LETTERS FROM THE GLOBAL PROVINCE
Risky Business, Global Province Letter, 28 November 2012
"Courage is to never let your actions be influenced by your fears" – Arthur Koestler
Throwing Caution to the Winds. The 20th century journalist, novelist, and adventurer Arthur Koestler, unlike the rest of his family, did not take the safe road. In his last year of college, during the waning days of the Austro-Hungarian Empire, he suddenly tore up his transcript, which was irreplaceable, and took off to kibbutz in Israel. Later, he became a well-paid successful journalist for the Ullstein newspapers in Berlin. But chagrined at the direction in which Germany was moving, he quit and embarked for the Soviet Union. The young idealistic Communist learned Russian from a dictionary as his train chugged across the vast country. Only much later in life did he convert into a vociferous anti-Communist author. Darkness at Noon, his best-known book, exposed all that was wrong with authoritarian regimes. Jailed in Spain during that country's civil war, he knew all about life under tyranny.
As he points out in the two-part autobiography of his early life–Arrow in the Blue and The Invisible Writing–the sudden changes in direction and of residence saved his life. All his relatives in Germany who led secure and stable bourgeois lives were thrown into concentration camps and went early to their graves. His neurotic restlessness and compulsive chance taking were his salvation.
In highly volatile times that are saturated with political instability, 'playing it safe' turns out to be a very dangerous game. It is the thesis of this investment essay that we are plagued by noxious political volatility in November 2012. Both business enterprises and individuals are at risk if they put their monies into assets that are deemed to be as safe as the rock of Gibraltar, for all the rocks are crumbling.
The Ultra Quest for Security. The very original economist William Baumol has long counseled us about the riskiness of obsessive anti-risk behavior. He feared that the attacks of September 11 would divert us from the business of business, as we roped ourselves off with security devices and fearfulness, avoiding the investments in the future and in crazy ideas that are the basis of sustained economic growth.
He was right. Huge amounts of capital have been sitting on the sidelines. There's been a tendency to go into treasuries, and bonds, and big, asset heavy institutions and companies. But the big guys often do not look very safe on closer inspection. When the economic-meltdown- into-depression occurred in 2008, we queried a number of money managers who had been astute enough to get into cash. We asked, "So where are you parking your cash?" Many, many had it at Goldman Sachs. "What," we said, "Makes you think Goldman is not shaky?" They had no answer. And, indeed, Goldman was quivering. It sat on the same quicksand as all the rest of our financial superstructure. Ultimately the U.S. Government and Warren Buffett came to its aid. The secure was insecure.
How weak are the biggies? It turns out that big institutions and big companies are very weak, indeed. All the airlines are a mess, even many of the smaller ones that like to pretend that they are more nimble. Forget about their ill maintained airplanes. If you look at their information systems, you would find all sorts of things they are not tracking, all manner of process that is out of control.
The telecoms (big telephone companies) are doing tolerably well, but only because they enjoy monopoly privileges in this country wherein they can charge very high prices for bad services. When Judge Greene broke up AT&T in 1984, he never dreamed that what he would be doing is to replace a well-regulated monopoly with a few very poorly regulated monopolies. This is unsustainable. Softbank of Japan is now coming into the States with a view to providing intense competition in this sector.
All the major banks do not have sufficient capital to offset the kinds of risks they are now taking: they are making most of their money from trading activities, and have little cash to contain the risks that constantly show up on their books. Even big companies in the tech sector threaten to implode, with Hewlett Packard and Dell in need of steroids.
What's up? Most big companies and institutions are dependent on GNP growth and yet the developed countries are experiencing little or no growth at the moment. The name brand companies cannot grow if the economy is not growing. JFK liked to say a rising tide lifts all boats: right now the tide is falling, and all boats are down in the mud
Secondly, most large companies are badly managed by overpaid executives whose main answer to everything at the moment is to cut expenses, eliminate service, and to savage product quality. In the main, they are not developing truly new products but offering product extensions, they are gutting their middle managements, and they are trying to do patches to old systems rather than developing the new processes they truly need. Thirdly, the private equity industry has severely damaged American industry in two ways: it has scared industry enough so that executives sacrifice long-term investment in order to bolster short-term returns.
But worse, it has stripped out heaps of cash from the companies in which it puts money. The cash is not put to good uses, but instead, has either gone into a few pockets or parked in other quickbuck investments.
Finally, much of the growth in the financial sector has been a mirage. Somebody who does a considered write up of America's economic history will note that much of the ostensible GNP growth from 1990 forward has to be discounted because the financial community was peddling hot air. In this vein one need only read the entertaining and depressing The Big Short, which deluges us with delicious details about the fraudulent investment-bank-engineered-housing-financial scam of the last several years, to realize that Wall Street has had to invent hollow products to sell in order to keep itself growing. Just like Western economies in general, our financial community, which has grown much too large, has had to invent balloons to keep itself aloft.
Under the Radar. The places where one must go for safety and possibly for some returns are not on everybody's screen. If warehousing one's monies, one should go to smaller banks with lots of cash in the till and very strong balance sheets. Then one must look around for small companies in which to invest, again with strong balance sheets, whose revenue growth appears stable, no matter the state of the national economy. And start ups, which may not have much cash nor revenue, but which hold strong intellectual property (patents, a pathfinding gadget, or unusually forward looking processes), will also do well over time, as large companies, with weak R&D departments (such as most of the pharmaceuticals), try to buy themselves a future. In other words, safety lies in investments that money managers and Wall Street savants cannot be bothered with. The shrewd investor is looking for small fry that the shirts in the Street cannot even see.
The Failure of the Spanish Armada. In the Battle of Gravelines, 1588, the Spanish invaders suffered an ignominious naval defeat at the hands of the English. The big Spanish galleys had more firepower in toto. But the English ships could be maneuvered more easily and their guns could be more quickly loaded. The Spanish strategy depended on coordination with land troops and on man-to-man engagement with the enemy. It was a case of modern technology and nimble players versus an outdated, clumsy Goliath activated by outdated concepts…
In the present, small, nimble companies, often running by quite different rules, are showing up old monopoly players stuck with notions from the past. The problem for investors is to move away from what was, since the depression that began in 2008 will be with us for a few years to come. The political stalemate, not only in the United States but also across much of the globe, will only lengthen our economic anguish. For forty years after World War II, one could be a relatively dumb investor and make money. But since it has become a game for the quick and the smart.
P.S. Just because the present crop of actors in the financial community mainly consists of weeds and parasites, we should not presume that it is always the case. We would refer you to Alfred Loomis and Landon Thorne, partners and in-laws who did important country-building financings in the first 30 years of the 20th century and who were clearly honorable fellows. Loomis, and to a lesser degree Thorne, are nicely portrayed in Jennet Conant's Tuxedo Park. Loomis is the most interesting, providing the mathematical brains for their joint ventures but going on to a second career as the scientist head of a renowned research lab on his own estate that led to ultrasound discoveries, radar, and much more. Everyone should have a second career, preferably one as creative as his. Indeed, only someone as inventive as he could have executed the great financial and scientific feats for which he is feted. It should be added that the two partners were in cash in 1929, because they could spot a bubble waiting to be pricked.
P.P.S. Everybody who wants to keep a weather eye on the financial shenanigans in the Street and in Government should read Ray Devoe's Report, which is the best written and most incisive newsletter to come out of Wall Street. Nonetheless, one should understand that our dear friend DeVoe is a bit myopic, all too ready to blame all the financial and business woes of the universe on the Federal Government. The fact is that the errors of government pale beside the greedy thievery of Wall Street, so amply illustrated in Michael Lewis's The Big Short, as we have mentioned. Moreover, Big Government cannot begin to match Big Business when it comes to mismanagement and shortsightedness. America's large companies are being run into the ground by the titans of industry, because they misuse resources but even more importantly because they have not truly adjusted to the demands of a totally different global economy. Governor Romney bragged about his business credentials in running for office. But one only need look at his campaign to realize that he cannot run much: the Obama campaign outmanaged him at every turn, relying on far superior technology and a mountain of data to beat his pants off. It is still a truism that managers in the financial sector are not very good, and cynics say they run a race with utility executives for the bottom of the barrel. Our biggest economic Achilles heel is not big government, but big business. No mindless shouting about "free markets" can hide this self-evident truth. Neither the gibberish from doctrinaire lefties or righties should serve as a cover up for the bumblers atop government, big business, and big institutions.
P.P.P.S. The financial sector has grown much, much too large in several countries, but particularly in the United States and Germany. Naturally the bankers claim they have invented wonderful new products which bolster modern economies. An awful lot of the new products are simply Emperor's New Clothes. Paul Volcker, the honest and wise onetime Federal Reserve Chairman, got it right when he said that the only worthwhile financial innovation in 30 years was the ATM (automatic teller machine). The rest has been largely flimflam.
P.P.P.P.S. Early writers about the advertising industry said all its puffery would lead to flimsy products we do not need, stimulated by an industry that makes us desire pure artifice. The financial industry has excelled at this tactic, wasting millions on advertising, hucksters, and lobbyists to create artificial demand.
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