Centre Street Cambridge Corporation

Private Investment Counsel


July 2005

Ironic, isn’t it, that the object of frenzied buying during the last speculative blow-out should become a tool for promoting the next. Consider the new dot-com offerings devoted to “flipping” condominium apartments, a breathtaking entrepreneurial practice in which a fleeting moment of ownership permits you to profit from a property’s rise in “value” even before the building is constructed! A business perfectly made for exploitation online (after all, virtual property is ideally suited for virtual reality), the first target is the city of Miami, with plans to move on to New York, Los Angeles and other hot markets soon. Even franchises are available. No doubt promoters will expand to time-shares and other forms of real estate; perhaps we will even see “day-trading” of properties. You have to admit, this is an interesting segue from the dot-com era. In fact, we always felt that the internet would prove a far more useful tool to traditional businesses than a source of profit in itself, and there is certainly nothing more traditional than profiting from the greed and gullibility of speculators.

As everyone who lived through Wall Street’s dot-com period should know, speculators eventually lose out, and late-comers to the real estate party will likely suffer the same fate as their forebears. It is important to remember, however, that the timing of such denouements is never certain, and market silliness can go on far longer than rational observers would believe possible, luring even greater numbers of losers into the fool’s paradise. Take another area that has seen a great deal of speculative interest in recent years: the markets for bonds of all stripes—domestic, international, junk, etc. For many months, commentators and market participants have been expecting bond yields to rise (in other words, bond prices to fall) in reaction to the U.S. Federal Reserve Board’s year-long campaign to lift interest rates. When the Fed increases short term rates (which it can greatly influence, if not control), yields across the maturity spectrum tend to rise as well. This time, long-term rates have fallen around the world, and currently stand near record-low levels. The phenomenon has defied a good explanation, but that is of secondary importance compared to the embarrassment felt by hedge fund operators and others who had bet significant amounts of capital on a decline in bond prices. There has been much throwing-in of towels lately as the bond-trading crowd has had to face up to the possibility that low yields may be with us for a while longer.

The currency markets have also proven enigmatic this year. A year-end consensus held that the U.S. dollar would continue a decline that had steepened last fall (we suspect the near universality of this view at the time was encouraged by a well-known investor’s negative position on the U.S. currency). Instead, our currency has risen smartly in value against those of some of the country’s major trading partners—Europe, Japan and the U.K. It could be that the Fed’s moves to lift rates have finally made the dollar more attractive in relation to other currencies, but rates had already been on the rise for several months by the end of 2004. As Floyd Norris of the New York Times recently pointed out, “When virtually everyone expects something to happen, it won’t.” That is probably about as good an explanation for such phenomena as you will find.

If you can stand the risk and care only for short-term results, then the bond market has been the place to be so far this year, despite that market’s “conundrum” pricing situation. Bond returns (including price appreciation) have been modestly positive (gains of 2%–3%), at least among the higher-quality issues. Stock results reflected in the popular averages remained modestly negative at quarter’s end (down 1%–5%). Again, for those concerned about such short periods of time, this is a vexing state of affairs as good returns have been hard to come by anywhere. Unfortunately, for those of us more concerned about the long term, the outlook isn’t so rosy, either. Prices remain generally unattractive in relation to risk, and protection of capital continues to be the overriding issue. Good (or even average) returns will likely have to await better conditions for buyers. Sellers, whether it be of stocks, bonds, property—almost any asset—have the upper hand at present.

Not All Who Wander Are Lost

Investment analysis rarely presents us with unambiguous results; there is always uncertainty and a certain amount of risk. Yet seldom are there times when our search and screening process leaves us empty-handed, with little or nothing to do. Even at the height of the great financial market speculation in late 1999 and early 2000 there were interesting opportunities, created to a large extent by the diversion of huge amounts of capital from traditional businesses to new and exciting technology enterprises (most of which ultimately proved to be of dubious value). The current period has quite a different character. Volatility in the markets has been historically low, creating a sense of calm that masks an underlying reality: the inflation of asset (security) values. In five years we have gone from a situation in which vastly overpriced assets co-existed with demonstrably undervalued assets, to one in which the worth of practically all assets is fully, if not excessively, appreciated. Hence, there is little for us to do—in an active sense, that is.

There is an important distinction to be made between having little to do and being at a loss as to what to do. We feel it safe to say that to most people operating in the fund and money management businesses (and perhaps their customers, too), doing nothing is equivalent to being clueless, incompetent, or lazy. A cynic might conclude that this attitude is merely an attempt on their parts to justify annual portfolio turnover rates of 100% or more. While this probably has something to do with the investment community’s widespread impatience with sitting still, we think that normal industry motivations, personnel training, business education and the like play important roles as well. The really important issue for investors of course is whether or not a lot of trading and re-balancing of portfolios does any good. We have never seen evidence to support the notion that activity per se (“doing something”) is positively associated with good investment results.

For us, investment activity is the direct result of the normal investment processes mentioned above; when good opportunities appear, we move to take advantage of them. But there are times when our thinking and analysis lead us to conclude that the greater part of valor lies in doing nothing. Hence, inactivity is in itself an active decision. This is a case-by-case decision-making process, however, and not a blanket statement. We look at individual situations rather than make market “calls.” Currently we find little to interest us—reward/risk ratios are unattractive—but that could change regardless of what happens in the broader financial marketplace, as opportunities appear from time to time under any and all conditions.

Nevertheless, while we act locally, we do think globally and are attuned to systemic risks. These risks are generally well-known; we have no unique insights on these matters. It is our own evaluation of these risks that impacts what we do. For example, we find the level of public and private indebtedness to be an increasing threat in that it reduces the financial flexibility that may be needed in an emergency. In the public sphere it also tends to hide the true costs of dealing with intractable challenges, such as the global effort to prevent international terrorism. Increasing speculation in financial assets and real estate is also a matter for concern. Players such as hedge funds are engaged in the trading of exotic and little-understood financial instruments that can involve indeterminable risks to the international financial system. The problems and losses associated with Orange County, California in 1994 and Long Term Capital Management in 1998 came about due to little-understood risks involving unusual instruments. We have already alluded to the real estate issue. Property, and its use in speculation and as a kind of “personal ATM machine,” seems to have become so central to the functioning of the economy (residential housing alone accounts for 16% of U.S. GDP) that it has constricted the options available to authorities to control excesses. One has to wonder about the consequences should the Federal Reserve raise rates so high as to stifle the housing market and kill what has been the major engine for growth in the U.S. during the past few years.

Every era has faced its problems, challenges, and threats, yet previously the problems and threats seemed to have been better reflected in asset prices. Our “conundrum” today is that assets, including stocks and bonds as well as property, are “priced to perfection,” meaning there is little room for error and unexpected “outlier” events. Acting locally, we are prepared to make commitments regardless of market conditions. Thinking globally, we feel compelled to confine ourselves to situations which are more than just marginally interesting, since the systemic risks threaten to create real bargains. Hence, our low level of activity at present is part and parcel of an investment process that seeks to protect against risk.

For Shame!

For years we have been engaged in a lonely, quixotic campaign to rid popular investment usage of confusion and contradictions. Our successes have been nil, but we persevere, hoping that one day we will be viewed as a beacon of clarity in a world of obfuscation. While we are inured to failure, still we were dismayed to see a distinguished and thoughtful publication—the British Financial Times—include the following header in its august pages: “Investors Speculate on Telecoms.” We mean no offense to the telecommunications industry, but why would an investor speculate on it or any other business? An investor invests, and if there is no good reason for investment, speculation is not the alternative. This and related linguistic abuses, such as “aggressive investors” or “nervous investors” are commonplace in investment commentary and the Financial Times should not be singled out for ignominy. Nevertheless, we had hoped for more precision from that particular newspaper. Abusus non tollit usum!


Dennis Butler, MBA, CFA