The Bonfire of the Intermediaries

We've heaped a lot of criticism on the dominant model of the financial services industry in the past, a model which we call "The Intermediary Trap."

We believe that the current system, which separates investors from their money managers and interposes an intermediary between the client and the manager, leads to performance which can be far worse than the performance of the overall market. Numerous studies back up this argument.

Let's pause, however, and consider for a moment the unfortunate plight of the intermediaries themselves, at this particular juncture in history.

For an entire generation now, entrants into the financial services industry who deal with investors have been told that they don't need to pick stocks (or other individual securities) but instead their role is to gather assets and to farm out the management of those assets to a variety of "professional" money managers. In other words, they don't pick individual securities: they pick managers (by picking mutual funds, or index funds, or exchange-traded funds, or separate portfolios, or some combination of all of them and a few others as well).

A large percentage of these intermediaries are reeling right now. They "diversified" their clients into a host of different areas, including international investments, commodity-based investments, and even "alternative investments" (such as hedge funds, managed futures, and other exotic products). They followed the modern portfolio theory advice that helped create the intermediary system to begin with, and in many cases their clients' investments are now down considerably; in some cases well in excess of the general market averages which they were so carefully designed to outperform under multiple scenarios. With this disastrous last years' performance and the horrendous long term performance noted in the studies referenced above, we can only imagine how many of these intermediaries (and their investors) must feel right now.

We have always maintained that the majority of intermediaries honestly try to do their best by their clients, and that the damage that is caused by the intermediary system to the investment returns of the actual investors is usually the result of good intentions. We've explained how these good intentions can lead to the intermediary chasing what has been doing well lately, for instance in "Investor behavior . . . or Advisor behavior?" and other posts that are linked in that piece.

Now, however, after a year that decisively showed the flaws in the system that they had relied on for their entire careers (some of them for decades), the intermediaries don't know which way to turn. They know that something needs to change, but they have not been equipped to know exactly what.

We would offer the advice that the way forward has always been there.

The severe bear market of 1973-1974 was the impetus that moved the investment world away from the world of "practical operators in the stock and bond markets" and into the world of "academics with their mathematical stochastic models," a move which led to the rise of the intermediary system we have today. The carnage of 2008 provides an opportunity to return to the path that many abandoned after 1974 -- the path of reliance upon investment in businesses through ownership of individual securities, as we have discussed many times on these pages (see here and here, for example).

The advantages of doing so are enormous. They are most important, perhaps, during tough times. Because of our approach, we know exactly why we own every single security in the portfolios that we manage for our clients. That is something that is almost impossible to achieve operating under the intermediary system.

It is a message that we don't want to keep to ourselves, but share with the world, because we believe it is a message that is particularly critical right now.

For later posts dealing with this same topic, see also:

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Schumpeter, Creative Destruction, and your Portfolio Recovery Plan

With "government stimulus" dominating most of the discussion in the pages and on the screens of the financial media right now, we would advise investors to focus their attention in an entirely different direction, towards an area of enormous importance that is all too often overlooked.

Investors should carefully consider the critical importance of innovation and the entrepreneurial spirit. The real engine of economic growth in a free economy has always been and will continue to be this spirit of innovation -- of creating completely new ways of adding value to consumers or to other businesses.

The economist most closely associated with this concept and with first articulating it most clearly is the Austrian-born emigrant to the United States, Joseph A. Schumpeter (1883 - 1950), pictured above. Of the most influential three Austrian economists (Hayek, von Mises, and Schumpeter), Schumpeter is perhaps the least familiar, yet his focus on the critical role of entrepreneurial innovation should make him mandatory reading for all investors.

Schumpeter elaborated at length about this topic in a section of his book Capitalism, Socialism and Democracy entitled "Can Capitalism Survive?" There, he explains that capitalism "is by nature a form or method of economic change and not only never is but never can be stationary."

He explains that in any given industry growth does not take place in a linear fashion but rather in a series of "revolutions," saying "the history of the productive apparatus of a typical farm, from the beginnings of the rationalization of crop rotation, plowing and fattening, to the mechanized thing of today -- linking up with elevators and railroads -- is a history of revolutions." He goes on to give another example from the steel industry, concluding that it "illustrates the same process of industrial mutation" that "incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism."

The importance of this concept of entrepreneurial "Creative Destruction" simply cannot be overlooked. Schumpeter is arguing that free enterprise, by its very nature, invites innovators to create radical new advances which overturn the previous paradigm, and that this process not only does not stop -- it cannot stop. We have touched on this subject in previous posts such as "Look for Paradigm Shifts" and "The Unstoppable Wave."

And yet the amazing thing to note is that much of economics (and much of investing since the arrival of so-called "modern portfolio theory") is dominated by mathematical formulas and models which purport to explain what will happen next -- completely oblivious to the fact that Schumpeter's "incessant revolutions" of "Creative Destruction" can never be predicted or incorporated into a bunch of mathematical economic models!

It is far better to heed the insight of Schumpeter, and then to see investing as a process of providing capital to fuel innovation. By doing so, the investor has the opportunity to participate in and to share the rewards of such revolutionary innovation!

This concept is at the heart of the investment philosophy that we have tried to explain from many different angles in our previous posts. It is the opposite of the concept of "playing the markets" or "tying up your money on Wall Street" that most people incorrectly believe to be synonymous with "investing."

From the perspective of investors who are standing in the current uncertain environment and looking forward to try to discern what the next decades will bring, it may seem as though increased government activity and intervention threatens to crush the spirit of innovation and entrepreneurship that we are discussing.

However, remember that Schumpeter said that capitalism simply cannot stand still, and in fact as we look back over previous decades (even decades as stifling as the 1930s and the 1970s) we must concede that this kind of revolutionary progress within businesses was taking place in different industries even during dark times.

Innovation may have a harder time, and be harder to find, in one time period than in another, based on a variety of circumstances, but it is a fact that it is always there if you look for it hard enough. And that is exactly what investors should be doing right now.

For later posts dealing with this topic, see also:

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It's a panic, not a Great Depression

We have previously written in some detail about our assessment of the events leading up to the current economic situation.

Our analysis is that the overall economy, outside of housing and the financial sector, was not in recession prior to September, and would probably have avoided a recession altogether had certain steps (such as the removal of mark-to-market accounting) been taken.

The economic data available from the Federal Reserve for 2008 reveal quite clearly that the conventional wisdom about the causes of the current recession misses the mark, and that what actually took place was a financial panic, which ultimately dragged the rest of the economy down with it.

For instance, one conventional explanation you hear constantly on the financial media is that we are in the midst of a "credit crisis." The above graph from the Federal Reserve showing total bank credit, however, clearly indicates that total bank credit for the past ten years has been growing at a rather robust pace, and that even during the most recent "recession" (shaded in gray and corresponding to the NBER's identification of the recession's start in November 2007), total bank credit has actually increased quite sharply. (Click on any of the graphs to see them in greater detail).

Another common assertion in the media is that "banks won't lend" right now. However, as the chart above showing commercial and industrial loans at all US commercial banks further indicates, the current level of bank lending to businesses has grown sharply in recent years, and is only down a very small amount since the start of the current recession (top right red circle). In fact, if you look at the two previous recessions (larger red circles), you will see that commercial and industrial lending dropped much more sharply then than they have in this supposedly historic current recession.

Lest the reader object that commercial and industrial loans might be holding up, but that banks have really been refusing to loan to the consumer, the above graph showing all consumer loans (individual loans) identifies that the level of consumer lending continued to climb unabated throughout 2008, to levels unmatched in any of the previous sixty years.

Even real estate loans, which you would think would show a marked reversal based on the reports you hear from the financial media, shows a similar pattern, as the chart above showing real estate lending at all commercial banks displays.

However, something clearly did take place which threw the economy into a recession in the fourth quarter of 2008. We maintain that the "something" was a financial panic, the likes of which the country has not seen since the financial panic of 1907.

Unwise lending practices (some of it encouraged or even mandated by the government), dangerous levels of leverage, and the unintended consequences of the increased scope of mark-to-market accounting and the removal of the uptick rule for short selling started a chain reaction that led to the collapse of Wall Street firms like a line of dominoes beginning on September 15.

Data on manufacturing, shown above for the year 2008 in the form of the Institute for Supply Managment (ISM) manufacturing index, clearly indicates that manufacturing was cruising along at a generally steady level throughout most of the year, until it took a steep dive beginning in September (red circle in the above chart marks the beginning of September 2008). This reinforces the thesis that we are in a recession that was caused by a financial panic, rather than another Great Depression.

There was a very clear distinction between the financial panic of 1907 and the Great Depression. The panic of 1907 was a banking panic, and it also had its causes in financial speculation which got out of control. It passed fairly rapidly and has largely been forgotten.

The Great Depression had much deeper systemic causes, and economic readings of the broader economy during that crisis reflected much more catastrophic problems than the charts we are seeing for 2008.

It is our contention that the environment today is much more akin to 1907 than to the Great Depression, although saying "the most serious panic since 1907" will never sound as newsworthy as all of the "worst . . . since the Great Depression" lines that you have been hearing every day for the past year.

For later posts discussing this same topic, see also:

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The consumption / production distinction with regard to stimulus plans

Today, the House Appropriations Committee announced details of the largest economic stimulus legislation ever proposed by the federal government.

Many believe that in a financial crisis, the best way to get the economy moving is for the government to "prime the pump" by putting money in the hands of consumers. In his remarks from last Thursday, President-elect Obama articulated the opinion that "Only government can break the vicious cycles that are crippling our economy – where a lack of spending leads to lost jobs which leads to even less spending; where an inability to lend and borrow stops growth and leads to even less credit."

The plan calls for government "priority investments" (with an unprecedented level of accountability built in, the House Appropriations Committee notes) into a variety of worthwhile causes amounting to $550 billion, as well as an additional $275 billion in "tax cuts."

These tax cuts are not actually tax rate cuts, however, and they are specifically targeting an increase in consumption, rather than production. This is an all-important distinction.

The tax cuts in the current legislature are described by President-elect Obama as tax-cuts "to get people spending again." In other words, to increase consumption. As he explained it, "95% of working families will receive a $1,000 tax cut - the first stage of a middle-class tax cut that I promised during the campaign."

As nice as a $1,000 tax cut might be, it is correct that it will mainly be effective in increasing "spending again" -- consumption rather than production. It is our firm conviction that increasing production is what actually helps the economy, and in turn leads to more jobs and to increased consumption, as well as to improved standards of living to more members of society at all income levels. The important distinction between production and consumption is perhaps best explained in this article by Pepperdine Professor Emeritus of Economics George Reisman entitled "Production versus Consumption."

What would really help the economy would be a decrease in the marginal tax rate as well as a decrease in the corporate tax rate. This action would be far more likely to increase business activity by existing businesses, the creation of new businesses, and the allocation of capital to investment, all of which increase production.

In the video linked above, Dan Mitchell explains the problems with "stimulus" plans designed to improve the economy from the consumption side, using clear visual diagrams and plenty of evidence from American history.

Regardless of the path that the federal government takes in responding to the current economic conditions, investors have an opportunity to take the opposite approach. While it may seem that consumption-oriented mistakes will doom all future growth, the counter is that there are seismic shifts going on now which can be tremendous opportunities for investors.

As we explained in our previous post, there are some paradigm shifts which government mistakes simply cannot hold back. This was also true during previous eras of government economic mistakes, including the 1970s and even the 1930s. Now is also an opportune time, albeit a difficult time, to allocate capital to well-run businesses (through investment in both equity instruments and debt instruments) at very attractive prices.

Determining which businesses are well-run, and are positioned in front of potentially fertile fields of growth, requires some research and due diligence -- not all businesses with apparently attractive prices are wise allocations of capital right now. But for those who understand the distinction between consumption and production, the start of 2009 could represent the kind of opportunity that does not come along many times in an investment lifetime.

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The Unstoppable Wave

The news today is full of speculation over the future of the economy. Will the recession run on "for years"? What kind of government stimulus should be applied? Are the proposed actions going to be too big, too small, too focused on this group or that group?

While these are important questions, and worthy of analysis by investors, there is a much bigger investment event taking place, of which many investors are completely oblivious.

This event is so momentous that it simply will not be stopped by this or that "stimulus package" decision, will not be stopped even by a recession as deep as the Great Depression, even though we do not believe investors have to fear a Great Depression on the horizon. In fact, the event of which we are speaking is as unstoppable as the Industrial Revolution, which was continuing its sweeping path of change through the economies of the West during the time of the Great Depression and was not something that the administrations of Coolidge, Hoover, or either Roosevelt could have prevented, even if they had wanted to.

There is every reason to believe that the world is today facing a Bandwidth Revolution which will be every bit as transformative and unstoppable as the Industrial Revolution and the Computer Revolution before it.

The most prescient herald of this approaching sea change has been and continues to be George Gilder. As early as 1996, he published an article in Wired magazine in which he articulated a vision which, thirteen years later, can be clearly seen to be materializing.

In that article, he explained the concept of "a new paradigm." Each economic era is dominated by a very different paradigm, characterized by "a key abundance and a key scarcity." For the thousands of years prior to the Industrial Revolution, the key scarcity was horsepower -- physical power -- while land was relatively abundant.

That dominant paradigm has undergone a seismic shift twice in the past century and a half. First, the Industrial Revolution made mechanical horsepower cheaper and cheaper and more and more plentiful. Towards the second half of that revolution, electrical power also became cheaper and cheaper and more and more plentiful. Power became cheap and plentiful enough to throw at almost any problem -- from washing and ironing your clothes, to planting and harvesting crops, to digging mines and tunnels . . . the list is endless.

Then, the Computer Revolution ushered in a completely new paradigm in which a new abundance would be applied to virtually all areas of business and life. Instead of supplying power to manipulate the physical world, it supplied enormous power to manipulate the world of words, images, numbers, texts, and information. Having lived through it and had its incredible transformations become part of daily life, we are almost blinded to what a change this second revolution brought about (desensitized like the proverbial frog being gradually boiled). But, if you look back at one of the first documents to predict this second revolution, the famous 1945 article by Vannevar Bush "As We May Think," you can see how radically the new capabilities have altered the world from which that prescient author was looking forward to ours. It is well worth a read.

However, while processing power became abundant, and was thrown at every aspect of life, connectivity -- bandwidth -- was scarce, and it was expensive. As George Gilder predicted in that Wired article thirteen years ago, "To grasp the new era, you must imagine that bandwidth will be free and watts scarce."

In other words, he foresaw yet another massive paradigm shift approaching which would be as transformative as the Industrial Revolution and the Computer Revolution. "If bandwidth is free," he wrote, "you get a completely different computer architecture and information economy." In fact, he predicted, "the most common computer of the new era will be a digital cellular phone with an IP address."

This prediction is rapidly becoming reality. The world in which bandwidth becomes abundant enough to throw at every aspect of life will usher in changes as momentous and transforming as those of the Industrial Revolution, as enormous as those that have made the world of today different from the world of film and typewriters described by Vannevar Bush in 1945.

It may seem that the bandwidth revolution has been sidetracked, and that it will never arrive, but in fact it is like a wave that cannot be stopped, even by the mistakes of the Fed or the miscalculations of Wall Street investment banks. Businesses need the efficiencies of connection, and consumers are ever hungrier for more bandwidth (which chiefly means more video and images). Enterprising companies will supply it to them, and as they do so, competition will cause them to supply it more and more abundantly, and more and more inexpensively.

We have published several previous posts hinting at some of the important aspects of this impending revolution, such as "Big Changes Coming," "Big Changes Coming Part II," and "Video is Clearly the Killer App Here."

We have also explained several times before that the investment process that we have pursued for decades is based upon finding well-run businesses in front of fertile fields of growth. To find those fields of growth, we look for major paradigm shifts. The paradigm shift discussed above is only one of the different paradigm shifts that we believe are taking place right now, although it is an important one.

While the rest of the financial world (and the financial media) are moaning about what a mess they've made of things, and wondering if the recovery is going to come in this month, or that month, or in a few years from now, investors who are aware of what is going on should be positioning themselves now to participate alongside the companies that are going to take advantage of the onrushing technological wave.

For later posts dealing with this topic, see also:

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The Investment Climate: January, 2009

We recently published "The Investment Climate: January, 2009" in the commentary section of our website.

In it, we summarize the current situation and provide some perspective on where we stand today.

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New Year's Resolution: swear off snake oil

One of the central themes of the investment philosophy that we espouse is that the average individual, given a reasonable amount of intelligence and discipline, can manage his own investments.

This concept is contrary to what Wall Street has been selling for decades, which is that there is a magic to it, that you need to tap in to the Street, where there are special elite insiders who can predict for you what is going to happen next.

As we have noted, there is hard evidence that the formula that Wall Street sells investors not only does not work but is actually harmful to their long-term returns.

We have also noted that much of the academic theory that Wall Street has bought into since 1974, with arcane terminology such as Chebyshev's inequality, the Sharpe ratio formula, excess kurtosis, and Jensen's alpha, serves to heighten the illusion that the average investor needs to depend upon those who have been initiated into such mysteries in order to invest successfully.

We believe that the events of 2008 should have shattered that illusion for most investors.

This makes the beginning of 2009 a very good time to resolve to swear off Wall Street snake oil for good, and to begin a new and healthy investment philosophy.

In his 1973 distillation of his investment philosophy (to which we have referred on several previous occasions, such as here and here), the late Thomas Rowe Price began with these words: "The purpose of this article is to help the investor, particularly the amateur, by directing his attention to the simplicity and soundness of the growth stock theory and away from the belief of most people that you have to play the stock market in order to be successful" (emphasis added).

The phrase "particularly the amateur" highlights the fact that Mr. Price believed that you do not need to be a professional or a Wall Street insider in order to be a successful investor.

Instead, his investment philosophy emphasizes reliance upon ownership of businesses characterized by "capable, dynamic management operating in a fertile field for future growth." It is possible, given the willingness and discipline to do so, for the amateur investor to evaluate these characteristics with the available information.

The emphasis on the ability of the nonprofessional to successfully invest using the growth stock investment philosophy is no coincidence. The reason, as we explained in part two of this previous post, is that the growth stock theory is not based upon secret or proprietary information but rather upon selecting the best-run companies in fertile fields for growth, buying their shares, and retaining their shares "until it becomes obvious that they no longer meet the definition of a growth stock," in the words of Mr. Price.

It must be stressed that success requires a very consistent discipline -- most investors achieve mediocre long-term returns because they jump from one process of selecting investments to another several times during their investment lifetime. This common problem is very much like someone who dabbles in one martial art for a couple years, then switches to another, and then another, and then another, and never becomes accomplished at any of them, whereas an individual who selects one martial art (whichever one it happens to be) and then sticks with it consistently for twenty years can expect to achieve real results.

For those who have the discipline to stick to it, the beginning of 2009 is an excellent time to begin a twenty- or thirty-year journey of practicing the "martial art" of the classic growth style.

As professional investment managers practicing the classic growth investment style, a reader might wonder why we would emphasize that non-professionals can do it themselves. Wouldn't that secret, if it "gets out," tend to put us out of business?

Unlike the salesmen of Wall Street, who do in fact depend on the illusion that you cannot do it yourself, we are not worried about that problem. We know that not everyone has the inclination to sacrifice the time and effort needed to do so on a consistent basis, week in and week out and through gut-wrenching economic and market cycles. The fact is, most people could do their own home plumbing or cabinet-making too, if they wanted to take the time to learn how and to buy the necessary tools, but many choose instead to hire someone who makes that their full-time occupation.

Whichever category you fall into, we wish you a prosperous 2009, and believe that swearing off Wall Street snake oil is an excellent New Year's resolution.

For later posts dealing with the same topic, see also:

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