Taking the pragmatic approach

Approximately a month ago, I began a metaphorical journey to relax my rather narrow-fitting investing thought corset. In writing “Learning by Doing”, posted on April 29^th, I ventured into the world of economic cycles and their inevitable consequences for investors around the world. Since that date, two additional posts have made references to the economic cycle. I’m afraid given the state of affairs in my home country of Spain and indeed in most western economies, this topic will also form the backbone of today’s exposé. Talking to or more precisely, listening to, experts in the dismal science has left me with a sense of not only unease but defeat.

Various academics and macroeconomic sages are openly venturing the idea that the once unthinkable is now likely. Indeed the possibility of a sovereign debt default by Spain and, some even argue, by the USA as early as 2013 is not to be underestimated. For us Iberians, it looks as if this scenario is all but inevitable and our efforts at this juncture would be best directed to “getting used to be treated like a pariah of the credit markets for years to come” as a close friend of mine succinctly put it.

Be that as it may, I remain thankful that, as a nation living in suspended disbelief, most Spaniards willfully continue to ignore the obvious warning signs. From a truly selfish and short-term point of view, this unfounded optimism and happy-go-lucky attitude so prevalent in our nation, is actually a bit of a blessing. After all, we’ve had plenty of scare-mongering from the Roubini’s and the Marc Faber’s of the world since 2008…

The flip side of this “ignorance is bliss” attitude is nonetheless a major concern. Both as an investor and as an ordinary citizen concerned with the progress of my immediate circle there’s plenty to be concerned about. First and foremost, if history serves a purpose (which I sometimes wonder…) no course of action (or as the case maybe, inaction) that I can envisage could possibly be more pernicious. Burying one’s head in the sand is not a wise idea. And yet that is precisely what is being done in Spain.

Sure, some fairly dramatic measures were hastily dawn up and narrowly approved in parliament last Friday. In any case, said measures as limited in their scope and one-sided in their impact. Drawing a parallel between macro-economic policy and security analysis with the subject being the Spanish economy, the actions taken to date serve only to reduce costs whilst doing absolutely nothing to enhance private sector revenues.

Am I too pessimistic? Apparently not. According to a recent study performed by Hussman Funds in their weekly commentary of late May 2010, the path to recovery after major financial crises is clearly laid out, though by no means is it easy to follow.

Using the example of the approaches to various severe financial downfalls in Sweden, Norway, Finland and Japan since the early 1990s some clear and useful conclusions can be drawn. Faced with capital-light structures as a result of ever-lower lending standards (sound familiar yet?), banks in these nations almost collapsed triggering off country-wide credit crises.

In dealing with this situation 2 very different approaches were followed, one by the Nordics and the other by Japan. Sweden, Norway & Finland opted for the pragmatic approach, exposing the true extent of the problems upfront, soliciting debt restructuring assistance and winding down troubled loans, whilst capitalizing their balance sheets.

Japan on the other hand, enforce lax accounting rules destined to render non-performing loans less transparent and continued to lend money to the wrong. By now, we all know how this played out for the Nikkei index over the next 20 years! But how did the Nordic economies and their stock markets perform after 1990?. Only 5 years later, the stock markets of these nations recovered to pre-crisis levels.

Whilst the nature of the 1990’s Nordic banking crisis and today’s macro picture in Spain and beyond may differ, there’ a lesson to be learned in applying a direct, face-on approach.

Unfortunately, for investors and regular citizens alike, recent actions by the Spanish government do not bode well in this sense.

Danger ahead

"I'm more worried about the world broadly than I've ever been in my whole career”

These words were uttered just a few days ago at a CFA conference by one of the most consistent investors of our time, none other than Seth Klarman of Baupost Group, who for over 25 years has delivered consistent 20%+ annual returns to his fortunate investors. When someone of this caliber and usually cool, detached demeanor makes so bold a statement, we’d better listen.

The fact remains that macro concerns are almost too numerous to mention. Our governments and central banks have tampered with the wrong levers and more worryingly in the wrong direction. Since the first signs of stress made their way into full public view in early ’08, the actions taken by those with political, monetary and fiscal clout have been, for the most part, misguided.

Some argue, rightly perhaps, that the risk of no intervention at the point of maximum stress (i.e. Sept, 15th ’08) as Lehman Brothers collapsed and credit markets froze, would have led us to a complete meltdown. Be that as it may, the aptly named “stimulus” packages brought on to re-vive the dying patient, (western economies in this case), have been in place well beyond the required duration. In the same way that methadone serves a purpose for a recovering drug-addict, there’s always the risk that the replacement medicine further exacerbates the addictive nature of the patient.

As I write these lines, some 20 months after the nadir reached on Sept’08, both the macroeconomic landscape AND the investment picture look awfully bleak.

On economic terms, most major industrialized economies have delivered meager upticks in GDP. Most of these however, are directly derived from the extraordinary level of public sector spending. Growth of this type can hardly be considered healthy, dependent as it is on external and by definition temporary forces. More serious are the consequences of said public sector debt frenzy. To put it bluntly, throwing good (and expensive) money after bad money was never a good idea and this time it’ll be no different.

Except it will. It will be even worse.

Adding the burden of public sector debt to escape from a situation where debt had been the originator of the crash, strikes me as deadly dangerous. From an investment point of view you’d think these would be the jolliest of times in the value-seeking crowd. Mr. Buffet himself taught us to be “greedy when others are fearful and fearful when other are greedy” and it holds that when thinks look the bleakest the seed of great investments is often sown. So what’s the problem then?

Well, the time for greed actually was terribly short-lived and lasted the 4th quarter of ’08 and the first half of ’09. This was a period of pessimistic contagion and, for once, reasonable valuations. Today, however the general state of the economy is only marginally better than then, (we may not be about to fall off a cliff but we remain awfully close to the proverbial edge!), but equity prices have rallied as if it were 2006 all over again!. Once again the wise words of JK Galbraith come to mind:

“There can be few fields of human endeavor in which history counts for so little as in the world of finance”.

All in all we may be heading into another “lost decade” in stocks and potentially a negative returns scenario for long dated bonds if, or should I say, once inflation returns.
Amidst all this gloom and doom it pains me to end the post on a negative note. Therefore I urge would be investors to search long and hard for areas of opportunity, which, given the erratic and emotional nature of our would-be trading counter-parties, will continue to arise.

Keeping one's head

As I write this lines, we are witnessing extreme volatility in both equity and debt markets. Just yesterday saw the largest single day rise in Spanish stock market history, up over 14%, only to be followed by today’s steep drop of 5%. At times like this, it’s all too easy to lose one’s nerves or worse, one’s head. Lest not forget, this comes after a 14 month rally of gigantic proportions which in turn follows the largest index-wide equity price drop in developed markets since the 1930s.

Remaining a committed long-term investor in these circumstances requires an almost heroic sense of perseverance. Not surprisingly some of Wall’s Street’s most famous sayings point in the opposite direction. “Don’t’ fight the tape” and “the trend is your friend” are popular mantras in the capital markets and are held dear by most participants.

Notice however that I said “most participants” and not “most successful participants”. My own experience, entering the equity markets via the allocation of a very significant portion of my entire net worth in mid-2007, has served to reinforce my belief on the undeniable benefits of a clear conviction and a cool head. Since that time I have seen the price of my holdings decline by almost 50%, literally decimating my hard-earned savings only to subsequently rise again above the original price paid, and thus earning a considerable “paper” gain.

Throughout this experience I restrained myself from the temptation to “cut my losses” by focusing on the value of the businesses I invested in and not on the random pricing offered by desperate and cash strained sellers of stocks.

For sure it has not been fun!. Many a times I’ve had to explain to others and sometimes even to myself that what matters in investing is not price but value. Convinced as I was that value had not been impaired I only wished I had additional cash at the time to further buy into great bargains. Along this tortuous period I also took considerable comfort from the alignment of my views with those of true experts boasting long and successful investing track records and for whom the ’07-’09 market dislocation was a merely a re-run of previous crises…

Along these lines, Seth Klarman of Baupost Group fame (over 20% annual returns for 25 years) was quoted as saying:

“We at Baupost prefer lost opportunity to lost capital”

Which I think highlights the rationale for avoiding the euphoria that characterizes long-running bull markets. On a similar note, Jean-Marie Eveillard of First Eagle funds defended his below-benchmark returns in ’97-’99 as he refused to buy high P/E tech stocks by stating:

“I would rather lose half my clients than half my client’s money”.

As it happens, Mr. Eveillard almost stood alone in his conviction and indeed lost half of his clients and very nearly closed his fund. However, vindication came as for the next 10 years , First Eagle delivered over 138% gross return while the overall market remained flat!.

Amidst the turbulence, wild price oscillations and often catastrophic macroeconomic predictions touted by analysts and journalists alike, there remains room for the calm, cold and reflective business appraisers out there.

And it’s not just me saying this!.