Centre Street Cambridge Corporation

Private Investment Counsel


April 2005

In the instant-coffee world of Wall Street, where the verdict on one’s judgement can be decided on an intra-day basis, certain truisms that have withstood the tests of centuries apply even today. Consider the following, attributed to Baron Rothschild, circa 1800: “There are three principal ways to lose money: wine, women, and engineers. While the first two are more pleasant, the third is by far the more certain.” Engineers have a way of becoming enthralled with the majesty of their creations and overlooking the economic viability of the projects (the English Channel “Chunnel” comes immediately to mind). We would add that something similar might be said of those who supply engineers with the materials for producing their works. Suppliers tend to become captivated by the fleeting moments of their own economic vitality, expecting good times to continue. At a recent meeting, for example, executives of a steel company waxed enthusiastic about a recent trip to China, a country whose rapid development has strained world steel supplies and caused the greatest boom the industry has seen in decades. During their travels they saw nothing but robust growth and development “all over the country, not just in the big cities.” This was meant to allay fears in certain quarters that an economic slowdown in China, coupled with rising domestic Chinese steel production, might bring an end to the steel industry’s good fortune. For an industry with a long-term average return on shareholders’ equity of 10% at best, things are indeed going splendidly. We sincerely wish its players big and small well and hope they make lots of money during this period of prosperity—nor do we begrudge managements’ taking advantage of strong stock prices to unload shares. But things could get iffy when supply and demand conditions become less favorable, which they inevitably will. At this juncture, those attempting to buy into the boom indirectly through share purchases could be in for disappointment.

For the long-standing owners of some resource-related stocks such as steels and energy, things have been rosy during the last two years (despite some recent weakness), but there was plenty of room for disappointment during 2005's first quarter. The major averages registered declines ranging from 2.5% to 8.0% and the markets began to show signs of “bad breadth,” when more stocks declined than rose, even on days when the major averages posted gains. Rising interest rates, more expensive oil, a weak dollar—the usual suspects behind the declines—certainly played a role, but there appeared to be a general pull-back from risk-taking as well. Those who at the end of 2004 displayed such great enthusiasm for the more dicey quarters of the financial sphere—emerging markets, junk bonds and the like—seemed to be pulling in their horns a bit. Mutual funds focusing on emerging markets suddenly experienced the largest withdrawals in quite some time at quarter’s end; yield spreads between treasury securities and issuers of lesser standing widened, indicating that risk was being priced into the market to a greater degree. Sooner or later this process of repricing risk will continue to the point where bonds are more reasonably priced—an eventuality perhaps unpleasant to current owners of risky assets, but favorable to fixed-income buyers.

A more reasonable pricing of risk could also make things tough for low-quality debt issuers who have enjoyed a bonanza of relatively low-cost financing to recent years. Much of this debt will need to be refinanced in the next few years—but what if no one were interested? Perhaps this is why some law firms have been adding bankruptcy specialists of late.

Quotes and Notes

“What's good for the country is good for General Motors, and vice versa.” If you think so, think again. GM sent shivers through the financial markets in March when the announcement of an unexpected earnings shortfall brought threats from rating agencies of a downgrade of GM’s debt to “junk” status (in early April Moody’s began that process by lowering GM’s rating to one notch above the “high yield” level). The automaker’s debt standing is important because its bonds—with over $300 billion outstanding—are widely owned and make up a significant part of some bond indexes, against which bond funds measure their performance. Also, many funds are prohibited from owning securities with a less than investment-grade rating; a forced liquidation could put even more pressure on the market for GM obligations. GM’s problems are well-known: falling market share, poor reception of new products, heavy debt load, and unfunded promises to current and former employees. Might the company’s fate provide a foretaste of what could be in store for the U.S. in a way that Charles Wilson (the source of the quote—GM’s CEO in the 1940s and later Secretary of Defense) could never have imagined? On March 20 Standard and Poor’s indicated that if current trends continue, the U.S. sovereign credit rating (along with those of other Western industrial nations) would decline to junk within thirty years. Farfetched? Consider this: the current era of unusually large budget deficits and government borrowing (excepting a respite in the late 1990s) has continued for nearly a quarter-century already.

“What is wanted is not the will to believe, but the will to find out, which is the exact opposite.” —Bertrand Russell, from his Skeptical Essays. It is fitting that Russell is one of our favorite philosophers. We are great skeptics—and a good thing, too, since it is our business to serve as a “firewall” between our clients’ money and those eager to get their hands on it. Wall Street’s willingness to believe rises and falls with the stock market, and that is what makes the sceptic’s “will to find out” so valuable: instead of blindly accepting the belief that a bull market will “rise to heaven” (as one astrologer predicted in 1929), or that a declining market will fall to nothing, the skeptic will analyze and find out what the risks really are. As we now know, Wall Street’s research standards during the dotcom era were corrupted by the willingness to believe any new “metric.” More skepticism and willingness to really find out could have limited the colossal losses of the dotcoms, not to mention the Enrons and Worldcoms. And nowadays? Perhaps people should find out more about hedge funds, emerging market funds, junk bonds, Exchange-Traded Funds, etc., before they take the plunge.

“We are an aggressive performance-oriented fund looking for blood-thirsty competitive individuals who show initiative and drive to make outstanding investments.” The Financial Times somehow got hold of an e-mail exchange between two hedge fund managers (one of whom was looking to land a job with the other), from which the foregoing is excerpted. First of all, funds such as this may be doing many things, but investing is unlikely to be among them. Honest hedge fund managers freely admit to engaging in pure speculation—trying to take advantage of predicted changes in asset prices—a practice that is usually not lucrative over the long run—at least for fund clients. Secondly, owners of capital may want to ask themselves whether they want “blood-thirsty” types running their money. A great investor named Benjamin Graham said long ago that “While enthusiasm may be necessary for great accomplishments elsewhere, in Wall Street it almost invariably leads to disaster.” This is another one of those truisms that has withstood the tests of time. Many people with capital burning a hole in their pockets, who have convinced themselves that there is nothing better to do with their money than take their chances with gun-slinging hedge fund managers, will probably find that the “great accomplishments” are indeed elsewhere.

“The sky is falling; the sky is falling!...The sky hasn’t ever fallen.” Three years ago the New York Times, in an article entitled “A Blasphemy Spreads: Debts Are O.K.,” reported that a growing number of economists were questioning the wisdom of old proverbs about taking on debt that have existed in Western culture from biblical times (“owe no man anything”), to Franklin (do not become a “slave to the lender”), down to current worries about high debt levels and low savings rates in the U.S. The economists argued that history shows debt has never caused the calamities that were feared, and that rising asset values —i.e. stocks and property—make the modern economy’s low savings rate irrelevant. Aided and abetted by the Federal Reserve, this view seems to be gaining favor. Granted, there may be quirks in the compilation of data that cause savings rates to be understated somewhat, but to suggest that capital gains make up for a shortage of savings out of income seems specious (have we so quickly forgotten the dotcom era, when stock market gains were seen as the solution to all of life’s financial needs?). After all, for most people it takes savings out of income to create the opportunity for capital gains. Furthermore, buying real property—usually a highly leveraged transaction increasingly dependent on the mortgage debt market—seems to be taking on the characteristics of arbitrage operations that take advantage of low-cost borrowing to obtain presumed higher returns from appreciation of property values. Arbitrage is not without risk.

Capital gains have a habit of not being there when you need them. In this light, we find it curious that these arguments are being put forward at this particular time. History may indeed show that increasing debt loads have not brought the ruin that many feared, but that may be because in the past, individuals paid more heed to Franklin and other sages and were more fearful of debts. Perhaps the economists are ignoring a bigger picture as well. For several decades now the U.S. has been in an inflationary period, and debts are less onerous when repaid in cheaper dollars. Property values have been increasing for a long time, too, and equities, for the most part, have risen strongly since 1982. Is it wise to project these happy trends into an indefinite future? Not too many people viewed the stock market as a substitute for savings in 1982. Might we experience a deflationary period when debts would indeed be a heavy and growing burden? The future can be fickle: in 1900, economists expected inflation to be non-existent and that bond values would rise and offer increasing real returns. This consensus followed twenty or thirty years of deflation and rising currency values. The consensus was confounded when the following twenty years saw steadily decreasing currency and bond values. Curious this idea of placing such faith in future asset values; but, as one of the great Wall Street speculators of old used to say, “You don’t know ‘til you bet.”

“Stay short, stay out of debt, and don’t buy property.” In our last newsletter we thus called attention to three trends that we felt held dangers for investors and for individuals in general: enthusiasm for long-term bonds, heavy debt levels, and a passion for real property. Well, apparently someone was listening! During the past three months long term interest rates rose (meaning long-term bond prices fell) and the interest in riskier issuers began to wane. Concerns about rising debt loads have been expressed with increasing frequency; as rates rise, what happens to overextended borrowers, many of whom owe floating-rate obligations? As for property, the Financial Times reports that in certain hot markets, renting now makes more economic sense than buying.


Dennis Butler, MBA, CFA