Category Archives: Economy

Financial Panics and Commercial Revulsions

Advance apologies for being two years late and perhaps a bit sour for today’s ebullient mood…

But a copy of “A Brief Popular Account of all the Financial Panics and Commercial Revulsions in the United States, From 1690 to 1857: with a More Particular History of the Two Great Revulsions of 1837 and 1857” found my hands in recent days. (Google eBook here)

Written at a time when the United States’ “business system” was laboring under “difficulties” (i.e., 1857), the author endeavors to uncover “the causes of financial revulsions” and distinguish them from financial panics, with the ultimate aim of “prevent[ing] the recurrence of similar periods of panic and disaster.”

Whereas a panic “is a pressure in the money market without adequate cause,” a revulsion “is pressure with adequate cause, and that cause invariably is a previous Destruction of Value” (1).

In other words, “a national Revulsion is a national pay day.  The nation has been drawing on the Future, and the Future dishonors the draft.  The forcing process is then applied, widespread ruin is the result, and long period of paralysis ensues.”

A simple insight and a memorable analogy–business transactions flourish or cease, largely based on the beliefs we hold about the future.  Most of the time, our beliefs imperceptibly wax and wane; of course, when they change in an instant, we write a book about it.

Whither the Economy?

securityanalysis1Over the weekend, I was paging through Graham and Dodd’s Security Analysis (5th edition, authors Cottle, Murray, and Block), and thinking especially about discount rates and the margin of safety concept, particularly in light of recent macroeconomic events. It is not yet clear to me how much attention an investor should yield to macroeconomic changes and predictions. Investors often take solace in Warren Buffett’s seeming ambivalence to most macroeconomic data, recalling his many quips about being wholly uninterested in the federal funds rate policy for the upcoming year. Cottle, Murray, and Block touch on these issues in their ninth chapter, on “Qualitative and Quantitative Factors in Security Analysis and the Margin of Safety Concept.” Having laid out the sources of information that an analyst should use, the authors move to the more difficult question—how should the analyst use them?

The basic quandary is this: the analyst could gather nearly infinite information about a given investment, information which would presumably help her to better judge its value. Any constraints on time and attention seemingly hold the analyst back from giving her best judgment. Yet, such constraints are not undesirable, for not all information is essential for a reasonably full evaluation. The analyst must cultivate discernment and practical wisdom in order to know whether the information she has is essential and enough. As our authors observe, “the analyst must exercise a sense of proportion in deciding how deep to delve” (114).

But the specifics here are likely the most useful. An analyst may not need to assess patent protections, geographical advantages, or labor conditions, which may or may not endure. For a stable company, five year financial statements “will provide, if not a conclusive basis, at least a reasonably sound one for measuring the safety of the senior issues and the attractiveness of the common shares” (114).

The company’s “statistical exhibit” though is not enough. “Exceedingly important” are qualitative factors, which—while difficult to assess—require the analyst to examine the nature of the business, the character of management, and the trend of future earnings (115). Particularly pertinent is the business’ position in its industry, its industry’s relative prospects, litigation risk, potential regulatory changes, and social issues. Management represent the face of the business, and many even consider picking good management more important than picking a business in a promising industry. Yet, our authors warn, “little tangible information is available about management… [and] objective tests of managerial ability are few and rather unscientific” (121). Even more worrisome, “there is a strong tendency in the stock market to value the management factor twice,” for both the fact that earnings growth is so robust, and that this capable management produced it (121). Though qualitative factors may be overemphasized and lead to an undue emphasis on perceptions of quality (think of the “Nifty Fifty” and the slogan “Make sure of the quality and price will take care of itself”), researchers Clugh and Meador have concluded that the predictive process is based primarily on qualitative factors.

Thoughout their discussion here, our authors say little explicitly about macroeconomic concerns, in large part because of their emphasis on the presence of a margin of safety for any true investment. As they observe, “when the price is well below the indicated value of a secondary share, the investor has a margin of safety which can absorb unfavorable future developments and can permit a satisfactory ultimate result even though the company’s future performance may be far from brilliant” (504). Though the margin of safety may not guarantee favorable performance by itself, when coupled with sufficient diversification, the margin of safety concept can produce acceptable returns in a variety of macroeconomic environments.

Since an analyst’s time and attention are limited, Graham, Dodd, and Buffett concentrate their energies almost solely on understanding businesses, and in particular, on those aspects of the business which management can control—namely, costs, marketing, and pricing. This concentration, coupled with the margin of safety concept, should be sufficient to defend the investor from unforeseen changes in the broader economy and render detailed economic analysis less relevant to the analyst’s work.

Simon Johnson on the Economic “Recovery”

topbanner_012Last Friday, Bill Moyers of PBS had an interview with the former chief economist of the IMF, and current MIT Sloan School of Management professor Simon Johnson. In my lights, it is the most powerful critical analysis of the U.S. government’s responses to the financial crisis (or, at least the most powerful to have been featured in the mainstream media).

Here is a crucial part of the exchange:

“BILL MOYERS: Both the “Wall Street Journal” and “The New York Times” reported this week that Obama’s top two political aides, Rahm Emanuel and David Axelrod, have pushed for tougher action against the banks. But they didn’t prevail. Obama apparently sided with Geithner and the Treasury Department in using a velvet glove.

SIMON JOHNSON: What I read from that is that there is an unnecessary and excessive deference to the experts, or the supposed experts…

There are many fine professionals at Treasury with great experience, who have spent their lives working on important issues related to the United States. What we face right now is not a typical U.S. issue. We face a crisis, and the president said this on Monday night, the president said, President Obama said, “We’ve never seen anything like this since the Great Depression.”

Therefore, nobody working now, you know, has any firsthand experience. And he also said, “We may face what we call a lost decade.” We’ve never seen that anywhere other than Japan in the 1990s, right? …

The correct people you should be asking this question to are people at the IMF. And I can tell you what they’re saying is the policy that we seem to be perusing, of being nice to the banks, is a mistake. The powerful people are the insiders. They’re the CEOs of these banks. They’re the people who run these banks. They’re the people who pay themselves the massive bonuses at the end of the last year. Now, those bonuses are not the essence of the problem, but they are a symptom of an arrogance, and a feeling of invincibility, that tells you a lot about the culture of those organizations, and the attitudes of the people who lead them…”

The interview insinuates that political donations may be at the root of Congress’ deference. While plausible, the presentation makes the insinuation appear as idle speculation.

I find the interview particularly interesting because it appears that the public clamour over the crisis is really beginning to increase.  As job losses mount, politicians will sense the building pressure and feel compelled to respond.  And if we follow Johnson’s reasoning, it is possible that our experts are currently ill-equipped to craft an expedient plan.

Given this uncertainty, I’m concentrating my research energies on companies with the widest of moats, the smallest of debts, the very highest returns on equity, and the richest cash flows.  To my disappointment, that will likely mean leaving some potentially interesting investments behind.