners was launched. It is regarded as the nation’s first venture capital firm. According to the company’s website (www .bvp.com), they currently manage “more than $4 billion of venture capital invested in over 130 companies around the world.”3

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Laurance Rockefeller inherited his grandfather’s seat on the New York Stock Exchange in 1937 and wasted no time investing his inheritance in his passion, aviation. In 1938, he provided $3.5 million for Eddie Rickenbacker to purchase Eastern Airlines and invested in the McDonnell Aircraft Corporation. The Rockefeller Brothers Fund was founded in 1940 as a philanthropic foundation, to allow Laurance and his siblings a vehicle through which to provide grants that promoted the noble ideals of democratic practice, sustainable development, and peace and security around the world. Laurance supported the fund, but saw an opportunity to provide an investment vehicle for his siblings and other wealthy individuals. In 1946, he founded Rockefeller Brothers Fund, Inc., as a limited partner investment firm. The firm was one of the first to establish the practice of pooling capital in a professionally managed fund. In 1969, the company changed its name to Venrock Associates. Venrock has been one of the most successful venture capital funds and has provided early funding for startups of such Silicon Valley giants as Intel and Apple Computer. While Venrock’s primary focus could be said to be firms involved with medical technology, they have spread their investments across biofuels, vehicle technology, mobile/social/digital media, software as a service (SaaS) and enterprise, and security.4 The post–World War II years saw rapid growth in this new style of development capital investing. John Hay “Jock”

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Whitney, another scion of nineteenth-century American wealth, spent the 1930s and the early 1940s living the archetypical high society, polo-playing playboy lifestyle, investing his $100 million trust fund in the fledgling motion picture industry. In late 1945, Jock Whitney had an epiphany. He enlisted a fraternity brother named Benno Schmidt, a tall Texan with working-class roots, to be his business partner. J.H. Whitney & Company (JHW) was founded in 1946 to finance entrepreneurs who were returning from the war with great ideas, but whose business plans were less than welcome at traditional banks. Schmidt is often credited with coining the term venture capital as a replacement for development capital, although there are earlier uses of the phrase. One of Whitney’s earliest and most famous investments was in the Florida Foods Corporation, later known as Minute Maid orange juice. Today, JHW remains privately owned by its investing professionals, and its main activity is to provide private equity capital to small and middle-market companies with strong growth prospects in a number of industries including consumer, healthcare, specialty manufacturing, and business services.5

The First VCs The influence of Jock Whitney in the world of venture capital doesn’t end with JHW and Minute Maid. In 1957, he recruited David Morgenthaler to serve as president and CEO of Foseco, Inc., a manufacturer of industrial chemicals in the

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J.H. Whitney & Co. investment portfolio. Morgenthaler made the company a multinational success before stepping down in 1968 to go into venture capital himself. He founded Morgenthaler Ventures in Cleveland and Menlo Park. Fortythree years later, the firm is still going strong. Morgenthaler Ventures has worked with over 300 young companies, including dozens of biomedical startups. Morgenthaler also served as a founding director of the National Venture Capital Association (NVCA) from 1977 to 1979.6 The year 1946 also saw the launch of the American Research and Development Corporation. ARDC was the brainchild of Georges Doriot, a business professor at Harvard before the start of World War II. Upon enlistment, he was given the rank of Brigadier General in the U.S. Army and served as Deputy Director of Research at the War Department. Working in concert with U.S. Senator Ralph Flanders of Vermont and MIT president Karl Compton, Doriot developed financial vehicles that allowed private sector participation in the war effort through investments in the manufacture of weapons, equipment, and supplies. After the war, Doriot continued his partnership with Flanders and Compton in ARDC. It is often called the first actual venture capital firm because it was the first to raise funds from institutional investors: $1.8 million raised from nine institutions, including MIT, the University of Pennsylvania, and the Rice Institute. ARDC also became the first private equity firm to operate as a

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publicly traded closed-end fund when it collected $1.7 million in a 1966 public offering. These innovations earned Doriot the moniker of “the father of venture capital.” Doriot’s best move, however, was his 1957 decision to invest $70,000 with MIT engineers Kenneth Olson and Harlan Anderson to start the Digital Equipment Corporation (DEC). Following DEC’s IPO in 1968, the value of ARDC’s stake had grown to $355 million. The success gave an early boost to high-tech development along Boston’s Route 128 and demonstrated the viability of the venture capital investment model. And, just like at J.H. Whitney & Company, ARDC employees went on to make their own mark in the world of venture capital. Bill Elfers had been the No. 2 employee at American Research & Development. When he left ARDC in 1965 to form Greylock & Co., he decided not to follow the restrictive public funding model. Instead, he operated as a limited partnership, now the typical structure for venture firms, and raised $10 million from six limited partners. A second fund followed in 1973, and last November, what’s now called Greylock Partners announced it had closed the $575 million Greylock XIII Fund.7

Shockley Chooses Silicon The entire VC industry has evolved from these kinds of fraternal, sometimes internecine relationships of people being brought in to work at a firm and then deciding that they

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The Little Book of Venture Capital Investing

would be happier on their own. There is no better illustration of this than the story of the Traitorous Eight. William Bradford Shockley Jr. (February 13, 1910 to August 12, 1989) was an American physicist who co-invented the transistor along with John Bardeen and Walter Houser Brattain. All three were awarded the 1956 Nobel Prize in Physics. Shockley grew up in Palo Alto and did his undergraduate studies at the California Institute of Technology (Caltech). He moved to Boston to complete his PhD at MIT and immediately started working at Bell Labs upon graduation in 1936. Despite his brilliance, Shockley was said to be “not terribly socially adept and didn’t understand what motivated people very well.”8 An example of this is the story that he left Bell Labs because the company listed Bardeen, Brattain, and Shockley in alphabetical order on the transistor’s patent; he felt his name should have been listed first because of the importance of his contribution. Whatever the reason, he returned to Caltech in 1953 as a visiting professor. Shockley had become convinced that the natural characteristics of silicon meant it would eventually replace germanium as the primary material for transistor construction. Texas Instruments had started production of silicon transistors in 1954, and Shockley thought he could improve upon their developments. Arnold Orville Beckman, founder of Beckman Instruments and one of Shockley’s few friends,

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agreed to back Shockley’s research in this area as a division of his company in Pasadena, California. Shockley’s mother was in declining health at the time, and he wanted to be closer to her home in Palo Alto, so a compromise was worked out. In the summer of 1956, the Shockley Semiconductor Laboratory division of Beckman Instruments opened operations in a small building located at 391 San Antonio Road in Mountain View, California. Shockley tried to hire some of his former workers from Bell Labs, but none of them wanted to leave the high-tech research corridor that was developing along Route 128 around Boston. Instead, he assembled a team of young scientists and engineers from the West Coast. They began researching a new method for producing a cylindrical arrangement of single-crystal silicon.9

The Traitorous Eight

Continues...

In October 1957, eight of these young and equally talented engineers reached the end of their ability to tolerate Dr.  Shockley’s management style. They quit the Shockley Semiconductor Laboratory and formed Fairchild Semiconductor in Mountain View. Legend says it was Shockley who branded them as “the traitorous eight” but it was really a moniker that was applied by a newspaper reporter several years later.10 Fortunately, the group was helped and guided by a young financier named Arthur Rock. Rock was a forward-looking

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Emerging Markets in an Upside Down World Challenging Perceptions in Asset Allocation and Investment Jerome Booth 978-1-118-87967-2 • Hardback • 280 pages • March 2014

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1 Globalisation and the Current Global Economy ‘Globalisation should not be just about interconnecting the bell jars of the privileged few.’ De Soto (2000, p. 219) ‘The benefits of globalization of trade in goods and services are not controversial among economists. Polls of economists indicate that one of [the] few things on which they agree is that the globalization of international trade, in which markets are opened to flows of foreign goods and services, is desirable. But financial globalization, the opening up to flows of foreign capital, is highly controversial, even among economists …’ Mishkin (2006) In this chapter we discuss some of the background to attitudes towards money and debt. We explore the historical erosion of despotic power. We aim to understand globalisation, both ancient and modern, identifying the trends most important for current events and policy actions.

1.1

What is globalisation?

Globalisation has been through a number of cycles including in the nineteenth century period of free trade.1 The term requires careful use: its range and ambiguity in common parlance can cause misunderstanding. Globalisation is both a state and a process. It has an economic facet, perhaps best described as the greater interconnectedness of trade and investment as transactions costs and barriers reduce, but also the idea of lack of constraint on markets by government. It is this element that investors are ultimately most interested in. But globalisation also has a technological aspect (not distinct from the economic aspect), notably as represented recently by innovations and speed in modern communications. And it has a cultural facet, as exposed in the spread of common means of entertainment and ideas. It homogenises, and through standardisation commodifies, but also creates diversity of choice; complicates and simplifies; brings benefits and conflicts; produces winners and losers. For emerging markets today, globalisation accelerates convergence to the living standards of developed markets. For some, in a world in which the voices of those with something to lose are louder than those who gain, the term is laced with emotive content, often negative, and while it creates jobs and wealth, globalisation is, for many, associated with job losses and erosion of local values. 1 The term has many definitions and while Findlay and O’Rourke (2007, p. 108) argue that globalisation may have begun with the Mongol unification of the Eurasian land mass, that process is a distant shadow of what is called globalisation today.

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Ridley (2010) argues that, among other things, it was trade which propagated innovation, technology and civilisation, as do Findlay and O’Rourke (2007). Jane Jacobs in her book Systems of Survival (1992) uses a Platonic dialogue to describe the different logics of politics, which is a zero-sum game, and commerce, a positive-sum game. Nations have historically competed for scarce territory, which, if one gained, another must lose; whereas both parties gain from a trade freely entered into. If we want to avoid conflicts, commerce has a positive role to play. It is no mere historical coincidence that periods of protectionism and limited international trade often precede wars. The failed logic of isolationism and of fighting over land and other limited resources leads from mercantilism to gunboats, to strategic invasions of third countries, and to empire. Empires fall, however, or at best are managed into relative decline. The human tendency to barter and trade is certainly older than recorded history, and has long been geographically broad in extent. Though this is a generalisation, in the progress of greater economic interconnectedness there are waves, affected by human policy and history, as well as trends, driven by technology. Wars of the ‘hard’ and trade variety, restrictions on economic activity and trade, mass migration and natural disasters have all been disruptive but also sometimes stimulate innovation and new forms of economic activity. In contrast, political stability and incentive structures compatible with innovation have generally nurtured both existing patterns in trade and globalisation. Braudel (1998) in his history of the ancient Mediterranean world argues that early transhumance (seasonal migration between summer and winter pastures) established a pattern of seasonal trade in the region. The world has clearly seen ebbs and flows in the extent of trade links and civilisations. Toynbee (1946) and others have categorised the rise and fall of civilisations, and with them trade and international links. The story of lack of stability wreaking havoc on economies and trade has repeated itself many times. Globalisation can and does ebb as well as flow. Technology has reversed on occasion as inventions have been forgotten once civilisations collapse. Our European Renaissance is in name a rediscovery. Arguably, however, it takes the destruction of civilisation to reverse technology, and in the modern era, as during periods of stability within earlier civilisations, it has been tenacious and non-reversible. Technology profoundly impacts globalisation. It can aid economic growth, productivity and, by reducing transport costs, trade. Technology, by changing relative prices, also changes our institutions, as Douglass North (1990) has taught us. For example, technology effects disruptive upheavals in communication from time to time. Neil Postman (1985) has described how the written word, printing and then newspapers changed the pace and nature of interconnectedness. For example, in the 19th century, the telegram helped create the commercial success of newspapers and their news – the interest and novelty of new information from a long distance being of interest primarily, if not solely, because it was new. This ‘news’ content eroded and then eclipsed more considered thought, telescoping cultural knowledge and political debate to focus more heavily on the near present. Thus with the telegram came the modern newspapers, and with them came trivia, including the invention of the crossword puzzle – to test the reader’s knowledge of news trivia. Subsequently broadcasting has impacted our communication patterns: for example, in the 1850s US presidential candidates would deliver speeches several hours long in public debates, long enough to justify meal breaks. That voters would spend the time to listen to such debates, and that they could comprehend the complex structured paragraphs which were so characteristic, stands in stark contrast to the norm of exchange so typical today.

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Have we since ‘dumbed down’, and does the process of globalisation contain a series of dumbing-down episodes? Not entirely: the telegram, newspapers and then radio and television created a breadth of participation in culture not previously experienced. Political debates became less elitist and more inclusive, with more elite communication and interaction continuing, but less dominantly – less unchallenged. The perception of dumbing down, and indeed the collapse of our sense of history to a more myopic immediate past, is clearly a strong one but not just a 19th-century one. The impact of television is an issue studied by Postman and especially in the post-Second-World-War US context by Robert Putnam (2000). His book Bowling Alone created a vigorous debate about whether television has been the main factor behind the postwar decline of US civic culture (an example of which has been the decline of community bowling alleys). Cries of ‘Dumbing down!’ go all the way back in history. The move from the oral tradition to the written word was lamented in ancient Greece and seen as destructive of the memory skills developed in the time when Homer’s ‘Iliad’ and ‘Odyssey’ – arguably still the greatest epics of literature – were related by word of mouth.2 Broad access to books, particularly the Bible in 16th-century Europe, facilitated religious revolution and war. Dumbing down may look sacrilegious to an elite,3 but while it may represent a destruction of the means of valuable interchange of ideas, at the same time it can be revelatory and intellectually enriching for many more people not previously communicating with each other. Technological change in the media has been not only traumatic but also irresistible as old technologies have been replaced. It affects the way newer generations think and interact. There is a feeling of erosive unstoppable destruction of the old as globalisation, via new media, invades. New technologies and the young bring myopia and collective amnesia. Older generations and traditional societies alike feel the tension as their children and communities adopt new modes of speech and ways of thinking and abandon the past. And this is not new. We may fear (or embrace) such change but we can’t credibly blame (or give all the credit to) our children. Globalisation may be a more convenient and acceptable receptacle for our emotional discomfort. Modern communications have massively increased information flow, and the technologies of the Internet and mobile phone have leapfrogged older technologies in many developing countries.4 As with technological change before, much of this is inexorable and non-reversible. Knowledge of the wider world and aspirations for a better life combine in emerging countries to increase awareness. As populations become more vocal, this leads to pressure on elites for political and economic reform at home. Economic growth and international competitiveness is in part the result of greater entrepreneurial opportunities. Others leave and migrate to the developed world, competing in labour markets there. Either way, the result is greater economic competition with the developed world, which either has to adapt or face job losses from increased competition. Thus many in the developed world feel threatened by globalisation, while at the same time it opens vast new opportunities to many in developing economies. Part of globalisation is significant international trade, and also substantial cross-border flows of factors of production (capital, labour, technology). These flows take advantage of See also Gleick (2011) p. 48 for more recent examples of complaints about the loss of oral culture. See for example Judt (2010, p. 172): “In the US today, town hall meetings and ‘tea parties’ parody and mimic the 18th century originals. Far from opening debate, they close it down. Demagogues tell the crowd what to think; when their phrases are echoed back to them, they boldly announce that they are merely relaying popular sentiment.” 4 See for example Jeffrey, R., and A. Doron’s The Great Indian Phone Book (2013). 2 3

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pricing differences, but in the process, also help reduce them – globalisation helps move the global economy towards an equalisation of returns to factors of production. It also involves multilateral production, and with it the spread of ideas and technology. There is greater openness to foreign inward investment. There is competition between governments for that investment, and for the jobs and knowledge which come attached. Different parts of the same production process may take place in several countries, exploiting comparative advantages. This is made possible by sufficiently low levels of protectionism and reliable low cost transport.

1.2 Economic history and globalisation To concentrate on the economic facets of globalisation, it may be useful to consider its historical precedents. Large-scale globalisation is not new. Maddison5 argues that ‘[i]n proportionate terms, globalisation was much more important from 1500 to 1870 than it has been since. A great part … due to gains from increased specialisation and increases in the scale of production’. International trade and capital flows are much larger today, but so is the global economy. There was an interruption as the world went to war in the 20th century, and then protectionism was only reduced gradually, but globalisation is clearly not a novelty. There are also long economic waves of concern with inflation and deflation. Allen (2005) for example argues that the inflation of the 1970s was partly born from the concern over employment that had previously dominated since the Depression, and similar long waves have been picked by many others since Kondratiev (1925). Kaplinsky (2005) makes a comparison between the late 19th and early 20th century period of internationalisation on the one hand, and on the other hand the period of globalisation starting in the late 20th century. He comments on the different mix of goods traded, and on the different migration patterns – of the poor in the earlier phase and the skilled and a greater proportion of the monied in the latter.6 He also points out7 that there is a high correlation between effective financial intermediation and economic growth, but that excessive volatility can reduce growth. Hence policymakers often want the competition, ideas and capital which come with openness but are concerned about volatility. Although portfolio investors are not necessarily short term in their outlook, some policymakers – not liking potential volatility in their exchange rate driven by short-term changes in cross-border portfolio flows – are attracted to the idea of discouraging portfolio flows through taxing capital inflows rather than trying to attract more long-term stable investors. Yet trying to prevent inflows rarely has more than a temporary impact on the exchange rate; given inevitable efforts to bypass the restrictions, it can encourage speculative pools of capital and discourage longer-term flows. Hence the simple mantra that characterises

Maddison (2007) pp. 78/9. He also asserts that the recent period saw short-term as opposed to long-term capital flows. Yet, although the speed at which financial transactions can occur has quickened, there were in both periods crises involving short-term bank loans as well as longer-term bonds. Moreover, after the Brady plans and certainly since the Russian crisis of 1998, as we shall relate in more detail in Chapter 2, the dominant investors in emerging debt moved from those with more speculative motives to those with long-term liabilities making strategic allocations. Markets have remained liquid and on occasion volatile, but both the bonds and the timeframes of the investors are now longer term. 7 p. 78. 5 6

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portfolio flows as speculative and thus undesirable may be misplaced. Indeed, efforts to restrict such flows can result in more not less volatility.8 1.2.1

the desire to control and its impact on trade

Why do simple policy measures to reduce volatility so often backfire? Today’s environment is one of economic complexity, economic liberty and freedom of thought and action. There is a lot of uncontrolled international movement of goods and capital, whereas in the preindustrial past the movement that did exist was smaller and simpler. The state may have become less able to impose direct control on the mass of individuals and firms, but many have also become more sophisticated at indirect control and at exploiting the behaviour of firms. As Lucas (1976) pointed out in the so-called ‘Lucas critique’, the use of aggregate macroeconomic data to predict the effect of policy changes can be frustrated. This is due to the behaviour captured by such aggregate data not being independent from policy, but affected in complex ways. Political control in many spheres has changed. It has been decentralised in some cases as smaller groups have asserted themselves and the centre become less powerful, such as during the fall of Rome in the 4th century, but also due to deliberate delegation of responsibility downwards. In other spheres power has centralised, and many of the problems faced by policymakers today require action above the level of the nation-state to be effective, including some aspects of anti-terrorism and environmental policy. As people’s identities and loyalties have multiplied and become more complex and global, identification with the state has also changed, and the degree to which countries can co-opt their citizens in certain ways. But democracy and well-being are both probably strengthened by this greater complexity. The multiplication of special interests, competing with each other, reaches a point beyond which any central source of political power can command a majority of support whatever mix of policies is chosen. Democratic institutional forms constitute instead legitimising filter mechanisms, the function of which is not merely to create compromises between political groupings but also to allow all politically active groups and individuals to accept and abide by these compromises. Such decentralisation of power is incompatible with authoritarianism. Authoritarian governments fail when their populations no longer acquiesce to their policies. Today, the freedom of action which comes from the failure of totalitarianism and central power through filter mechanisms such as democracy, erodes national boundaries and creates more scope for globalisation. Competition of ideas and in markets aids creativeness and wealth production. Let us cast our minds back to medieval Europe, and in particular England. A useful working hypothesis for any government is that it strives to maximise revenue in order, in turn, to maximise power.9 Medieval monarchs needed revenues for wars, and could often justify taxes to finance them. How they managed this is instructive for how economies, international trade and capital markets developed. A characteristic of England’s history is that the king’s power, being weaker with regard to the aristocracy compared with that of the king of France, had greater need to legitimise taxation. The Magna Carta of 1215 limited King John’s and 8 Li and Rajan (2011) conclude from an empirical study that controls on equity inflows tend to raise the volatility of those inflows, and controls on FDI (foreign direct investment) and also on debt outflows may both increase the volatility of equity outflows – substitution effects. Controls on FDI inflows may also raise the volatility of FDI outflows. Controls on debt inflows tend to raise the volatility of those inflows. See also Frenkel et al. (2001). 9 See Levi (1988).

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subsequent monarchs’ powers (weakening under the Tudors and Stuarts in particular), establishing personal and property freedoms and elevating the rule of law above the will of the monarch. Subsequent efforts to raise taxes were notoriously difficult, but this led to an ironic reversal. ‘The relatively weaker bargaining position of English monarchs vis-à-vis their constituents led to concessions that French monarchs did not have to make. However, the Parliament that evolved ultimately enhanced the ability of English monarchs to tax. Parliament provided a forum for conditional cooperation. It engendered quasi-voluntary compliance and reduced transactions costs.’ Levi (1988) Compared to 18th-century France or Rome under the later Caesars, tax farming in England was not widely employed, but rather the taxes collected by Parliament and later the bonds issued involved lower transaction costs, were more legitimate and more reliable. The range of taxes to finance the monarchs (and their wars) was varied, but was also driven by and impacted the pattern of trade. Taxes needed to be collectible with minimum transaction costs and maximum legitimacy, and hence moved from general levies (amounts collected across the population) to consumer goods to trade to income. But strategic and mercantilist concerns over trade led to developments in policy too. In the mid-16th century the focus of English trade policy was to generate employment and food after the devastating costs of war on the continent (the English were at war for much of the previous 50 years, with a break in the 1530s). The discouragement of domestic production of luxuries including luxury clothing, seen as unnecessary and sapping of the national economy, led to surges of some of these items as imports, and so eventually the reversal of the original trade policy.10 Then mercantilist and strategic concerns regarding foreign trade started to give way in the later 17th century to the appreciation that ‘projects’ (schemes of domestic investment for home consumption) were important for the country’s overall income and economic health.11 Patents, starting from the Tudors (the first in 1552 for a technique for making glass, then in 1554 to search for and work metals in England), were established to promote production but often led to the aristocratic holders of such exclusive licences closing down domestic (and less aristocratic) competition. International trade was a small share of the total economy, but it was also clearly impacted by the dominant position of government policy in the national economy. We can say there were periods of great increase in foreign trade, but it was still very much monitored and to a large extent controlled or controllable by governments. Governments in turn acted for a combination of political, strategic and revenue-maximising ways, both directly and through taxes, distorting the incentives to trade. Today’s economic freedoms contrast with more restricted governance structures dominated by guilds and serfdom, tariffs and trade restrictions, economic dependency and personal immobility, and general government heavy-handedness. Whereas the norm in medieval Europe was that companies would seek a licence to engage in certain activities, now companies are prevented from not doing certain things – i.e. they can do anything else. Over time,

10 Sir Thomas Smith listed various imports in his Discourse of the Commonwealth, and then sat on a committee in 1559 which framed plans for legislation to promote import substitution for a similar list of goods. 11 As described by Joan Thirsk (1978).

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governments have become less able to ignore the wishes of their citizens. And this is true globally not just nationally. 1.2.2

the influence of money

While our focus is economics, other social forces have also constrained and shaped economic activity. If importation of luxuries was long seen in medieval England as a distraction from more legitimate economic activities, attitudes to money as the medium of exchange take centre stage in the battle between God and Mammon. The history of money is fascinating, as is its sociology and philosophy.12 The association of money with moral impurity is a common thread from Judas Iscariot to the laws against usury and right up to the present day. In Christian Europe at least, financial market development was restricted by religious mores. However, monarchs still needed to fight, and that cost money. The first banks began in the 15th century, and international loans commonly funded wars between monarchs. Potosí silver fuelled the wealth and power of 16th-century Spain, but the lack of development of a domestic capital market led to Spain under Philip II defaulting again and again to foreign bankers. Florence, Genoa and Amsterdam built their economies on international loans as well as international trade. Banks were originally a place to secure one’s money. Once they started lending out more than they had through issuing notes, there was a risk of bank runs… and the bigger the bank, the bigger the run. Though the Bank of England (1664) and Sveriges Bank (1668) were already established, the mass creation of credit proposed by John Law to the French government, in effect creating a central bank, was initially rejected in 1715, even though the French government was near default following the War of the Spanish Succession (1701–1714) and the Sun King’s defeats at the hands of the Duke of Malborough and Prince Eugene. However, Law was allowed to establish the Banque Général, a private bank allowed to issue bank notes in place of scarce gold and so stimulate the economy. The bank in effect became the central bank, and from there Law’s scope for credit creation grew and grew in an 18th-century version of our modern-day quantitative easing (QE). Initially providing assistance in financing government, by 1717, Law’s notes were legal tender for paying taxes. The attraction of printing money and credit extension became apparent as a giant means of financing government. Depositors and equity holders came to trust in paper returns. The bank also became an investor in the Mississippi, and shares in the bank were bid up in a financial bubble fuelled by promises of profits which were not forthcoming. It all ended in tears with one of the largest bubble-bursts in history in 1720; but for about 15 months this Scotsman, made Duke of Arkansas but wanted for murder in England,13 was the most powerful man in France. Love of ingenious financial alchemy (the successful stimulus to the French economy by the initial period of credit creation) was followed by hate (the bursting of the Mississippi speculative bubble); just as today international bank alchemy (a key element of modern globalisation) can create huge benefits but then excessive leverage and crises, followed by public opprobrium.

See for example Dodd (1994), Buchan (1998), Galbraith (1975), Shell (1982) and Simmel (1990). John Law initially fled to Scotland to escape justice, and lobbied against the Union with England, but then had to flee Scotland when the Act of Union (Scotland with England) was passed in 1707. 12 13

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The closeness of bankers to political power continues to the present day.14 The Rothschilds’ agent in 19th-century Berlin, Gerson Bleichröder, became Bismarck’s personal banker but also was central to the finances of the German state and even to foreign policy. Bleichröder provided Bismarck with backchannels via the Rothschilds to the government in Paris and to Disraeli in London. He also was heavily involved in foreign investment, particularly in railways (see Stern, 1977). Likewise in the 20th century, John Pierpont Morgan was famous for playing the role of domestic central bank, stopping the US financial panic of 1907. The associations between finance, international relations and globalisation have long been strong. 1.2.3 trade and commodification International trade enables international specialisation. In Britain’s case it was the colonies and the ability to import food and raw materials which enabled the industrial revolution. One needs political stability and trust for international trade and globalisation, and trust is personal and built on reputation – hence the growth of family partnership merchant banks, with their own money on the line. These banks had detailed knowledge about others; but, as they lived or died on their reputation, which could be shattered by a single scandal, they kept secrets well. Globalisation also entails creating the demand for international trade. Trade has existed for centuries, but large-scale trade had to wait for the consumer society. Prior to this, trade was either in luxuries for the few, or in one or two goods for the many. Roman imports of grain from North Africa were clearly considerable in scale, and a staple for the urban population, but the more normal pattern has been of relative self-sufficiency in most staples until the past few centuries, when large-scale trade in grain and textiles resumed. Trade built over several centuries in Europe, but important steps on the way were recognition from the late 17th century of the importance of domestic demand; increasing rural industry and incomes; agricultural enclosure and labour specialisation; and urbanisation. Commodification – assigning economic value to things not previously so considered – was also a crucial step. London’s Great Exhibition of 1851 was a triumph for the establishment of the commodity at centre stage. The exhibits were not explicitly for sale, but rather there for the glorification of industry and the production of items – commodities from soap to tea to heavy machinery – of use to the consumer and society. This was a revolutionary change and to a large extent the attraction of the exhibition: the focus of the commodity from derivative to dominator of human relations (and not just economic relations). Modern advertising and branding were born, and in some of the pictorial advertisements of the time people were in clearly subservient (smaller and not as important) positions to the commodity.15 Complementary to this radical change was the British Empire, acquired as if by accident for an unknown purpose, but now perceived as having an important role in supplying the growing needs of the consumer (even if the Americas in practice were more important in this role). If the Great Exhibition drove the desire for domestic consumption, truly dominant mass consumption had to wait for Henry Ford in the US during the early 20th century.

14 In Atlantic Monthly May 2009, Simon Johnson, Former IMF Chief Economist, referred to this bankingpolitics nexus as a “financial oligarchy that is blocking essential reform” http://www.theatlantic.com/magazine/ archive/2009/05/the-quiet-coup/307364/ 15 See Richards (1990).

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Commodification continues to this day and is a distinctive part of globalisation, combined with its offspring, advertising and branding. 1.2.4

nationalism

Interaction between nations has also changed. Nationalism is a fairly new concept in its modern sense, with nation-states developing in the 1700s, as Hobsbawm (1990) has pointed out. It may yet, as a result of globalisation and the political consequences of societal complexity already mentioned, give way to more multinational political structures. It has already changed greatly. No longer (with a few exceptions) is it an extension of a monarch’s ego: ‘L’état, c’est moi’ as Louis XIV, the Sun King, is supposed to have described it. The peace of Westphalia in 1648 after the devastating Thirty Years’ War between Catholic and Protestant forces defined the sovereign state and established the principle of non-interference in the affairs of other sovereign states. But as Philip Bobbitt (2002) has described, the state has been through several stages of development since. Most recently, as the 1990s Balkan wars demonstrated, the concept of non-interference established in 1648 is now in conflict with that of self-determination. Having said that, global interference has always been with us: stronger states interfering in the affairs of smaller ones for a combination of reasons: their own (individual or collective) security, economic self-interest and humanitarian aid. In all but the short term, however, self-interest of some description invariably dominates.16 What global media and culture have aided is the move to a new reality in which the winning of hearts and minds is central to the modern strategic battleground, and in which traditional armed forces are largely redundant. As a population becomes more educated it will organise and will demand political rights: its voice17 will be heard and authority perceived to be unjust becomes more difficult to preserve. The days when the 1000-strong Indian Civil Service of British expatriate administrators could run a subcontinent of 300 million is long gone, as was predicted since the British enhanced education for Indians from the 1830s. The values the British chose to spread in India were incompatible with their longer-term presence. Today the spread of these and similar values makes similar long-term passive subjugation of nations quite impossible. In today’s world of the Internet and global media, guerrilla not industrial warfare, mass political participation not autocracy, control by physical force alone has become absurdly difficult – even if this is not yet sufficiently understood to have prevented some recent attempts. Winning minds is the clear preferred route to stable prosperity in today’s world, with a more limited support role reserved for physical force. This is in contrast to much of the structure of defence spending, as discussed by two modern generals with recent experience in the Balkans: Clark (2001) and Smith (2005). What has changed is not merely our education and communications technology, but the number of independent countries18 and also the principle of non-intervention in what were previously considered the internal affairs of nation-states. The principle of such non-interference is now in conflict with the desires, often supported by international opinion, of certain sub-national groups for self-determination. The nation-state 16 So-called humanitarian imperialism is not particularly credible as a justification for armed intervention in a foreign country for the simple reason that it tends not to work. 17 See Hirschman (1970). 18 The increase in the number of countries has made international policy co-ordination more difficult. This fragmentation has been the result of the end of empire, decolonisation and more self-determination. These processes in turn have been assisted by globalisation and with it the spread of economic liberty, education and liberal values.

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has changed its form several times before. As nationalism is a relatively modern phenomenon in many ways, one should expect it to change further.19 Jane Jacobs describes politics as a zero-sum game, but maybe it is even worse: due to fragmentation and more issues requiring international co-operation, states are experiencing shrinking power. Some international problems which would have been resolved by a few countries in the past are now not being resolved. In the wake of globalisation, national politics are becoming less and less autonomous. A number of immigration, environmental and economic issues require supranational governance. In the face of these issues, and in the absence of powerful international institutions, national governments are becoming more impotent; and electorates, realising this, are becoming more frustrated that issues are not being resolved – more apathetic (as shown by voter participation trends), more difficult to please. Winning minds is about having people agree with you, after letting them freely choose to do so. For the West this freedom or empowerment means allowing people to run their own lives, but also giving up some power – including sharing responsibility with emerging markets. Much more serious reform of the voting shares of the IMF, still heavily dominated by the US and Western Europe, would be a start. The problem is that some Western politicians have great difficulty with implementing this, or giving up their influence, especially when they have little central collective leadership, or are leaders with outdated world views. They often seem oblivious to the observable reality that their policies are getting in the way. Investors, the ultimate pragmatists, have the potential to offset the zero-sum (or all too often negative-sum) logic of politics. Commerce is an important component in bridging conflicts and avoiding them, of getting over ideological prejudices, of creating mutually aligned incentives: in short, of keeping down the testosterone levels in politics. History can teach us a lot about globalisation but we have to be cautious in interpretation. A reader may misinterpret the values and motives of past decision makers. How do we square Britain’s great historical achievements with urban squalor, Irish famine in the 1840s, and Orwell’s description of waning empire in Burmese Days? Much of the past has been horrific, and governments have gone to great efforts to rewrite and in some cases to deny history20, but we also need to recognise that moral values change over time and geography.21 And values remain different in different geographies today, even if people in distant lands consume some of the same brands and superficially may appear very similar in their values. Also, in the midst of global economic dynamism, there can still be a tendency to be surprised, antisympathetic and hostile to change. The combination of remaining partially myopic yet more interconnected leads to greater risk of sudden uncomfortable change, and indeed conflict.

Continues...

1.3

rEcEnt globalisation

International trade often collapses during war, and economies have struggled with inflation and debts in peacetime. Hence the importance of local and global rules to facilitate trade and capital flows – to facilitate globalisation. Stability matters, as Maddison (2007, p. 111) writing about the period 1500–1800, points out:

19 20 21

See Bobbitt (2002) and Hobsbawm (1990). See for example Paris (2000). See Harris (2010) for an interesting exposition of how science can determine morality.

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Code Red How to Protect Your Savings From the Coming Crisis John Mauldin & Jonathan Tepper 978-1-118-78372-6 • Hardback • 304 pages • November 2013

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Chapter One

The Great Experiment Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. —Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve Bank of the United States

P

resident Lyndon B. Johnson once summed up the general feeling about economists when he asked his advisers, “Did you ever think that making a speech on economics is a lot like pissing down your leg? It seems hot to you, but it never does to anyone else.” Reading a book about monetary policy and central banking can seem equally unexciting. It doesn’t have to be. Central banking and monetary policy may seem technical and boring; but whether we like it or not, the decisions of the Federal Reserve, the Bank of Japan (BoJ), the European Central Bank (ECB), and the 13

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Bank of England (BoE) affect us all. Over the next few years they are going to have profound impacts on each of us, touching our lives in every way. They influence the value of the dollar bills in our wallets, the price of the groceries we buy, how much it costs to fill up the gas tank, the wages we earn at work, the interest we get on our savings accounts, and the health of our pension funds. You may not care about monetary policy, but it will have an impact on whether you can retire comfortably, whether you can send your children to college with ease, or whether you will be able to afford your house. It is difficult to overstate how profoundly monetary policy influences our lives. If you care about your quality of life, the possibility of retirement, and the future of your children, you should care about monetary policy. Despite the importance of central bankers in our lives, outside of trading floors on Wall Street and the City of London, most people have no idea what central bankers do or how they do it. Central bankers are like the Wizard of Oz, moving the levers of money behind the scenes, but remaining a mystery to the general public. It is about time to pull the curtains back on monetary policy making. Even though they are separated by oceans, borders, cultures, and languages, all the major central bankers have known each other for decades and share similar beliefs about what monetary policy should do. Three of the world’s most powerful central bankers started their careers at the Massachusetts Institute of Technology (MIT) economics department. Fed chairman Ben Bernanke and ECB president Mario Draghi earned their doctorates there in the late 1970s. Bank of England governor Mervyn King taught there briefly in the 1980s. He even shared an office with Bernanke. Many economists came out of MIT with a belief that government could (and, even more important, should) soften economic downturns. Central banks play a particularly important role, not only by changing interest rates but also by manipulating the public’s expectations of what the central bank might do. We are living through one watershed moment after another in the greatest monetary experiment of all time. We are all guinea pigs in a risky trial run by central bankers: it’s Code Red time. Those of us who are of a certain age remember the great Dallas Cowboys coach Tom Landry. He would stalk the sidelines in his fedora, holding a sheet of paper he would consult many times. On it were the

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plays he would run, worked out well in advance. Third down and long and behind 10 points? He had a play for that. The Code Red policies that central bankers are coming up with more closely resemble Hail Mary passes than they do Landry’s carefully worked out playbook: they are not in any manual, and they are certainly not normal. The head coaches of our financial world are sending in one novel play after another, really mixing things up to see what might work: “Let’s send zero interest rate policy (ZIRP) up the middle while quantitative easing (QE) runs a slant, large-scale asset purchases (LSAPs) goes deep, and negative real interest rates, financial repression, nominal gross domestic product (GDP) targeting, and foreign exchange intervention hold the line.” The acronym alphabet soup of the playmakers is incomprehensible to the average person, but all of these programs are fancy, technical ways to hide very simple truths. In Through the Looking Glass, Humpty Dumpty says, “When I use a word, it means just what I choose it to mean—neither more nor less.” When central bankers give us words to describe their financial policies, they tell us exactly what they want their words to mean, but rarely do they tell us exactly the truth in plain English. They think we can’t handle the truth. The Great Financial Crisis of 2008 marked the turning point from conventional monetary policies to Code Red type unconventional policies. Before the crisis, central bankers were known as boring, conservative people who did everything by the book. They were generally disliked for being party poopers. They would take away the punch bowl just when the party got going. When the economy was overheating, central bankers were supposed to raise interest rates, cool down growth, and tighten monetary policy. Sometimes, doing so caused recessions. Taking away the punch bowl could hardly make everyone happy. In fact, at the start of the 1980s, former chairman Paul Volcker was burnt in effigy by a mob on the steps of the capitol for hiking short-term interest rates to 19 percent as he struggled to fight inflation. Central bankers like Volcker believed in sound money, low inflation, and a strong currency. In the throes of the Great Financial Crisis, however, central bankers went from using interest rates to cool down the party to spiking

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code red

the punch with as many exotic liqueurs as possible. Ben Bernanke, the chairman of the Federal Reserve, was the boldest, most creative, and unconventional of them all. With his Harvard, MIT, and Princeton background, he is undoubtedly one of the savviest central bankers in generations. When Lehman Brothers went bust, he invented dozens of programs that had never existed before to finance banks, money market funds, commercial paper markets, and so on. Bernanke took the Federal Funds rate down almost to zero, and the Fed bought trillions of dollars of government treasuries and mortgage-backed securities. Bernanke promised that the Federal Reserve would act boldly and creatively and would not withdraw the punch bowl until the party was really rolling. Foreign central bankers like Haruhiko Kuroda (BoJ); Mervyn King and his replacement from Canada, Mark Carney (BoE); and Mario Draghi (ECB) have also promised to do whatever it takes to achieve their objectives. We have no doubt that whoever replaces Bernanke will be in the same mold. These are the days of a new breed of central banker who believes in the prescription of ultra-easy money, higher rates of inflation, and a weaker currency to cure today’s ills. Their experimental medicine may have saved the patient in the short term, but it is addictive; withdrawal is ugly; and because long-term side effects are devastating, it can be prescribed only for short-term use. The problem is, they can’t openly admit any of that. Central bankers hope that unconventional policies will do the trick. If everything goes as planned, inflation will quietly eat away at debt, stock markets will go up, house prices will go up, everyone will feel wealthier and spend the newfound wealth, banks will earn lots of money and become solvent, and government debts will shrink as taxes rise and deficits evaporate. And after all is well again, central banks can go back to the good old days of conventional policies. There is no guarantee that will happen, but that’s the game plan. So far, Code Red policies have lifted stock markets, but they have not worked at reviving growth. But Code Red–type policies are like a religion or communism. If they don’t work, it is only proof that they were not tried in sufficient size or with enough vigor. So we’re guaranteed to see a lot more unconventional policies in the coming months and years.

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How I Learned to Stop Worrying and Love Inflation The Great Financial Crisis was a story of a huge mountain of debt that was piled too high, reached criticality, and then collapsed. For decades, families, companies, and governments had accumulated every kind of debt imaginable: credit card bills, student loans, mortgages, corporate and municipal bonds, and so on. Once the mountain rumbled, broke, and started to collapse, the landslides spread everywhere. The epicenter of the crisis was the U.S. subprime mortgage market (in fact, many foreign leaders still think it was fat, suburban, Big Mac–eating Americans who caused the global crisis), but the United States was just a small part of a much bigger problem. Countries such as Ireland, Spain, Iceland, and Latvia also had very large real estate bubbles that burst. Other countries, including Australia, Canada, and China, have housing bubbles that are still in the process of bursting. It’s the same problem everywhere: too much debt that cannot be paid back in full. (We certainly would not minimize the role of the Federal Reserve in failing to supervise the banks and especially subprime debt. By holding interest rates too low for too long and by willfully ignoring the developing bubble in the U.S. housing market, they certainly played a central role.) When a person has too much debt, the sensible thing to do is to spend less and pay down the mortgage or credit card bills. However, what is true for one person isn’t true for the economy as a whole. Economists call this principle the paradox of thrift. Imagine if everyone decided overnight to stop spending beyond what was absolutely necessary, save more, and pay down their debts. That would mean fewer dinners out, fewer visits to Starbucks, fewer Christmas presents, fewer new cars, and so on. You get the picture. The economy as a whole would contract dramatically if everyone spent less in order to pay down debts. But, in fact, that is exactly what happened during the Great Financial Crisis. Economists call this process deleveraging. And the last thing central banks want is for everyone to stop spending money and reduce their debts at the same time. That leads to recessions and depressions. At least that was the theory proposed by John Maynard Keynes, the father of one of the most influential economic schools of thought,

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and it has become the reigning paradigm. It’s all about encouraging consumption and reviving “animal spirits.” If the economy is in the doldrums (recession), it is up to the government to run deficits, even massive ones, in order to “prime the pump.” Put plenty of money into people’s hands so they will go out and spend, encouraging businesses to expand and hire more workers, who will then consume yet more goods, and so on. Wash, rinse, and repeat. Another solution if you have too much debt is to declare bankruptcy. In many countries that can be an effective way of starting over again. You put behind you debts you can’t pay, offer to pay what you can, and start anew. Once again, what is good for the individual isn’t necessarily good for the economy as a whole. Imagine what would happen if millions of people declared bankruptcy at the same time. Banks would all go bust, and the government would probably have to pick up the tab and recapitalize the banks. And then, before long, the government would find itself going bust. The difference between what is right for one person and what is right for society is paradoxical. It is what logicians call the fallacy of composition. What is true for a part is not true for the whole. If you drive to work 10 minutes early, you might avoid traffic. If everyone drives to work 10 minutes early, the traffic jam will happen 10 minutes earlier. Central banks don’t want everyone to be prudent or to go bankrupt at the same time. They would simply prefer everyone to remain calm and carry on spending. If you want to avoid everyone’s ceasing to spend—or, worse yet, everyone’s going bankrupt at the same time—the only way to make the debt go away in real terms is through inflation. Inflation is the Ghostbusters of debt. It wipes debt out over time. For the sake of simplicity, imagine that you owe $100,000. If inflation is 2 percent, it will take about 30 years to cut the value of the loan in half. But if the rate of inflation doubles to 4 percent, it will take just 18 years to halve the value of the loan. And if inflation doubles again to 8 percent, you will halve the loan in 8 years! Inflation is just what the doctor ordered for an economy with too much debt. By ratcheting up inflation, central bankers can erode debt quickly and quietly. But while inflation is the friend of debtors, it is the enemy of savers; so for central bankers to come out and say they’re

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in favor of inflation would be like the pope’s announcing one day that he’s not Catholic. That isn’t going to happen. Inflation is a subject that divides economists because it means different things to different people. Not all inflation is bad. Inflation is generally considered to be problematic when the broad price level of most goods and services starts to go up because too much money is chasing too few goods. The increase in the price of a haircut is bad inflation. The method of cutting hair is no different than it was in the 1930s or the 1950s, yet it is vastly more expensive to get your hair cut today. (I [ John] pay 200 times more for a haircut today than I did when I was a kid.) However, an increase in the price of a Picasso or de Kooning is considered to be normal, or “good,” inflation. The higher prices are merely a reflection of more wealthy people in the world chasing fine art. They reflect the scarcity of the goods for sale and the laws of supply and demand at work. And who complains about the asset inflation of a rising stock market or rising home values? Then there is good deflation and bad deflation. The deflation of falling telegraph, telephone, or Internet prices is viewed as good. Better technology means that prices fall because we can do the same things more cheaply or even nearly for free. For example, in Money, Markets & Sovereignty, Benn Steil and Manuel Hinds describe the second phase of the Industrial Revolution in the United States between 1870 and 1896. Prices fell by 32 percent over the period, but real income soared 110 percent amid robust economic growth, expanded trade, and enormous innovation in telecommunications and other industries. The bad kind of deflation is different. When demand drops because people have too much debt and not enough money to spend, prices fall, too, though the cost of production does not. Jobs dry up, leaving people with even less to spend. That is the kind of deflation central bankers fear today.

Alphabet Soup: ZIRP, QE, LSAP Let’s look at how central bankers attempt to create inflation and how they help households, companies, and governments burdened with too much debt. We’ll go through the main acronyms and technical terms and explain what they mean and how they affect you.

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Federal Reserve Bank of Japan

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Figure 1.1 Global Interest Rates Source: Variant Perception, Bloomberg.

The main way monetary authorities have an impact on the economy is by setting interest rates. Interest rates determine the price at which people will borrow and lend. In the old days, when the economy was growing quickly, central banks would raise rates. When the economy was slowing, they’d cut rates, which meant that financing got cheaper, credit was easier, and money was looser. The reason the Fed cut interest rates was to stimulate the economy. Lower rates mean lower mortgage, credit card, and car payments. They give businesses access to cheaper capital and hopefully spur profits and thus hiring. This puts more money into the hands of consumers. As an example, U.S. 30-year mortgage rates recently hit a record low of 3.66 percent, down from 4.5 percent the same time last year. A number of mortgage holders will refinance, given the much lower rates, increasing their disposable income. That almost makes us want to buy a house or two. Who can complain about a free lunch? Cutting rates can only go so far until you hit zero. Then you’re stuck with a floor. In fact, central banks cut rates during the financial crisis, and then left them near zero and have not raised them since. Leaving rates at or near zero is what central banks refer to as zero interest rate policy (ZIRP). Currently, the United States, United Kingdom, Japan, Switzerland, and, arguably, the Euro area are all engaging in ZIRP.

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In a ZIRP world, debtors are overjoyed and savers are screwed. Imagine borrowing at 5 or 10 percent and then suddenly seeing your borrowing costs fall to a little above zero. No matter how much debt you had before, paying very little interest every month is a lifesaver. Low borrowing costs make it easier for struggling businesses to roll over their debt and reduce the real value of debt payments. If you reduce the coupon payment on a loan, that is economically the same thing as forgiving part of the principal amount, but this forgiveness is hidden. The low rates effectively allow “zombie” households and businesses to limp along without going bankrupt. Near-zero interest rates are, however, terrible for savers, investors, and lenders. Imagine you’re a retiree, and you’ve been responsible and saved all your life; you’ve put money in the bank that you expect to pay you interest every month. You probably bought some bonds as well so you could collect coupons every quarter. In a ZIRP world, you would be getting very little every month from interest and coupon payments. You would live your retirement years with far less income than you had planned for, or you would need to work far longer in order to save more. This is happening to retirees all over the world—it’s why more and more people over 60 are still working. The Federal Reserve and central bankers are not particularly worried about savers. Most Americans are struggling with debt. In an indebted society, helping debtors beats helping savers. Inflation is the opposite of a gift that keeps on giving. Higher inflation allows the Federal Reserve and other central banks to take real interest rates below zero. Nominal interest rates are the actual interest rate you get. Real interest rates are nominal rates minus the inflation rate. If your bank offers you 2 percent on your bank account, the nominal rate is 2 percent. So far, so simple. If inflation is 2 percent, then the real interest rate is 0 (2 − 2 = 0). The interest rate is only just keeping up with inflation. If inflation is 4 percent, then the interest you are getting on your bank account isn’t even keeping pace with inflation. Your real interest rate would be negative 2 (2 − 4 = −2). As you can see, with rates near zero, as long as inflation is positive, central banks can create negative real rates. Even though nominal rates can be trapped at zero, real interest rates can go below zero.

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When real rates are negative, cash is trash. Negative real rates act like a tax on savings. Inflation eats away at your money, and is in effect a tax by the (unelected!) central bankers on your hard-earned money. Leaving money in the bank when real rates are negative guarantees that you will lose purchasing power. Negative real rates force savers and investors to seek out riskier and riskier investments merely to tread water. It almost guarantees people don’t save and stop spending. In fact, Bernanke openly acknowledges that his low interest-rate policy is designed to get savers and investors to take more chances with riskier investments. The fact that this is precisely the wrong thing for retirees and savers seems to be lost in their pursuit of market and economic gains. Simply by opening their mouths, central bankers can affect not only today’s interest rate, but tomorrow’s expected interest rate as well. If Bernanke (and his successors) or Mario Draghi of the ECB promise to keep interest rates near zero until kingdom come, investors will generally take them at their word. By promising to keep rates low, central banks have crushed bond yields. The bond yield curve tells the story. The yield curve is the structure of interest rates for bonds for today, tomorrow, and the day after tomorrow. By plotting a line for each bond maturity, you can see what expected rates are out into the future: 2 years, 5 years, 10 years, and 30 years. The U.S. government can now issue 10-year debt for less than 2 percent yield. This is below the rate of inflation. It implies the Fed has been successful at keeping rates below inflation all the way out to 10 years. Lots of big economists such as Paul Krugman, Ben Bernanke, Gauti Eggertsson, and Michael Woodford, have provided the intellectual underpinnings that justify Code Red policies (the list of names is actually quite long). They argued that if unconventional monetary policy can raise expected inflation, this strategy can push down real interest rates even though nominal rates cannot fall any further (i.e., they can’t fall below zero). Read their research and bear that in mind when these same economists say they don’t want to create inflation. Government bonds used to offer a risk-free rate of return. You took no risk in buying them, and you were guaranteed a return. Jim Grant, the astute financial analyst, has noted that bonds have rallied so much, and the yields on government bonds are so low, that they now offer investors return-free risk: you’re now guaranteed a loss buying

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government bonds. Coupons are so low that investors are not even being compensated at the rate of inflation. It is hard to see how rates can go much lower or how more fools can be found to buy the bonds. The only people who buy British, Japanese, German, or American government bonds today in any size are institutions that are legally forced to do so, like insurance companies and pension funds. From a central banker’s point of view, leaving interest rates near zero is useful, but it has given them little direct influence over the economy. They can control rising inflation and expectations of higher prices only indirectly. However, central banks still have more bullets in the chamber they can use.

Quantitative Easing, a.k.a. Money Printing In addition to manipulating interest rates, central banks have the ability to increase the money supply through quantitative easing (QE). Despite all the syllables, that’s just a fancy way to say money printing. When the Fed wants to print new money and expand the money supply, it goes out and buys government bonds from banks that it has designated as “primary dealers.” The Fed takes delivery of the securities and pays the dealers with newly printed money. The money goes into the dealers’ bank accounts, where it can then support lending and money creation by the banking system. Likewise, when the Fed wants to reduce the money supply, it sells bonds back to the banks. The bonds go to the dealers, and the money paid to the Fed simply disappears. (As you can see, both “printing” money and making money disappear happen electronically and instantly. No actual printing of currency is involved. No trees are harmed in the process.) Banks absolutely love QE—it is a gift to them, and it’s one that circumvents the congressional appropriations process. To pay for QE, the Fed credits banks with electronic deposits that are reserve balances at the Federal Reserve. These reserve balances have ballooned to $1.5 trillion, from a mere $8 billion in late 2008. The Fed now pays 0.25 percent interest on reserves it holds, which amounts to nearly $4 billion a year in the banks’ coffers. If interest rates rise to 3 percent, and the Federal Reserve then raises the rate it pays on reserves

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The Warren Buffett Way, 3rd Edition Robert G. Hagstrom 978-1-118-50325-6 • Hardback • 320 pages • October 2013

Buy Now!

Remember, simply quote promotion code SPR30 when ordering direct through www.wiley.com to receive 30% off! £19.99 £13.99 / €24.00 €16.80 / $29.95 $20.97


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A Five-Sigma Event

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race yourself,” Buffett said, with a sly grin. He was sitting in a Manhattan living room on a spring morning with one of his dearest and oldest friends, Carol Loomis. A New York Times best-selling author and an award-winning journalist, Carol is senior editor-atlarge at Fortune magazine, where she has worked since 1954, and is considered to be the magazine’s resident expert on Warren Buffett. It is well known among the Buffett faithful that she has also been editing Berkshire Hathaway’s annual reports since 1977. On that spring day in 2006, Buffett told Carol that he had changed his thinking about how and when he was going to give away his fortune in Berkshire Hathaway stock. Like most people, Carol knew that Buffett, after a small allocation to his three children, was going to leave 99 percent of his wealth to charity, but it was always thought it would go to the Buffett Foundation established by his late wife, Susan. Now he was telling Carol he had changed his mind. “I know what I want to do,” he said, “and it makes sense to get going.”1 So, shortly before lunch, on June 26, 2006, Warren Buffett, who was then the second richest man in the world, stepped up to the microphone inside the New York Public Library. The audience— hundreds of the wealthiest people in the city—greeted him with a standing ovation. After a few brief words, Buffett reached inside his 1

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jacket pocket and pulled out five letters. Each one announced the disposition of his fortune, and only awaited his signature. The first three letters were easy; he just signed “Dad” and then handed them to his children: daughter Suze, eldest son Howard, and second son Peter. The fourth letter was turned over to a representative of his late wife’s charitable foundation. Together, these four letters promised to give away a combined $6 billion.2 The fifth letter was the surprise. Buffett signed it and handed it to the wife of the only man on the planet who was richer than himself, Bill Gates. With that last letter, Buffett pledged over $30 billion in Berkshire Hathaway stock to the world’s largest philanthropic organization, the Bill and Melinda Gates Foundation. It was by far the single greatest amount of money ever given away, miles bigger than the contributions by Andrew Carnegie ($7.2 billion when adjusted to current dollars), John D. Rockefeller ($7.1 billion), or John D. Rockefeller Jr. ($5.5 billion). In the days that followed, there were countless questions. Was Buffett ill, perhaps even dying? “No, absolutely not,” he said. “I feel terrific.” Did his wife’s passing have anything to do with his decision? “Yes, it does,” confessed Buffett. It was well known that Susie would have inherited Buffett’s fortune for the Buffett Foundation. “She would have enjoyed the process,” he said. “She was a little afraid of it, in terms of scaling up. But she would have liked doing it, and would have been very good at it.”3 But after his wife’s death, Buffett changed his thinking. He realized that the Bill and Melinda Gates Foundation was a terrific organization, already scaled to handle the billions of dollars Buffett was going to send its way. They “wouldn’t have to go through the real grind of getting to a megasize like the Buffett Foundation would—and they could productively use my money now,” he said. “What can be more logical, in whatever you want done, than finding someone better equipped than you are to do it?”4 It was quintessential Buffett. Rationality prevailed. At Berkshire Hathaway, Buffett reminds us there are scores of managers running businesses that do a much better job of running their operations than he ever could. Likewise, the Bill and Melinda Gates

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Foundation would do a better job of managing his philanthropy than he could do himself. Bill Gates said of his friend, “Warren will be remembered not only as the greatest investor, but the world’s greatest investor for good.”5 This will most certainly be true. But it is important to remember that the good his philanthropic generosity will do was made possible in the first place by his unparalleled investing skill. When Buffett handed the letter and check for $30 billion to Melinda Gates, I immediately thought back to another check he had written 50 years earlier—for $100, his initial investment in the Buffett Partnership, Ltd. Buffett has always claimed he won the ovarian lottery. He figures the odds of him being born in 1930 in the United States were about 30:1. He admits he couldn’t run fast and would never have been a good football player. Neither, despite his talents at plucking a ukulele, would he ever become a concert violinist. But he was “wired in a particular way” that would allow him “to thrive in a big capitalist economy with a lot of action.”6 “My wealth has come from a combination of living in America, some lucky genes, and compound interest,” said Buffett. “My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well.” To keep it all in perspective, Buffett humbly reminds us that he happens to work “in an economy that rewards someone who saves lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mispricing of securities with sums reaching into the billions.” He called it fate’s capricious distribution of “long straws.”7 That may be true. But in my mind, Buffett carved his own destiny, which determined his own fate—not the other way around. This is the story of how Warren Buffett made his own long straw.

Personal History and Investment Beginnings Warren Edward Buffett was born August 30, 1930, in Omaha, Nebraska. He was the seventh generation of Buffetts to call Omaha home. The first Nebraskan Buffett opened a grocery store in 1869.

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Buffett’s grandfather also ran a grocery store and once employed a young Charlie Munger, the future vice chairman of Berkshire Hathaway. Buffett’s father, Howard, was a local stockbroker and banker who later became a Republican Congressman. It was said that as soon as Warren Buffett was born he was fascinated by numbers. That may be a stretch, but it is well documented that before he entered kindergarten he was already a calculating machine. As young boys, he and his best friend Bob Russell would sit on the Russell family porch recording license-plate numbers of the cars that passed by. When darkness fell, he and Bob would go inside, spread the Omaha World-Herald on the floor, and count the number of times each letter appeared in the paper. They then tallied their calculations in a scrapbook, as if it was top-secret information. One of young Buffett’s most prized toys came from his Aunt Alice, who was quite fond of her peculiar but immensely likable nephew and made him an irresistible offer: If he would agree to eat his asparagus, she would give him a stopwatch. Buffett was mesmerized by this precise counting machine and used it in endless little-boy ventures, like marble races. He would summon his two sisters into the bathroom, fill the tub with water, and then direct them to drop their marble into one end. The one whose marble reached the drain stopper first was the winner (utilizing the tub’s sloped shape). Buffett, stopwatch at the ready, timed and recorded each race. But it was the second gift from Aunt Alice that sent six-yearold Buffett into a new direction—a fascination not with just numbers, but with money. On Christmas day, Buffett ripped open his present and strapped onto his belt what would become his most treasured possession—a nickel-coated money changer. He quickly found many ways to put it to good use. He set up a table outside his house and sold Chiclets to anyone who passed by. He went doorto-door selling packs of gum and soda pop. He would by a six-pack of Coke at his grandfather’s grocery store for 25 cents and sell the individual bottles for a nickel: 20 percent return on investment. He also sold, door-to-door, copies of the Saturday Evening Post and Liberty magazines. Each weekend he sold popcorn and peanuts at

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local football games. With him through all these enterprises was his money changer, taking in dollars and making change.8 What now sounds like an idyllic childhood took an abrupt turn when Buffett’s father returned home one night to inform the family the bank where he worked had closed. His job was gone and their savings were lost. The Great Depression had finally made its way to Omaha. Buffett’s grandfather, the grocery store owner, gave Howard money to help support his family. Fortunately, the sense of hopelessness did not last long. Howard Buffett soon pulled himself up and got back on his feet, announcing that Buffett, Sklenicka & Company had opened for business at the Union State building on Farnam Street, the same street where Buffett would someday buy a house and start his investment partnership. The effect of the Great Depression, albeit brief, was hard on Buffett’s family. It also made a deep and profound impression on young Warren. “He emerged from those first hard years with an absolute drive to become very, very, very rich,” wrote Roger Lowenstein, author of Buffett: The Making of an American Capitalist. “He thought about it before he was five years old. And from that time on, he scarcely stopped thinking about it.”9 When Buffett turned 10, his father took him to New York. It was a birthday gift Howard gave to each of his children. “I told my Dad I wanted to see three things,” said Buffett. “I wanted to see the Scott Stamp and Coin Company. I wanted to see the Lionel Train Company. I wanted to see the New York Stock Exchange.”10 After an overnight ride on the train, Buffett and his dad made their way to Wall Street, where they met with At Mol, a member of the exchange. “After lunch, a guy came along with a tray that had all these different kinds of tobacco leaves on it,” recalled Buffett. “He made up a cigar for Mr. Mol, who picked out the leaves he wanted. And I thought, this is it. It doesn’t get any better than this. A custom-made cigar.”11 Later, Howard Buffett introduced his son to Sidney Weinberg, a senior partner at Goldman Sachs, then considered the most famous man on Wall Street. Standing in Weinberg’s office, Buffett was mesmerized by the photographs and documents on the wall. He took note of the framed original letters, knowing full well they were

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written by famous people. While Howard and Sidney talked about financial issues of the day, Buffett was oblivious, walking around and around Weinberg’s office staring at the artifacts. When it was time to go, Sidney Weinberg put his arm around Buffett and jokingly asked him what stock he liked. “He’d forgotten it all the next day,” Buffett recalled, “but I remembered it forever.”12 Even before Buffett traveled to New York, he was already intrigued with stocks and the stock market. He was a frequent visitor to his dad’s brokerage office, where he would stare at stock and bond certificates that hung on the wall, just like in Sidney Weinberg’s office. Often he would bounce down the two flights of stairs right into the Harris Upham brokerage firm. Many of the brokers became fond of the pesky kid who never seemed to stop asking questions. From time to time they would allow young Warren to chalk the prices of stocks on the blackboard. On Saturday mornings, when the stock exchange was open for two hours, Buffett would hang out with his paternal great-uncle Frank Buffett and his maternal great-uncle John Barber at the brokerage office. According to Buffett, Uncle Frank was a perpetual bear and Uncle John was the ever-optimistic bull. Each competed for Buffett’s attention with stories of how they thought the world would unfold. All the while, Buffett stared straight ahead at the Trans-Lux stock ticker, trying to make sense of the continually changing stock prices. Each weekend he read the “Trader” column in Barron’s. Once he finished reading all the books on his father’s bookshelf, he consumed all the investment books at the local library. Soon he began charting stock prices himself, trying to understand the numerical patterns that were flashing by his eyes. No one was surprised when 11-year-old Buffett announced he was ready to buy his first shares of stock. However, they were shocked when he informed his family he wanted to invest $120, money he had saved from selling soda pop, peanuts, and magazines. He decided on Cities Service Preferred, one of his father’s favorite stocks, and enticed his sister Doris to join him. They each bought three shares, for an investment of $114.75 each. Buffett had studied the price chart; he was confident.

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That summer the stock market declined, hitting its yearly low in June. The two junior Buffetts saw their stocks decline 30 percent. Not a day went by when Doris did not pester Warren about their loss, so when Cities Service Preferred recovered to $40 per share, he sold their holdings, for a $5 profit. To Buffett’s chagrin, Cities Service Preferred soon soared to $202 a share. After commissions, Buffett calculated he had forgone a profit of over $492. Since it had taken him five years to save $120, he figured he had just given up 20 years of work. It was a painful lesson, but ultimately a valuable one. Buffett swore that, first, he would never again be sidetracked by what he paid for the stock, and, second, he would not settle for small profits. At the wise age of 11, Buffett had already learned one of the most important lessons in investing—patience. (More about this crucial quality in Chapter 7.) In 1942, when Buffett was 12, his father was elected to the U.S. Congress and moved the family to Washington. The change was hard on the young boy. Miserable and hopelessly homesick, he was allowed to return to Omaha for a year, to live with his grandfather and Aunt Alice. The following year, 1943, Warren gave Washington another chance. With no friendly brokerage firms to hang out in, gradually Buffett’s interest moved away from the stock market and toward entrepreneurial ventures. At age 13, he was working two paper routes, delivering the Washington Post and the Washington Times-Herald. At Woodrow Wilson High School, he made friends with Don Danly, who quickly became infected with Buffett’s enthusiasm for making money. The two pooled their savings and bought reconditioned pinball machines for $25. Buffett convinced a local barber to let them put a machine in his shop for half the profits. After the first day of operation, they returned to find $4 in nickels in their very first machine. The Wilson Coin-Operated Machine Company expanded to seven machines, and soon Buffett was taking home $50 per week. By the time Buffett graduated from high school, his savings from various endeavors totaled $9,000. He promptly announced that he saw no reason to go to college, as it would interfere with his business ventures. His father overruled him, and by the fall

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Buffett found himself enrolled at the University of Pennsylvania’s Wharton School of Business and Finance. Despite Wharton’s emphasis on business and finance, Buffett was unimpressed with the university. “Not exactly turned on by it,” he confessed; “it didn’t seem like I was learning a lot.”13 The Wharton curriculum stressed the theoretical aspects of business; what interested Buffett were the practical aspects of a business—how to make money. After two years at Wharton (1947–1949), he transferred to the University of Nebraska. He took 14 courses in one year and graduated in 1950. He was not yet 20 years old. Back in Omaha, Buffett reconnected with the stock market. He started collecting hot tips from brokers and subscribed to publishing services. He resurrected his price charts and studied books on technical analysis. He applied the McGee point-and-figure system and every other system he could think of, trying to figure out what would work. Then one day, browsing in the local library, he came across a recently published book titled The Intelligent Investor by Benjamin Graham. “That,” he said, “was like seeing the light.”14 Graham’s treatises on investing, including Security Analysis (1934), cowritten with David Dodd, so influenced Buffett that he left Omaha and traveled to New York to study with Graham at the Columbia University Graduate School of Business. Graham preached the importance of understanding a company’s intrinsic value. He believed investors who accurately calculated this value and bought shares below it in price could be profitable in the market. This mathematical approach appealed to Buffett’s love of numbers. In Graham’s class were 20 students. Many were older than Buffett and several were working on Wall Street. In the evening, these Wall Street professionals sat in Graham’s class discussing which stocks were massively undervalued, and the next day they would be back at work buying the stocks analyzed the night before and making money. It was soon clear to everyone that Buffett was the brightest student. He often raised his hand to answer Graham’s question before Graham had finished asking it. Bill Ruane, who later cofounded

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the Sequoia Fund with Rick Cuniff, was in the same class. He recalls that there was an instantaneous chemistry between Graham and Buffett, and the rest of the class was primarily an audience.15 Buffett’s grade for the class was an A+—the first A+ Graham had awarded in 22 years of teaching. After graduating from Columbia, Buffett asked Graham for a job but was turned down. At first he was stung by the rejection but later was told that the firm preferred to fill the slots at GrahamNewman with Jewish analysts who, it was perceived, were being treated unfairly on Wall Street. Undeterred, Buffett returned to Omaha, where he joined Buffett-Falk Company, his father’s brokerage. He hit the ground running, eagerly recommending stocks that met Graham’s value criteria. All the while Buffett stayed in touch with Graham, sending him stock ideas after stock ideas. Then, in 1954, Graham called with news: The religious barrier had been lifted and there was a seat at Graham-Newman if he was still interested. Buffett was on the next plane to New York. During his tenure at Graham-Newman, Buffett became fully immersed in his mentor’s investment approach. In addition to Buffett, Graham also hired Walter Schloss, Tom Knapp, and Bill Ruane. Schloss went on to manage money at WJS Ltd. Partners for 28 years. Knapp, a Princeton chemistry major, was a founding partner in Tweedy, Browne Partners. Ruane cofounded the Sequoia Fund. For Buffett, Graham was much more than a tutor. “It was Graham who provided the first reliable map to that wondrous and often forbidding city, the stock market,” wrote Roger Lowenstein. “He laid out a methodological basis for picking stocks, previously a pseudoscience similar to gambling.”16 Since the days when 11-yearold Buffett first purchased Cities Service Preferred, he had spent half of his life studying the mysteries of the stock market. Now he had answers. Alice Schroeder, author of The Snowball: Warren Buffett and the Business of Life, wrote, “Warren’s reaction was that of a man emerging from the cave in which he had been living all his life, blinking in the sunlight as he perceived reality for the first time.” According to Schroeder, Buffett’s original “concept of a stock was derived from the patterns formed by the prices at which pieces of

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The Warren Buffett Way

paper were traded. Now he saw that those pieces of paper were simply symbols of an underlying truth.”17 In 1956, two years after Buffett arrived, Graham-Newman disbanded and Graham, then 61, decided to retire. Once again Buffett returned to Omaha. Armed with the knowledge he had acquired from Graham, and with the financial backing of family and friends, he began a limited investment partnership. He was 25 years old.

The Buffett Partnership Ltd. The Buffett Partnership began with seven limited partners who together contributed $105,000. Buffett, the general partner, started with $100. The limited partners received 6 percent annually on their investments and 75 percent of the profits above this bogey; Buffett earned the other 25 percent. But the goal of partnership was relative, not absolute. Buffett’s intention, he told his partners, was to beat the Dow Jones Industrial Average by 10 percentage points. Buffett promised his partners that “our investments will be chosen on the basis of value not popularity” and that the partnership “will attempt to reduce permanently capital loss (not short-term quotational loss) to a minimum.”18 Initially, the partnership bought undervalued common stocks based on Graham’s strict criteria. In addition, Buffett also engaged in merger arbitrage—a strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit. Out of the gate, the Buffett partnership posted incredible numbers. In its first five years (1957–1961), a period in which the Dow was up 75 percent, the partnership gained 251 percent (181 percent for limited partners). Buffett was beating the Dow not by the promised 10 percentage points but by an average of 35. As Buffett’s reputation became more widely known, more people asked him to manage their money. As more investors came in, more partnerships were formed, until Buffett decided in 1962 to reorganize everything into a single partnership. That year Buffett moved the partnership office from his home to Kiewit Plaza in

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A Five-Sigma Event

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Omaha, where his office remains today. The following year, Buffett made one of his most famous investments, one that served to boost his already growing reputation. One of the worst corporate scandals in the 1960s occurred when the Allied Crude Vegetable Oil Company, led by Tino De Angelis, discovered it could obtain loans based on the inventory of its salad oil. Using one simple fact—that oil floats on top of water— De Angelis rigged the game. He built a refinery in New Jersey, put in 139 five-story storage tanks to hold soybean oil, then filled the tanks with water topped with just a few feet of salad oil. When inspectors arrived to confirm inventory, Allied employees would clamber up to the top of the tanks, dip in a measuring stick, and call out a false number to the inspectors on the ground. When the scandal broke, it was learned that Bank of America, Bank Leumi, American Express, and other international trading companies had backed over $150 million in fraudulent loans. American Express was one of the biggest casualties of what became known as the salad oil scandal. The company lost $58 million and its share price dropped by over 50 percent. If Buffett had learned anything from Ben Graham, it was this: When a stock of a strong company sells below its intrinsic value, act decisively. Buffett was aware of the $58 million loss, but what he did not know was how customers viewed the scandal. So he hung out at the cash registers of Omaha restaurants and discovered there was no drop-off in the use of the famous American Express Green Card. He also visited several banks in the area and learned that the financial scandal was having no impact on the sale of American Express Travelers Cheques. Returning to his office, Buffett promptly invested $13 million—a whopping 25 percent of the partnership assets—in shares of American Express. Over the next two years, the shares tripled and the partners netted a cool $20 million in profit. It was pure Graham, and pure Buffett. In the beginning, Buffett confined the partnership to buying undervalued securities and certain merger arbitrage announcements. But in the fifth year, he purchased his first controlling interest

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The Warren Buffett Way

in a business—the Dempster Mill Manufacturing Company, a maker of farm equipment. Next he began buying shares in an ailing New England textile company called Berkshire Hathaway, and by 1965 he had control of the business. Continues...

■ ■ ■

In differential calculus, an inflection point is a point on a curve at which the curvature changes from being plus to minus or minus to plus. Inflection points can also occur in companies, industries, economies, geopolitical situations, and individuals as well. I believe the 1960s proved to be Buffett’s inflection point—where Buffett the investor evolved into Buffett the businessperson. It was also a period when the market itself reached an inflection point. Since 1956, the valuation strategy outlined by Graham and used by Buffett had dominated the stock market. But by the mid-1960s a new era was unfolding. It was called the “Go-Go” years—the “GoGo” referred to growth stocks. It was a time when greed begin driving the market and where fast money was made and lost in the pursuit of high-flying performance stocks.19 Despite the underlying shift in market psychology, the Buffett Partnership continued to post outstanding results. By the end of 1966, the partnership had gained 1,156 percent (704 percent for limited partners), blitzing the Dow, which was up 123 percent over the same period. Even so, Buffett was becoming increasingly uneasy. Whereas the market had been dancing to the principles outlined by Graham, the new music being played in the stock market made little sense to Buffett. In 1969, Buffett decided to end the investment partnership. He found the market highly speculative and worthwhile values increasingly scarce. By the late 1960s, the stock market was dominated by highly priced growth stocks. The Nifty Fifty were on the tip of every investor’s tongue. Stocks like Avon, Polaroid, and Xerox were trading at fifty to one hundred times earnings. Buffett mailed a letter to his partners confessing that he was out of step with the current market environment. “On one point, however, I am clear,” he said.

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The Essays of Warren Buffett, 4th Edition Lessons for Investors and Managers Lawrence A. Cunningham 978-1-118-82115-2 • Paperback • 320 pages • December 2013

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I

Corporate Governance

M

any annual meetings are a waste of time, both for shareholders and for management. Sometimes that is true because management is reluctant to open up on matters of business substance. More often a non-productive session is the fault of shareholder participants who are more concerned about their own moment on stage than they are about the affairs of the corporation. What should be a forum for business discussion becomes a forum for theatrics, spleenventing and advocacy of issues. (The deal is irresistible: for the price of one share you get to tell a captive audience your ideas as to how the world should be run.) Under such circumstances, the quality of the meeting often deteriorates from year to year as the antics of those interested in themselves discourage attendance by those interested in the business. Berkshire’s meetings are a different story.The number of shareholders attending grows a bit each year and we have yet to experience a silly

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question or an ego-inspired commentary.1 Instead, we get a wide variety of thoughtful questions about the business. Because the annual meeting is the time and place for these, Charlie and I are happy to answer them all, no matter how long it takes. (We cannot, however, respond to written or phoned questions at other times of the year; one-personat-a-time reporting is a poor use of management time in a company with [thousands of] shareholders.) The only business matters that are off limits at the annual meeting are those about which candor might cost our company real money. Our activities in securities would be the main example.2

A. Full and Fair Disclosure3 At Berkshire, full reporting means giving you the information that we would wish you to give to us if our positions were reversed.What Charlie and I would want under that circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business. We would expect both a lot of financial details and a discussion of any significant data we would need to interpret what was presented. When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder— does management think the tooth fairy pays for capital expenditures?4 We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something. And we don’t want to read messages that a public relations department or consultant has turned out. Instead, we expect a company’s CEO to explain in his or her own words what’s happening. For us, fair reporting means getting information to our 300,000 “partners” simultaneously, or as close to that mark as possible. We therefore

1 [Subsequent letters sometimes report on the turnout at prior annual meetings. The turnout went from 12 at the 1975 meeting to approximately 7,500 at the 1997 meeting to over 15,000 in the early 2000s and to 35,000 in 2008, with steady increases since 1984.] 2 [Introductory essay, 1984.] 3 [Divided by hash lines: 2000; 2002.] 4 [See the essay Owner Earnings and the Cash Flow Fallacy in Part VI.E.]

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put our annual and quarterly financials on the Internet between the close of the market on a Friday and the following morning. By our doing that, shareholders and other interested investors have timely access to these important releases and also have a reasonable amount of time to digest the information they include before the markets open on Monday. We applaud the work that Arthur Levitt, Jr., until recently Chairman of the SEC, has done in cracking down on the corporate practice of “selective disclosure” that had spread like cancer in recent years. Indeed, it had become virtually standard practice for major corporations to “guide” analysts or large holders to earnings expectations that were intended either to be on the nose or a tiny bit below what the company truly expected to earn. Through the selectively dispersed hints, winks and nods that companies engaged in, speculatively-minded institutions and advisors were given an information edge over investment-oriented individuals. This was corrupt behavior, unfortunately embraced by both Wall Street and corporate America. Thanks to Chairman Levitt, whose general efforts on behalf of investors were both tireless and effective, corporations are now required to treat all of their owners equally. The fact that this reform came about because of coercion rather than conscience should be a matter of shame for CEOs and their investor relations departments. One further thought while I’m on my soapbox: Charlie and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble. It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble. That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 to 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than

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10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years. The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to “make the numbers.” These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more “heroic.”These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.) Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic—but others will turn out to be congenital optimists, or even charlatans. Unfortunately, it’s not easy for investors to know in advance which species they are dealing with.

Three suggestions for investors: First, beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out.When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen. Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would

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lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense—a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality? Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me. Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don’t know today what our businesses will earn next year—we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future—and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.

B. Boards and Managers5 [The performance of CEOs of investee companies], which we have observed at close range, contrasts vividly with that of many CEOs, which we have fortunately observed from a safe distance. Sometimes these CEOs clearly do not belong in their jobs; their positions, nevertheless, are usually secure. The supreme irony of business management is that it is far easier for an inadequate CEO to keep his job than it is for an inadequate subordinate. If a secretary, say, is hired for a job that requires typing ability of at least 80 words a minute and turns out to be capable of only 50 words a minute, she will lose her job in no time. There is a logical standard for this job; performance is easily measured; and if you can’t make the grade, you’re out. Similarly, if new sales people fail to generate 5 [Divided by hash lines: 1988; 1993; 2002; 2004; 2003; 1986; 1998; 2005.]

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sufficient business quickly enough, they will be let go. Excuses will not be accepted as a substitute for orders. However,a CEO who doesn’t perform is frequently carried indefinitely. One reason is that performance standards for his job seldom exist. When they do, they are often fuzzy or they may be waived or explained away, even when the performance shortfalls are major and repeated. At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands. Another important, but seldom recognized, distinction between the boss and the foot soldier is that the CEO has no immediate superior whose performance is itself getting measured. The sales manager who retains a bunch of lemons in his sales force will soon be in hot water himself. It is in his immediate self-interest to promptly weed out his hiring mistakes. Otherwise, he himself may be weeded out. An office manager who has hired inept secretaries faces the same imperative. But the CEO’s boss is a Board of Directors that seldom measures itself and is infrequently held to account for substandard corporate performance. If the Board makes a mistake in hiring, and perpetuates that mistake, so what? Even if the company is taken over because of the mistake, the deal will probably bestow substantial benefits on the outgoing Board members. (The bigger they are, the softer they fall.) Finally, relations between the Board and the CEO are expected to be congenial. At board meetings, criticism of the CEO’s performance is often viewed as the social equivalent of belching. No such inhibitions restrain the office manager from critically evaluating the substandard typist. These points should not be interpreted as a blanket condemnation of CEOs or Boards of Directors: Most are able and hardworking, and a number are truly outstanding. But the management failings that Charlie and I have seen make us thankful that we are linked with the managers of our three permanent holdings. They love their businesses, they think like owners, and they exude integrity and ability.

At our annual meetings, someone usually asks “What happens to this place if you get hit by a truck?” I’m glad they are still asking the question

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in this form. It won’t be too long before the query becomes: “What happens to this place if you don’t get hit by a truck?” Such questions, in any event, raise a reason for me to discuss corporate governance, a hot topic during the past year. In general, I believe that directors have stiffened their spines recently and that shareholders are now being treated somewhat more like true owners than was the case not long ago. Commentators on corporate governance, however, seldom make any distinction among three fundamentally different manager/owner situations that exist in publicly-held companies.Though the legal responsibility of directors is identical throughout, their ability to effect change differs in each of the cases. Attention usually falls on the first case, because it prevails on the corporate scene. Since Berkshire falls into the second category, however, and will someday fall into the third, we will discuss all three variations. The first, and by far most common, board situation is one in which a corporation has no controlling shareholder. In that case, I believe directors should behave as if there is a single absentee owner, whose longterm interest they should try to further in all proper ways. Unfortunately, “long-term” gives directors a lot of wiggle room. If they lack either integrity or the ability to think independently, directors can do great violence to shareholders while still claiming to be acting in their longterm interest. But assume the board is functioning well and must deal with a management that is mediocre or worse. Directors then have the responsibility for changing that management, just as an intelligent owner would do if he were present. And if able but greedy managers over-reach and try to dip too deeply into the shareholders’ pockets, directors must slap their hands. In this plain-vanilla case, a director who sees something he doesn’t like should attempt to persuade the other directors of his view. If he is successful, the board will have the muscle to make the appropriate change. Suppose, though, that the unhappy director can’t get other directors to agree with him. He should then feel free to make his views known to the absentee owners. Directors seldom do that, of course. The temperament of many directors would in fact be incompatible with critical behavior of that sort. But I see nothing improper in such actions, assuming the issues are serious. Naturally, the complaining director can expect a vigorous rebuttal from the unpersuaded directors, a

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prospect that should discourage the dissenter from pursuing trivial or non-rational causes. For the boards just discussed, I believe the directors ought to be relatively few in number—say, ten or less—and ought to come mostly from the outside. The outside board members should establish standards for the CEO’s performance and should also periodically meet, without his being present, to evaluate his performance against those standards. The requisites for board membership should be business savvy, interest in the job, and owner-orientation. Too often, directors are selected simply because they are prominent or add diversity to the board. That practice is a mistake. Furthermore, mistakes in selecting directors are particularly serious because appointments are so hard to undo: The pleasant but vacuous director need never worry about job security. The second case is that existing at Berkshire, where the controlling owner is also the manager. At some companies, this arrangement is facilitated by the existence of two classes of stock endowed with disproportionate voting power. In these situations, it’s obvious that the board does not act as an agent between owners and management and that the directors cannot effect change except through persuasion. Therefore, if the owner/manager is mediocre or worse—or is over-reaching—there is little a director can do about it except object. If the directors having no connections to the owner/manager make a unified argument, it may well have some effect. More likely it will not. If change does not come, and the matter is sufficiently serious, the outside directors should resign. Their resignation will signal their doubts about management, and it will emphasize that no outsider is in a position to correct the owner/manager’s shortcomings. The third governance case occurs when there is a controlling owner who is not involved in management. This case, examples of which are Hershey Foods and Dow Jones, puts the outside directors in a potentially useful position. If they become unhappy with either the competence or integrity of the manager, they can go directly to the owner (who may also be on the board) and report their dissatisfaction. This situation is ideal for an outside director, since he need make his case only to a single, presumably interested owner, who can forthwith effect change if the argument is persuasive. Even so, the dissatisfied director has only that

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single course of action. If he remains unsatisfied about a critical matter, he has no choice but to resign. Logically, the third case should be the most effective in insuring firstclass management. In the second case the owner is not going to fire himself, and in the first case, directors often find it very difficult to deal with mediocrity or mild over-reaching. Unless the unhappy directors can win over a majority of the board—an awkward social and logistical task, particularly if management’s behavior is merely odious, not egregious— their hands are effectively tied. In practice, directors trapped in situations of this kind usually convince themselves that by staying around they can do at least some good. Meanwhile, management proceeds unfettered. In the third case, the owner is neither judging himself nor burdened with the problem of garnering a majority. He can also insure that outside directors are selected who will bring useful qualities to the board. These directors, in turn, will know that the good advice they give will reach the right ears, rather than being stifled by a recalcitrant management. If the controlling owner is intelligent and self-confident, he will make decisions in respect to management that are meritocratic and pro-shareholder. Moreover—and this is critically important—he can readily correct any mistake he makes. At Berkshire we operate in the second mode now and will for as long as I remain functional. My health, let me add, is excellent. For better or worse, you are likely to have me as an owner/manager for some time. All in all, we’re prepared for “the truck.”

Both the ability and fidelity of managers have long needed monitoring. Indeed, nearly 2,000 years ago, Jesus Christ addressed this subject, speaking (Luke 16:2) approvingly of “a certain rich man” who told his manager, “Give an account of thy stewardship; for thou mayest no longer be steward.” Accountability and stewardship withered in the last decade, becoming qualities deemed of little importance by those caught up in the Great Bubble. As stock prices went up, the behavioral norms of managers went down. By the late ‘90s, as a result, CEOs who traveled the high road did not encounter heavy traffic.

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The Road to Recovery How and Why Economic Policy Must Change Andrew Smithers 978-1-118-51566-2 • Hardback • 360 pages • September 2013

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2 Why the Recovery Has Been So Weak We are now suffering from a weak and halting recovery. Chart 1 shows that among G5 countries only in Germany and the US has real GDP risen above the level that was achieved in the first quarter of 2008. Both the UK and the US provide examples of how unusual the recession has been, both in terms of the slowness of the recoveries and in the depths of the downturns. It has taken longer to recover to the previous peak in real GDP than on any previous occasion since World War II. Indeed, there are claims that the UK recovered more quickly in the 1930s than it has after the recent recession.1 The US took four years from Q4 2007 to Q4 2011 to recover to its previous peak and the UK after four and half years has still not recovered to its Q1 2008 peak. In both countries the loss of output from peak to trough was the greatest seen in the post-war period, amounting to 6.3% of GDP for the UK and 4.7% for the US.2 1 “A funny way of firing up the locomotive” by Sam Brittan, Financial Times (17th January, 2013). 2 The worst previous post-war recessions were during the first (c.1973–1976) and second oil shocks (c.1979–1983); neither their length nor their duration was as severe in either country as the post-shock recessions.

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Chart 1. The Weak Recovery of G5 Countries. Sources: National Accounts via Ecowin.

The weak recovery has occurred despite the most aggressive attempt at stimulating the economy, in terms of both fiscal and monetary policy, that has been tried since World War II. Interest rates were kept low in wartime, but then rose and have now fallen back to their lowest post-war level in nominal terms (Chart 2). The pattern is similar, though more nuanced and less marked in real terms. Chart 3 shows that for both the UK and the US interest rates were very low in real terms after the war and after the oil shock, owing to high rates of inflation. With these exceptions, current real interest rates and bond yields are at their lowest postwar levels. Chart 4 shows that the pattern was the same for other G5 countries. Both real and nominal rates are exceptionally low and the fall in real rates is only constrained by the relatively low levels of inflation. As Chart 5 and Chart 6 illustrate, the Japanese, UK and US governments’ deficits have all risen to over 10% of GDP in recent years, while Germany’s budget is currently balanced. France’s deficit

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-4

Chart 6. UK & US: Fiscal Balances. Source: OECD via Ecowin.

peaked at 7.6% of GDP and is thought to have fallen to 4.5% of GDP in 2012. Large deficits have not therefore been successful in generating strong recovery. Nor has the growth of individual economies been associated with the size of their deficits. Japan, which has the largest current deficit, shares with the UK the wooden spoon for recovery, and Germany with no deficit has achieved the best recovery alongside the US. Neither fiscal nor monetary policy has therefore been successful in creating the growth rates that are generally assumed to be possible. It follows that either the growth potential is less than assumed, the policies are correct but have not been pursued with sufficient vigour or the policies are ill considered. My view is that the policies have been the wrong ones and, although I am not alone in thinking this, my reasons seem very different from those of other economists who share my conclusion. At the centre of the disagreement that I have with those who favour more stimulus is why the economy remains weak. The central issue is whether it is due to short-term, temporary problems, which are

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termed cyclical by economists, or structural ones which last longer and tend to be more intractable. The key difference between my views and the proponents of more stimuli is that I see today’s problems as structural which need to be addressed with different policies, while those who favour continuing the current medicine but upping the dosage assume that the problems are purely cyclical. On the other hand I do not agree with those who see the structural problem as being a lack of output capacity. This in my view is overly pessimistic. There seems to be plenty of unused capacity in terms of both labour and capital equipment; the problem is that there are structural inhibitions to this capacity being used, without creating inflation. We are not being held back by either a simple cyclical weakness in demand or a lack of capacity to grow: we have a new structural problem that we have not encountered before. As I will seek to explain, the key structural inhibition that is preventing the spare capacity which we have in both labour and capital equipment from being fully used is the change in the way company managements behave, and this change has arisen from the change in the way managements are paid. There is abundant evidence that a dramatic change has taken place in the way those that run businesses are paid. Their incentives have been dramatically altered. It should therefore be of no surprise that their behaviour has changed, as this is the usual result of changed incentives. For the economy as a whole, incomes and expenditure must be equal. No one can spend more than their income unless someone else spends less. If one company, individual or sector of the economy spends more than its income, it must find the balance by selling assets or borrowing from somewhere else, and the company, individual or sector that lends the money or buys the asset must spend less than its income. A cash flow deficit in one sector of an economy must therefore be exactly matched by a cash surplus in another. I am not here making a forecast but pointing to a necessary identity and one which it is essential to understand in order to comprehend the nature of the problem that we face in trying to bring government budget deficits under control. Although much that is forecast is not very likely, almost anything in economics is possible, subject only to the essential condition that the figures must add up. This is always important, and often neglected

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Why the Recovery Has Been So Weak

9

by forecasters, but it is particularly informative when a large reduction in fiscal deficits is essential. This is because any reduction in fiscal deficits must be exactly matched by reductions in the combined cash surpluses of the household, business and foreign sectors. When the deficits fall, the cash surpluses of these other sectors of the economy must fall by an identical amount. The OECD estimates that in 2012 the UK and US economies had government budget deficits, which are also known as fiscal deficits, equal to 6.6% and 8.5% of GDP respectively. To prevent a dangerous and unsustainable situation arising in which the ratios of national debts to GDP are on a permanently rising path, these fiscal deficits must be brought down to about 2% or less of GDP. It follows, as a matter or identity, that the surpluses in the household, business and foreign sectors of the economies must fall by around 4.6% of GDP for the UK and 6.5% for the US from the level estimated by the OECD in 2012. One of the major lessons of history is that economies must from time to time adjust to large changes and can do so without disaster, provided that the speed at which they are required to adjust is not too rapid. It will therefore be very important to make sure that there are smooth rather than abrupt declines in the fiscal deficit and thus in the matching declines of other sectors’ cash flows. Unfortunately, ensuring that the adjustment is smooth is also likely to be very difficult. This is partly because the economy is unpredictable and partly because political decisions are often wayward. But it is also because the impact is likely to fall mainly on the business sector, and, if the hit is too sharp, companies are likely to respond by reducing investment and employment, thus causing another recession. The probability that a reduction in the fiscal deficit will fall most heavily on the business sector is shown both by past experience and from considering the contributions that are likely from other sectors. In the past, changes in the fiscal balances of the major Anglophone economies have moved up and down with fluctuations in the business sector’s cash flow, as I illustrate in Chart 7 for the UK and for the US in Chart 8.3 On historical grounds, therefore, the 3 The correlation coefficient between business cash flow and the fiscal deficit is 0.71 for the UK and 0.83 for the US. In each case we measure the relationship for the whole period for which we have data, which are annual from 1987 to 2011 for the UK and quarterly from Q1 1960 to Q3 2012 for the US.

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the road to recove ry 8 Government

10

Corporations

8

6 4

6 2 4 0

2

-2

0 -2

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Net lending (+) or borrowing (-) by business sector as % of GDP.

Fiscal deficit (+) or surplus (-) as % of GDP.

12

-4

Net lending (+) or borrowing (-) by business sector as % of GDP.

6 4

14 12 Business

Government deficit

10 8

2

6 4

0

2

-2

0 -2

-4

-4

-6 -6 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Fiscal deficit (+) or surplus (-) as % of GDP.

Chart 7. UK: Budget Deficits & Business Cash Surpluses Go Together. Source: ONS (EAOB, NHCQ & YBHA).

Chart 8. US: Budget Deficits & Business Cash Surpluses Go Together. Sources: NIPA Tables 1.1.5 & 5.1.

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Why the Recovery Has Been So Weak

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Table 1. Business Cash Flow Surpluses (+) or Deficits (−) as % of GDP (Sources: ONS & NIPA) UK 1987 to 2001 2002 to 2011

US −1.65 4.54

1960 to 2001 2002 to 2011

−0.85 3.34

scale of the reductions required in the fiscal deficits means that large compensating falls in the cash surplus of the business sectors will be needed. As Chart 7 and Chart 8 show, companies in both the UK and the US are currently running exceptionally large cash surpluses. It is the existence of these surpluses as well as their size which is unusual. As Table 1 shows, until recently companies have tended to run cash deficits. It is only over the past decade that companies have been producing more cash than they pay out, either to finance their spending on new capital investments or to pay out dividends. The regular cash deficits shown before 2001 are the expected pattern. The business sector normally finances itself partly from equity and partly from debt. The extent to which companies finance their business by debt compared to equity is called their leverage. If, for example, half of companies’ finance comes from borrowing and the rest from equity, the ratio of debt to equity will be 100%, i.e. debt and equity will have equal values. There are limits to the extent that companies can finance themselves with debt. Their leverage rises as the proportion of finance from debt rises, and as this ratio becomes higher so does the risk that lenders will lose money when the economy falls into recession. This puts a limit on the extent to which companies can finance themselves with debt, but this limit is not fixed. If lenders don’t find that they are experiencing losses from bad debts, they assume that current leverage ratios are conservative and are willing to lend on the basis of even higher ratios of debt to equity. But this is a dangerous process, because high leverage increases the risks of a financial crisis and the risks that it will cause a deep recession. Leverage can vary a lot over time, and I will be showing later that business debt had risen to unprecedented heights prior to the financial crisis. It has since fallen a little but remains nearly at record

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levels and it is almost certain that it is still dangerously high. We should therefore wish to see leverage falling and thus see equity providing a higher proportion of companies’ financial requirements than has been the case in recent years. It is easy to see how the growth of the economy can be financed by a mixture of equity and debt. In a long run stable situation the leverage ratio will also be stable. If debt and equity each provide half the capital needed, this will also be the ratio by which new investment is financed. However, the proportion of new investment that needs to be financed with equity will always be a large one. If, for example, over the long-term, investment is financed 60% by debt and 40% by equity, rather than 50% by each, the leverage rises sharply. In the first example debt will equal 100% of equity and in the second it will be 150%. This measure of leverage would thus be 50 percentage points higher than if the proportions financed by debt and equity had remained equal. In practice things can be more complicated, but the broad outline is nonetheless clear. Over time the capital stock must grow if the economy is to expand and, over the long-term, companies must therefore add to their equity capital at a steady rate. This equity capital is equal to the value of companies’ assets less the amount that they have borrowed to finance them and is also known as net worth. Equity rises from operations if companies pay out less than 100% of their after-tax profits as dividends and falls if they pay out more. Equity can also be increased by new issues and will fall if companies buy back their own shares or acquire other companies using cash or debt. Companies either run down their cash or increase their debt when they buy back their own shares, and this often occurs when they acquire other companies. It is possible to finance acquisitions with the whole cost being met by equity through companies using their own shares. In recent years companies have been using debt to finance acquisitions of their own and other companies’ shares to a much greater extent than they have been making new equity issues and they have also, of course, been paying dividends. By adding up the sums of money spent on buybacks, acquisitions and dividends, and deducting any amount raised from new issues, we know the total amount of cash that companies are paying out to shareholders.

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The Manual of Ideas The Proven Framework for Finding the Best Value Investments John Mihaljevic 978-1-118-08365-9 • Hardback • 336 pages • September 2013

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CHAPTER

1

A Highly Personal Endeavor What Do You Want to Own? Man the living creature, the creating individual, is always more important than any established style or system. —Bruce Lee

T

he stock market is a curious place because everyone participating in it is loosely interested in the same thing—making money. Still, there is no uniform path to achieving this rather uniform goal. You may be only a few mouse clicks away from purchasing the popular book The Warren Buffett Way,1 but only one man has ever truly followed the path of Warren Buffett. In investing, it is hard enough to succeed as an original; as a copycat, it is virtually impossible. Each of us must carve out a personal way to investment success, even if you are a professional investor. That said, great investors like Ben Graham, Seth Klarman, and Warren Buffett have much to teach us, and we have much to gain by learning from them. One of the masters’ key teachings is as important as it is simple: A share of stock represents a share in the ownership of a business. A stock exchange simply provides a convenient means of exchanging your ownership for cash. Without an exchange, your ownership of a business would not change. The ability to sell your stake would be negatively affected, but you

1

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would still be able to do it, just as you can sell your car or house if you decide to do so. Unfortunately, when we actually start investing, we are inevitably bombarded with distractions that make it easy to forget the essence of stock ownership. These titillations include the fast-moving ticker tape on CNBC, the seemingly omniscient talking heads, the polished corporate press releases, stock price charts that are consolidating or breaking out, analyst estimates being beaten, and stock prices hitting new highs. It feels a little like living in the world of Curious George, the lovable monkey for whom it is “easy to forget” the well-intentioned advice of his friend. My son loves Curious George stories, because as surely as George gets into trouble, he finds a way out of trouble. The latter doesn’t always hold true for investors in the stock market.

Give Your Money to Warren Buffett, or Invest It Yourself? I still remember the day I had saved the princely sum of $100,000. I had worked as a research analyst for San Francisco investment bank Thomas Weisel Partners for a couple of years and in 2003 had managed to put aside what I considered to be an amount that made me a free man. Freedom, I reasoned, was only possible if one did not have to work to survive; otherwise, one was forced into a form of servitude that involved trading time for food and shelter. With the money saved, I could quit my job, move to a place like Thailand, and live on interest income. While I wisely chose not to exercise my freedom option, I still had to find something to do with the money. I dismissed an investment in mutual funds quite quickly because I was familiar with findings that the vast majority of mutual funds underperformed the market indices on an after-fee basis.2 I also became aware of the oft-neglected but crucial fact that investors tended to add capital to funds after a period of good performance and withdraw capital after a period of bad performance. This caused investors’ actual results to lag significantly behind the funds’ reported results. Fund prospectuses show time-weighted returns, but investors in those funds reap the typically lower capital-weighted returns. A classic example of this phenomenon is the Munder NetNet Fund, an Internet fund that lost investors billions

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of dollars from 1997 through 2002. Despite the losses, the fund reported a positive compounded annual return of 2.15 percent for the period. The reason? The fund managed little money when it was doing well in the late 1990s. Then, just as billions in new capital poured in, the fund embarked on a debilitating three-year losing streak.3 Although I had felt immune to the temptation to buy after a strong run in the market and to sell after a sharp decline, I thought this temptation would be easier to resist if I knew exactly what I owned and why I owned it. Owning shares in a mutual fund meant trusting the fund manager to pick the right investments. Trust tends to erode after a period of losses. Mutual funds and lower-cost index funds should not be entirely dismissed, however, as they offer an acceptable alternative for those wishing to delegate investment decision making to someone else. Value mutual funds such as Bruce Berkowitz’s Fairholme Fund or Mason Hawkins’s Longleaf Funds are legitimate choices for many individual investors. High-net-worth investors and institutions enjoy the additional option of investing in hedge funds, but few of those funds deserve their typically steep management and performance fees. Warren Buffett critiqued the hedge fund fee structure in his 2006 letter to shareholders: “It’s a lopsided system whereby 2 percent of your principal is paid each year to the manager even if he accomplishes nothing—or, for that matter, loses you a bundle—and, additionally, 20 percent of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10 percent in a year will keep 3.6 percentage points—two points off the top plus 20 percent of the residual eight points—leaving only 6.4 percentage points for his investors.”4 A small minority of value-oriented hedge fund managers have chosen to side with Buffett on the fee issue, offering investors a structure similar to that of the limited partnerships Buffett managed in the 1960s. Buffett charged no management fee and a performance fee only on returns in excess of an annual hurdle rate. The pioneers in this small but growing movement include Guy Spier of Zurich, Switzerland-based Aquamarine Capital Management and Mohnish Pabrai of Irvine, California-based Pabrai Investment Funds. These types of funds bestow a decisive advantage, ceteris paribus, on long-term investors. Table 1.1 shows the advantages of an investorfriendly fee structure.

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TABLE 1.1 Effect of Fees on the Future Wealth of a Hedge Fund Investor Typical Hedge Fund Fee Structure: “2 and 20”

Buffett PartnershipStyle Fee Structure

Management fee: 2%

Management fee: 0%

Performance fee: 20%

Performance fee: 20%

Annual hurdle rate: 0%

Annual hurdle rate: 6%

Assumed gross return

5.0%

10.0%

5.0%

10.0%

Resulting net return

2.4%

6.4%

5.0%

9.2%

Gross value of $1 million . . . after 10 years

$1,628,895

. . . after 20 years

2,653,298

$2,593,742 $1,628,895 $2,593,742 6,727,500

. . . after 30 years

4,321,942

17,449,402

2,653,298

6,727,500

4,321,942 17,449,402

Net value of $1 million . . . after 10 years

$1,267,651

. . . after 20 years

1,606,938

$1,859,586 $1,628,895 $2,411,162 3,458,060

2,653,298

. . . after 30 years

2,037,036

6,430,561

4,321,942 14,017,777

5,813,702

Value lost due to fees . . . after 10 years

$361,244

$734,156

$0

$182,580

. . . after 20 years

1,046,360

3,269,440

0

913,798

. . . after 30 years

2,284,906

11,018,842

0

3,431,625

I also considered investing my savings in one of a handful of public companies that operate as low-cost yet high-quality investment vehicles. Berkshire Hathaway pays Warren Buffett an annual salary of $100,000 for arguably the finest capital allocation skills in the world. Buffett receives no bonus, no stock options, and no restricted stock, let alone hedge-fund-style performance fees.5 It certainly seems like investors considering an investment in a highly prized hedge fund should first convince themselves that their prospective fund manager can beat Buffett. Doing this on a prefee basis is hard enough; on an after-fee basis, the odds diminish considerably. Of course, buying a share of Berkshire is not quite

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associated with the same level of privilege and exclusivity as being accepted into a secretive hedge fund. Berkshire is not the only public holding company with shareholder-friendly and astute management. Alternatives include Brookfield Asset Management, Fairfax Financial, Leucadia National, Loews Companies, Markel Corporation, and White Mountains Insurance. While these companies meet Buffett-style compensation criteria, some public investment vehicles have married hedge-fundstyle compensation with a value investment approach. Examples include Greenlight Capital Re and Biglari Holdings. These hedge funds in disguise may ultimately deliver satisfactory performance to their common shareholders, but they are unlikely to exceed the long-term after-fee returns of a company like Markel, which marries superior investment management with low implied fees. In light of the exceptional long-term investment results and low fees of companies like Berkshire and Markel, it may be irrational for any long-term investor to manage his or her own portfolio of stocks. Professional fund managers have a slight conflict of interest in this regard. Their livelihood depends rather directly on convincing their clients that the past performance of Berkshire or Markel is no indication of future results. Luckily for them, securities regulators play along with this notion, thereby doing their part in encouraging a constant flow of new entrants into the lucrative fund management business. Rest assured, we won’t judge too harshly those who choose to manage their own equity investments. After all, that is precisely what I did with my savings in 2003 and have done ever since. You could say that underlying my decision has been remarkable folly, but here are a few justifications for the do-it-yourself approach: First, investment holding companies like Berkshire and Markel are generally not available for purchase at net asset value, implying that some recognition of skill is already reflected in their market price. While over time the returns to shareholders will converge with internally generated returns on capital, the gap is accentuated in the case of shorter holding periods or large initial premiums paid over net asset value. Even for a company like Berkshire, there is a market price at which an investment becomes no longer attractive. In addition, one of the trappings of investment success is growth of assets under management. Few fund managers limit their assets,

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and this is even rarer among public vehicles. Buffett started investing less than $1 million six decades ago. Today he oversees a company with more than $200 billion in market value. If Buffett wanted to invest $2 billion, a mere 1 percent of Berkshire’s quoted value, into one company, he could not choose a company with a market value of $200 million. He would likely need to find a company quoted at $20 billion, unless he negotiated an acquisition of the entire business. Buffett is one of few large capital allocators who readily admit that size hurts performance. Many others evolve their view, perhaps not surprisingly, as their assets under management grow. Arguments include greater access to management, an ability to structure private deals, and the spreading of costs over a large asset base. Trust Buffett that these advantages pale in comparison with the disadvantage of a diminished set of available investments. If you manage $1 million or even $100 million, investing in companies that are too small for the superinvestors offers an opportunity for outperformance. Buffett agrees: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”6 The corollary: When small investors commit capital to megacaps such as Exxon Mobil or Apple, they willingly surrender a key structural advantage: the ability to invest in small companies. Echoing Buffett’s sentiments on the unique advantages of a small investable asset base, Eric Khrom, managing partner of Khrom Capital Management, describes the business rationale he articulated to his partners early on: “The fact that we are starting off so small will allow me to fish in very small pond where the big fishermen can’t go. So although I’m a one man shop, you don’t have to picture me competing with shops that are much larger than me, because they can’t look at the things I look at anyway. We will be looking at the much smaller micro caps, where there are a lot of inefficiencies. . . .”7 The last argument for choosing our own equity investments leads to the concept of capital allocation. Contrary to the increasingly popular view that the stock market is little more than a glorified casino, the market is supposed to foster the allocation of capital

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to productive uses in a capitalist economy. Businesses that add value to their customers while earning acceptable returns on invested capital should be able to raise capital for expansion, and businesses that earn insufficient returns on capital should fail to attract funding. A properly functioning market thereby assists the process of wealth creation, accelerating the growth in savings, investment, and GDP. If the role of the market is to allocate capital to productive uses, it becomes clear that a few dozen top investors cannot do the job by themselves. There are simply too many businesses to be evaluated. By doing the work the superinvestors must forgo due to limited bandwidth, we put ourselves in a position to earn the just reward of good investment performance. This idea of capital allocation ties in with the previous point regarding our ability to invest in companies that are too small for the superinvestors. We may safely assume that Buffett and the others will allocate capital to mega-caps such as Coca-Cola, if those companies deserve the money. On the other hand, companies such as Strayer Education and Harvest Natural Resources may be left without capital even if they can put it to productive use. Smaller investors can fill this void and make money, provided that they make the right capital allocation judgments.

Cast Yourself in the Role of Capital Allocator It is little surprise that the world’s richest investor is a capital allocator rather than a trend follower, thematic investor, or day trader. Buffett is famous for his buy-and-hold strategy, which has been the hallmark of Berkshire’s portfolio investments and outright purchases of businesses. Buffett looks to the underlying businesses rather than stock certificates to deliver superior compounding of capital over the long term. Buying businesses cheaply has not generated his long-term returns—it has merely accentuated them. Buffett raised eyebrows in the investment community many years ago when he bought Coca-Cola at a mid-teens multiple of earnings. Most value investors could not understand why Buffett considered it a bargain purchase. Buffett was allocating capital to a superior business at a fair price. He knew that Coca-Cola would compound the capital employed in the business at a high rate for a long time to come. Buffett did not need P/E multiple expansion to make the investment in Coca-Cola pay off.

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Similarly, famed value investor Joel Greenblatt paid roughly 20 times earnings for Moody’s when it went public in 2000. Greenblatt was allocating capital to a superior business, one that could grow earnings at a high rate without requiring additional capital, thereby freeing up large amounts of cash for share repurchases. Despite trading at a relatively high earnings multiple at the time of the initial public offering (IPO), Moody’s shares more than quintupled in the subsequent six years. Of course, the company ran into major trouble when the U.S. housing bubble burst a few years ago. Despite the steep decline, Moody’s traded at $48 per share in early 2013, up from a comparable price of $12.65 per share the day it was spun off from Dun & Bradstreet in October 2000.

Role versus Objective: A Subtle but Important Distinction Our role in the stock market may at first glance seem like a trivial issue. It is hardly a secret that rational investors seek to maximize risk-adjusted after-tax returns on invested capital. What is our role, therefore, if not to make the most money by identifying investments that will increase in price? This question is misplaced because it confuses objective (making money) and role. We typically view our role in the market as insignificant. While most investors do have a negligible impact on the overall market, the accompanying small fish mind-set does not lend itself to successful investing. Even when I invested a tiny amount of money, I found it helpful to adopt the mind-set of chief capital allocator. I imagined my role as distributing the world’s financial capital to activities that would generate the highest returns on capital. Consider the following subtle difference in how investors may perceive their portfolios in relation to the available investment opportunities. Many of us inappropriately consider the scale of our portfolio ahead of the scale of potential investments. To illustrate this, imagine we wanted to invest $100,000 in one of the stocks in Table 1.2 in late 2001. When selecting a company from this list, we might analyze financial statements and consider various valuation measures. But even before embarking on a detailed analysis, some of us may think, “I have $100,000 to invest, which will buy me a tiny stake in one the above companies. It looks like I can buy a few thousand

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A Highly Personal Endeavor TABLE 1.2 “Mind-Set A”—Selected Investment Opportunities, November 20018 Ticker

Company

Stock Price

Market Value

$100,000 Buys . . .

AET

Aetna

$30.52

$4.4 billion

DAL

Delta Air Lines

29.31

3.6 billion

3,277 shares 3,412 shares

F

Ford Motor

17.88

32.4 billion

5,593 shares

GM

General Motors

47.69

26.5 billion

2,097 shares 2,222 shares

LMT

Lockheed Martin

45.01

19.8 billion

NYT

New York Times

45.15

6.8 billion

2,215 shares

TIF

Tiffany & Co.

29.17

4.3 billion

3,428 shares

TM

Toyota Motor

53.71

99.0 billion

1,862 shares

shares of any of these stocks” (“mind-set a”). Without realizing it, we are committing the fallacy of considering the scale of our portfolio ahead of the scale of potential investments. On the flip side, if we adopted an asset allocator’s mind-set, we might ask, “If I could buy one of the above companies, which would I choose?” This question focuses attention on the relative scale of the potential investments rather than the size of our portfolio. By applying this mind-set even before embarking on in-depth analysis of the various companies, we might make the observation shown in Table 1.3. Toyota alone was valued more highly than all the companies on the left combined (based on market value rather than enterprise value, which in this case would have been a more appropriate measure). The investor with mind-set b might wonder: “Would I rather own Toyota or Aetna, Delta, Ford, GM, Lockheed Martin, the New York Times, and Tiffany combined?” While after careful analysis the answer might indeed be Toyota, it is obvious that we would need well-founded reasons for that choice. Had we kept a small fish mentality, however, we might have completely missed this issue of relative scale and invested in Toyota, ignorant of the severity of the implied relative value bet. In Table 1.4, we revisit the previous comparison as of late 2004. As a comparison of the market values shows, Toyota outperformed a portfolio of the companies on the left over the three-year

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TABLE 1.3 “Mind-Set B”—Selected Investment Opportunities, November 2001 Ticker Company

Market Value Ticker Company Market Value

AET

Aetna

$4.4 billion

DAL

Delta Air Lines

F

Ford Motor

32.4 billion

GM

General Motors

26.5 billion

LMT

Lockheed Martin

19.8 billion

NYT

New York Times

6.8 billion

TIF

Tiffany & Co.

4.3 billion

TM

Toyota Motor

$99.0 billion

3.6 billion

$97.8 billion

$99.0 billion

TABLE 1.4 “Mind-Set B”—Selected Investment Opportunities, October 2004 9 Ticker Company

Market Value Ticker Company Market Value

AET

Aetna

$12.8 billion

DAL

Delta Air Lines

F

Ford Motor

23.7 billion

GM

General Motors

21.4 billion

LMT

Lockheed Martin

23.8 billion

NYT

New York Times

5.7 billion

TIF

Tiffany & Co.

4.1 billion

TM

Toyota Motor

$125.3 billion

0.4 billion

$91.9 billion

$125.3 billion

period ending in late 2004.10 While this may come as a surprise, it simply means that mind-set b is not a sufficient condition for investment success: Good decision making requires thorough analysis of underlying fundamentals. (Giving the previous table another thought, it is interesting that, in theory, by selling short all of Toyota in late 2004, we could have bought not only the companies on the left but also 93 percent of McDonald’s.)

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