Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

October 2010

The challenges facing investors are sometimes compared to those of sea captains, but an equally apt analogy, and one more familiar to the average person, would be driving a car down a crowded freeway. As long as you follow the rules of the road, drive at a reasonable speed, and allow a respectable distance between your car and the one in front of you (a “margin of safety”), you will in all likelihood get to where you want to go safely and soundly. If you drive with excessive speed and weave in and out of traffic you may reach your goal a little sooner, but this entails heightened risks. You may be delayed by an encounter with your friendly highway patrol, but getting pulled over is far better than not reaching your destination at all due to injury or death. Investing, too, has its rules of the road, its own margin of safety, and investors who proceed with proper caution instead of aiming for the fast buck usually reach their goal with their capital—and lives—intact.

The past few years have proven to be a real test of investor driving skills. The great pile-up of 2008-2009 caused extensive damage to wealth and egos, but it would have taken a great deal of foresight and strength of character to avoid the dangers posed by unproven and overpriced securities and inflated real estate. The temptation to step down hard on the gas proved to be too much for Wall Street and most investors. Good drivers, on the other hand, bypassed the crash and continued on their journeys.

Despite the financial market recovery since March, 2009, there are still many potential dangers on the road. The bond market remains an area of great concern for us. Corporations are borrowing more money than ever at some of the lowest rates in history, and the cash thus raised has been piling up. Cash on industrial company balance sheets now stands at about $840 billion, or nearly twelve percent of aggregate stock market value for those concerns. Government debt yields are minuscule, and inflation-protected bonds even sold at negative yields recently. High-yield (“junk”) bonds have been selling at par (100% of face value) for the first time since 2007. Newly-minted junk bonds, of which more have been sold so far in 2010 than in all of 2009, share something else in common with their predecessors of a few years back: weaker “covenants,” or features found in bond documents that protect buyers. Even “century bonds”—debt maturing in 100 years—have made a comeback. The old saying “feed the birdies when they’re hungry” was never more apt in a situation where investors large and small are throwing billions of dollars at the fixed-income markets. The phrase, “Will they ever learn?” also comes to mind.

In a fashion typical of speculative markets, interest in gold continues to rise in tandem with its price. Left for dead in 2000, the metal’s price has increased for nine years in a row, from under $300 per ounce to its current level near $1300. Even central banks—sellers when gold prices were less than the metal’s cost of production—have reduced or stopped sales, and a few banks have become buyers as well. A dozen years ago gold was interesting as a form of insurance against calamity; now it is a sucker’s game. That notwithstanding, gold could hit $1500 an ounce, or even $5000 as some “gold bugs” predict. It’s a fun game to watch, but definitely not a participatory sport.

Meanwhile, equities have not done too badly, considering the fact that money has fled from stocks to bonds, gold, and emerging markets all year long. About $57 billion left U.S. stocks in the first seven months of the year, and an additional $24 billion went elsewhere in August, the largest negative monthly figure since March 2009. Bond funds saw $26 billion of new money in August, the twentieth consecutive month of inflows. Such figures might gladden a contrarian’s heart, since they indicate widespread disgust with stocks—often a good sign of future gains ahead.

After the big run-up in 2009, some slowdown was to be expected. The gains continued into April, but stocks fell substantially afterwards, although a market recovery has resulted in year-to-date gains of 3–4% for the popular averages. September, a month feared by prognosticators because of its history of negative news for stocks, was particularly strong. In a widely noted statistical tidbit, the S&P 500 average, up almost 9% for the month, had its best September since 1939. Interestingly, the average earnings yield on stocks—earnings divided by stock price—currently stands in the 6–7% range. A return of that amount is not terribly attractive in itself, but it is roughly 1.7 times the average yield on good quality corporate bonds. A ratio this high would normally mean stocks are relatively attractive; however, we believe conditions in the bond markets are far from being normal.

It will be interesting to see how the various forces currently at work shaping the markets play out in the coming months and years. Tumultuous events tend to shake things up for a while. Add in political uncertainty and we could be in for interesting times, indeed. But as a Wall Street wise man once said (quoting the Aeneid), “Through chances various, through all vicissitudes we make our way...”

Too Big To Jail?

The behavior of banks was a critical factor leading up to the financial crisis that began three years ago. One amazing statistic tells it all: in the aggregate, banks have never made money over time. Like the airlines, banks historically have seemingly made money hand-over-fist during good times, but they give it all back and then some when the cycle turns. Yet how many bankers have suffered the same fate when it comes to their own personal financial affairs? The answer to this question gets to the heart of what we believe to be a significant problem with corporate governance, and one which was a major contributing factor in setting up the financial system for a crisis of the magnitude we have experienced.

The business model of a bank is really quite simple: borrow short, lend long. In other words, a bank borrows short-term from depositors (CDs, money funds, etc.) to fund a longer-term loan, say a thirty-year mortgage. This “intermediation” function nets the bank a “spread,” the difference between what it pays on its liabilities (CDs) and earns on its assets (loans), due to the fact that short term rates are usually lower than long-term ones. Banks, as their customers well know, also earn a plethora of fees on other services such as transactions and payments processing.

There are a couple of inherent risks in this model. Rates of return on banks’ long-term assets change gradually, but the returns demanded by investors in their short-term liabilities change constantly. The cost of banks’ short-term borrowing can unexpectedly and quickly rise to the point where spreads become unprofitable. The other risk has to do with what we might call banks’ strength of character—the discipline employed when underwriting loans. The probability that loans will be repaid with interest and on time—asset quality—is a risk factor that has wreaked havoc with banking institutions in the current crisis: simply put, too many bad loans were made.

Banks traditionally dealt with these risks by holding capital, which may be thought of as a rainy-day fund that absorbs unexpected losses on loans, or unusual demands for cash. In recent years the development of an active secondary market for loans (through which the loans became components of so-called “asset-backed” securities) enabled institutions to sell their credit risk to outside investors and get it off their balance sheets. However, the recent financial crisis revealed critical problems in this system. Capital reserves were in many cases woefully inadequate. The risks that so many believed had been spread around to innumerable investors in asset-backed paper were found to be concentrated in other institutions, or in parties with little understanding of the instruments they were buying, where they could do great damage. Perverse incentives encouraged bankers to grow loan volumes at the expense of loan quality since the risks could be foisted off onto others. International regulators meeting in Basel, Switzerland have issued new guidelines in an attempt to address the capital adequacy issue and reduce the likelihood of future public bailouts of large financial institutions. Other regulations are in the works to require institutions to retain an interest in the loans they make—“skin in the game”—by holding on to portions of the ones they sell, thereby lessening the incentive to simply push through loans without regard to quality.

The new rules, as well as national legislation such as the Dodd-Frank bill in the U.S., are steps in the right direction. Nevertheless, none of these measures address a core problem, which we believe stems from a fundamental flaw in the corporate form of business organization—the lack of personal liability on the part of the people in charge. This has permitted individuals responsible for huge losses and public burdens to walk away virtually unscathed and with fortunes unimaginable to the average taxpayer. The new reforms may have an effect for a while, until diluted by lobbying and corruption of the regulatory oversight process. As long as the incentives for personal gain and corporate risk-taking remain in place, we fear that episodes of over-reaching will inevitably recur.

 

Dennis Butler, MBA, CFA