sovereign man

PRICE VALUEINTERNATIONALOCTOBER 2014 ISSUE ONE

OCTOBER 2014 ISSUE ONE2

PRICE VALUE INTERNATIONAL

THE FOUR LIES AT THE HEART OF OUR FINANCIAL SYSTEM

Designed by the Frenchman Frederic-Auguste Bartholdi and weighing over 200 metric tonnes, the Statue of Liberty measures 93 metres from her base to the tip of her torch.

She has a 35-foot waistline, and if you could find enough leather to make it, she takes a size 879 shoe. 300 different types of hammer were used to make her external copper structure; Lady Liberty’s infrastructure is made of iron.

Dedicated on October 28, 1886, the Statue of Liberty (or strictly, ‘Liberty Enlightening the World’) was a gift from France to the United States, which came to be irrevocably, associated with immigration during the second half of the nineteenth century. For over 9 million immigrants to the United States, she was often the very first thing they saw as they approached New York by boat.

At least two people have committed suicide by jumping off the statue. When she was first erected in 1886 she was the tallest iron structure ever built. And on April 8, 1983, the magician David Copperfield, in front of an invited audience including Morgan Fairchild, and a TV audience of millions, made her disappear.

Just how do you make a well-lit, iconic, 93 metre-tall statue vanish into thin air? It seems that the following accounts for the act. Copperfield had erected two towers on his stage, supporting an arch to hold the huge curtain that temporarily fell, briefly obscuring the audience’s view of the statue while he conducted his trick.

The TV cameras and the live audience could only see Lady Liberty through this arch. When the curtain was dropped, Copperfield started a prepared speech, to music, while the stage was slowly and indiscernibly rotated. When the curtain was finally lifted, the statue was obscured by one of Copperfield’s giant towers, and the audience was looking out into a blank nightscape. A helicopter with an arc light helped with the illusion.



The secret to all ‘magic’ is misdirection. Admittedly, diverting people’s attention during a card trick is a lot easier than when they’re in front of a gigantic statue, but it comes down to misdirection all the same, just on a much bigger scale. Don’t look over here, look over there.

Ever since the first tremors of the global financial crisis back in 2007, I’ve been nursing a fear that we are all in danger of falling victim to a similar kind of misdirection.

What the media report on a daily basis: coverage of the latest Wall Street research; brokerage firm updates on the latest glamour stocks; an unending circus of analysts, economic commentators and financial promoters of one type or another; breathless anticipation of the latest Fed monetary policy decision… It’s all misdirection.

But first, a confession. I didn’t study Economics at university. At Oxford I read English Language and Literature instead – a vocational subject that I hugely enjoyed and which I intended to exploit in a career in journalism. But that isn’t quite what Fate determined.

As luck would have it, I graduated, in 1991, in the middle of a tough recession (but nowhere near as severe as the one that I think has become entrenched throughout the developed world. More on that later.)

Through a perversity that I still think about, there were no jobs – at least for me – in journalism, or advertising, or similar fields associated with the liberal arts. By dint of an older brother who had read Economics, at Cambridge, I had half-heartedly also applied to some investment banks as a backstop.

Ironically, the first job I secured was as a bond salesman. Since I had no knowledge of economics whatsoever and would have struggled to tell you what a bond even was, this tells you more than you need to know about the apparent sophistication of the City and Wall Street.

I used to be defensive about my lack of familiarity with the world of economics. Until around 2007, that is. Until then, I found that in the financial markets, practical experience is, ultimately, just as good a teacher as economics textbooks or a degree.

And then, as the credit markets started to seize up and detach from reality, and the stock markets started to wobble, the rot started to set in. I started to get a feeling, vague at first, that the system wasn’t working according to plan.



Conventional economic theory seemed to be founded on sand. And as bank after bank started to fail, it struck me that nobody could really account for what was going on. Both in the run-up to the failure of Lehman Brothers and especially thereafter, traditional, Keynesian economics seemed to have been caught with its pants down.

There’s a quote from Lord Keynes himself that sums up the predicament pretty well. He originally said it in his essay ‘The Great Slump of 1930’, written that same year:

“But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time – perhaps for a long time.”

Keynes was undoubtedly correct in anticipating that the ruin of what turned out to be the Great Depression would last “for a long time”. But his initial metaphor, of economy as some kind of delicate machine, is fundamentally flawed. It can be no surprise that one’s thinking is wrong if one’s use of metaphor is essentially wrong, too.

What I came to understand during 2007 and afterwards is that the entire Keynesian conception of economy-as-machine, with confident Keynesian financial engineers and monetary overlords standing at hand to direct it, is simply a fake.

Inappropriate metaphor, invalid thinking.

What I also came to understand is that we cannot in any fundamental sense even attempt to model something as complicated as the economy, because the economy is us. We, all of us, are the economy, all seven billion of us, all interacting with our various hopes and fears and financial aspirations. Try modelling that.

And this is a key insight from the one school in Economics that I do respect, namely the so-called Austrian school. The magnum opus of one of its founding fathers, Ludwig von Mises, is titled ‘Human Action’. That, not some form of machine, is what drives our economy and financial markets: human action.

So, what are my own hopes and expectations in writing this letter?

Firstly, I’d like to share some of my more valuable experiences after nearly a quarter of a century



working in the capital markets. My second confession is that I have a deeply jaundiced view of the financial services industry. The best way to sum it up would be an old gag used in the context of the advertising industry (and certainly plenty of others):

“Please don’t tell my mother I’m in advertising; she thinks I’m a piano player in a brothel.”

I’m not presuming to have all the answers. But some of the principles of successful investing are timeless and they do not age. I hope to share many of them with you in the course of these letters.

In addition to discussing some essential principles, I also hope to highlight some of the best individual investments as they arise, wherever and whenever that might be. And we’ll also cover the business of asset allocation and how it’s impacted by geopolitics and macroeconomics in this bizarre ‘new normal’ landscape.

Most importantly, I hope to share with you some of the most compelling insights into ‘value’ investing, on a global basis. Having advised institutional clients and managed institutional and private client portfolios for over 20 years, I’m convinced that ‘value’ investing across international equity markets is the most meaningful way of navigating an otherwise treacherous investment landscape.

And I’d also like this to be a conversation of sorts, a two-way dialogue. So feel free to contact me with any questions you might have about the service and I’ll be happy to try and answer them.

So, back to the misdirection.

THE FOUR MYTHS OF MODERN FINANCE

Open a financial newspaper or visit any financial website and what will you see? Chances are, it will be melodramatic features on the fast-evolving strategies of ‘exciting’ companies and their ‘glamorous’ management; breathless reports of the latest product launches; giddy coverage of the next, hotly anticipated IPO… An endless stream of financial promotions and hucksterism, with the stock market as the Circus Maximus and gravitational hub to all financial things.



To add gravitas, you’ll also find feverish analysis of current economic trends and worrisome reports hinting archly at the prospects for a slowing economy. There will be four key subtexts:

• Consumption is all. Our society and economy requires ever-expanding consumption;

• To attain wealth, you must make risky bets in the wild casino of the stock market;

• Growth is everything. The economy must grow at all cost. Without perpetual economic growth we will all perish;

• The monetary system is too important to be left to free market forces – only wise central bankers should be entrusted to ‘guide’ interest rates, currencies and the stock and bond markets.

All of which, of course, is complete nonsense – but these subtexts constitute the prism through which almost all financial journalists and investment commentators view the world.

Perpetual growth is taken utterly for granted, as if the business cycle were some quaint memory from a bygone age. The impossibility or even desirability of perpetual growth and consumption in a finite world is never questioned. And the idea that interest rates – the most important price in the entire market, the price of money itself – should be left to the tender mercies of central bankers is never disputed for a moment.

The growth and consumption canard was refuted powerfully by the late Albert Allen Bartlett, emeritus Professor of Physics at the University of Colorado at Boulder. During his lifetime Dr. Bartlett gave literally thousands of presentations on the seemingly dull topic of ‘Arithmetic, Population and Energy’. Over five million people have watched his presentation on YouTube, which you can see here.

But the essence of Bartlett’s argument is extremely simple.

First, mankind’s biggest weakness is our inability to understand the power of the exponential function – the extraordinary future growth inherent in anything growing at a fixed rate over time. Einstein made exactly the same point when he described compound interest as the eighth wonder of the world.

http://www.youtube.com/watch?v=F-QA2rkpBSY



Second, Bartlett asked the question:

“Can you think of any problem in any area of human endeavour on any scale, from microscopic to global, whose long-term solution is in any demonstrable way aided, assisted, or advanced by further increases in population, locally, nationally, or globally?”

To put it in an even broader context than population alone, Bartlett made another observation; that for any entity, beyond a certain level, further growth equates to either obesity, or cancer.

This latter observation gets to the heart of the financial crisis. The financial system itself has metastasised. Freed from any last vestige of restraint by President Nixon’s suspension of US dollar convertibility into gold in 1971, the growth of credit has become uncontrollable.

This accounts for the investment world and media’s focus on constant economic growth: only constant economic growth can allow the US government to even attempt to service otherwise utterly unpayable debts (the nearly $18 trillion US national debt is merely the tip of the iceberg above the waterline – once you factor in the off-balance sheet debts, unfunded liabilities like Social Security and Medicare, the real total rises to well over one hundred trillion dollars).

The collapse of Lehman Brothers in 2008 was the moment at which we saw that the Emperor wore no clothes. Which, in due course, is why central banks throughout the indebted West have been so accommodating to their client national treasuries: interest rates have been forced to all-time lows to try and ensure that deflation does not bring down the entire government debt edifice. (In a true deflation, the real cost of servicing government debt rises.)

But actions have consequences. In their increasingly desperate attempts to keep the government bond bandwagon on the road, central banks have impoverished savers and all those on fixed incomes, like pensioners.

With bond yields at all-time lows, despite the grotesque surge in the supply of the stuff, desperate investors have, in turn, stampeded into the one asset class where they feel they can earn a decent real return: stocks.

Investment bank dealing rooms once resonated with one specific piece of advice: don’t fight the Fed. No investor, whatever his size, has a chance against the firepower and the unlimited ability



to print money possessed by the US Federal Reserve. When the Fed is easing monetary policy, don’t resist the trend.

But now the market environment is that much more perilous. Just as the “Greenspan put” was developed as a theory to account for boundless optimism when it came to stock market investing (the Fed has your back, in other words, and will act swiftly to support the market, come what may), so the “Bernanke put” and now the “Yellen put” have persuaded a whole new generation of investors that the stock market only ever rises. In a Battle Royale between the capital markets and the State, does the State always win? We are about to find out.

Please note, I am not making any forecast of an imminent market collapse. One lesson we know from history is that a fundamentally dysfunctional system can still outlast our worst expectations. Take the former Soviet Union, for example. Born in the Russian Revolution of 1917, a thoroughly dysfunctional and economically bankrupt regime survived the most apocalyptic of prognostications until the Berlin Wall finally fell in 1989. 72 years is a long time to wait to be proved right.

But rather than throw up our hands in disgust at the financial repression being conducted throughout the ‘developed’ economies of the West, as investors it makes sense to try and make the best of our situation.

Bond markets are clearly a bug in search of a windshield. Traditional asset allocation holds that investment grade bonds represent the risk-free rate of return. But traditional asset allocation has been turned on its head by six years of emergency monetary stimulus.



10 year US Treasury Constant Maturity Rate – 1962 to 2014

The chart above shows the comparatively recent history of the 10-year US Treasury bond yield. (The ‘constant maturity rate’ simply reflects a range of Treasury bonds with an average maturity of 10 years.) You can clearly see the success of the then Fed Chairman Paul Volcker’s policy of squashing inflation during the early 1980s, as Treasury yields plummeted from the high teens to just 5 percent or so by the year 2000. You can also see the panic lows in yield as the market fretted about outright deflation during and after the financial crisis in 2007/8. But take a much longer perspective and you can see just how freakish bond yields currently are:



10-year US Treasury Constant Maturity Rate – since 1790

In short, the cynical answer as to why bond yields are at their lowest level in history even as the US national debt is at its highest level in history, would be: because the central bank has rigged the market. So-called quantitative easing (QE) involves the Fed creating money out of thin air and using it to buy Treasury bonds and other debt securities.

The theory – based on the flimsiest logic – has it that the banks holding US Treasuries that are bought by the Fed will be increasingly willing to lend out their sudden cash windfalls; and that investors suddenly enriched by this money creation and its attendant spur to asset prices will go on a spending spree that will ignite the economy.

Economic data would tend to suggest otherwise. But it is undeniable that QE has been a huge boon to financial asset prices, notably stocks. So what happens to asset prices, notably stocks, when, as planned, the Fed’s ‘tapering’ of QE comes to its conclusion in this month? Again, we will soon find out.

My suspicion is that the Fed has now entirely lost control of the bond market. And since the size of the bond market completely dwarfs the value of listed stocks, this is a market you don’t want to lose control of.

In any event, there is one thing close to an iron law in financial markets: if interest rates rise, bond prices fall. This is entirely logical, since conventional bonds carry a fixed coupon or



interest rate. If official interest rates, such as the Fed Funds Rate, go up, they make the fixed coupons on bonds comparatively less attractive, so bond prices fall to compensate the investor. Since bonds are now at their most expensive level in history, the future prognosis for bondholders is hardly rosy.

So by a process of elimination, we end up scouring the equity market for opportunities instead. But equity prices have also been distorted by QE, and it is anybody’s guess how Fed tapering – if it conclusively terminates official purchases of government debt – will impact an already frothy stock market. Which is why ‘value’ equity investing, for me, is now the only game in town.

THE MEANING OF VALUE

When I use the phrase ‘value investing’, I am essentially referring to the style of investing first described in detail by the veteran investor Benjamin Graham, mentor to Warren Buffett, in his classic book on the subject, ‘The Intelligent Investor’, first published in 1949. If you don’t already have a copy, buy one. It will transform your outlook on equity investing. And don’t worry about its apparent age – its message is timeless. Human nature doesn’t change, and neither do successful investment principles.

Graham warned that:

“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes – in fact very frequently – they make mistakes by buying good stocks in the upper reaches of bull markets.”

There you have it. There is no crime in “buying good stocks at fair prices”. The risk is in buying garbage (one might cite any number of candidates in the social media space here), or in simply overpaying (“buying good stocks in the upper reaches of bull markets”). And the risk of overpaying today is high. We know that bonds are expensive. But stocks are hardly cheap.

My favourite metric for assessing the overall expensiveness or cheapness of the stock market is Robert Shiller’s cyclically adjusted price/earnings ratio for the market, or CAPE. CAPE simply takes the 10-year average of P/E ratios for the market to smooth out the spikes in short-term volatility so we can see the broader trend.



Shiller CAPE ratio for the US stock market 1880-2014

Source: www.econ.yale.edu/~shiller/data/ie_data.xls

As you can clearly see from the chart, the Shiller P/E (at around 26x) has rarely been higher. More specifically, it has been higher only twice before in history. The first was in 1929. The second was in 2000. On neither occasion did it end well.

For the entire history of the US stock market, the average Shiller P/E has been 16.5x. The two historic outliers were in December 1920, when a war-ravaged market traded at just 4.8 times (a huge buying opportunity, with hindsight), and in December 1999, when during the insanity of the dotcom bubble the market reached an unsustainable Shiller P/E of 44 times. But today’s level of 26x is still pricy.

The beauty of a classic ‘value’ approach to stocks is that it forces us not to overpay. Following Ben Graham’s advice, we are not interested in buying junk. And we’re not interested in paying over the odds. But a quality business at a fair or very fair price – that’s a different proposition entirely.

http://www.econ.yale.edu/~shiller/data/ie_data.xls



A QUALITY BUSINESS AT A FAIR PRICE

You will know the name Warren Buffett – almost certainly the most successful investor in history. You may not be so familiar with the name of Prem Watsa. His family emigrated from India and he ended up in Canada. Watsa began his career as a securities analyst at a prominent insurance company. He then left to establish his own investment firm. He subsequently bought a small insurance company... If this sounds a little like the history of Berkshire Hathaway, the comparison isn’t without foundation. Under Prem Watsa’s leadership, his business, Fairfax Financial Holdings Ltd (stock ticker: FFH on the Toronto Stock Exchange; ISIN code CA3039011026) has compounded its book value at an average annualised 21% over a period of 28 years. That may not sound extraordinary, but trust me, it is.

Fairfax Financial share price - total returns 1988 to 2014

The chart above shows just how spectacular Fairfax Financial has been as a listed stock over the past quarter century. In pure price terms alone (not including reinvested dividends, which are important) Fairfax has delivered a stunning return of almost 4,000 percent. The TSX Composite



Index, by comparison, has delivered “just” 394 percent. Factoring in dividends, and Fairfax stock has generated average annualised returns to shareholders of over 15 percent.

So what does Fairfax actually do? The company is a collection of global insurance and reinsurance businesses that have competent management teams and a disciplined approach to taking underwriting risks.

In a sense, Fairfax is a ‘value’ proposition squared, since in deploying its investment ‘float’ (the pool of funds it earns from insurance that it hasn’t yet had to pay out in policy claims) it also adopts a ‘value’ investing philosophy. This is the very strategy that made Warren Buffett a billionaire. (Prem Watsa is also a self-made billionaire.) Fairfax has also built a meaningful business in India and across Asia – markets that interest me a lot more than the economically ailing and debt-dependent ‘Old World’ in Europe, for example.

What makes Fairfax doubly appealing to me is that Prem Watsa’s investment focus is distinctly conservative. 100% of the equity exposure in its investment book is hedged, i.e. insured against a market collapse. It also holds roughly 30% of its investments in cash, and has a 15% exposure to a variety of municipal bonds guaranteed by Berkshire Hathaway itself.

As things stand I hate prospects for financial businesses, especially banks, because I think there is still a day of reckoning to come that was deferred by the massive bailouts that started in 2007 and 2008. Europe’s banks, unlike those in North America, remain hopelessly unreconstructed. And it’s impossible to imagine what horrors might still be lurking on their balance sheets. But I’m willing to be pragmatic when it comes to the insurance business, and Fairfax to me looks like an incredibly classy act, so I’m willing to make an exception.

Since Fairfax’s investment portfolio has been more or less fully hedged over recent years, that conservatism has impacted its profitability. The stock trades at just above 1.1 times book value – which, for a company with Prem Watsa’s track record of acquiring and managing businesses, looks extremely conservative.

According to Bloomberg analytics, the shares trade on a current price/earnings ratio of 16 times, but a forward P/E of just 7x, which is firmly in ‘deep value’ territory. Its gross dividend yield is 2.2%.



For a business with a market valuation of C$11.5 billion, Fairfax is barely covered by the investment analyst community (another reason to find it attractive). Just five brokers cover the stock. Three analysts rate Fairfax a ‘Hold’; one rates it a ‘Buy’, the other a ‘Sell’. Make of that what you will – I think those opinions, in line with most Wall Street research, are almost wholly irrelevant.

I should add, as a disclaimer, that I don’t own Fairfax Financial Holdings – yet. But I certainly intend to. On which note, I will always declare when I have any form of financial interest in a recommendation I make here. Another caveat: don’t commit money to the stock market if you’re not comfortable having it tied up for several years or perhaps more. The stock market can and will be volatile. I’m not interested in ‘quick wins’ (though they’re delightful if they happen) – what interests me is the slow and steady compounding of value over time.

That just about wraps it up for this inaugural edition of Price Value International. As I say, if you have any comments, thoughts or requests about the service and would like to help shape its evolution, just drop me a line.

To your investment freedom,

Tim Price is a portfolio manager and global strategist based in London. He is currently Partner and Director of Investment at PFP Wealth Management LLP. He welcomes any queries about the Price Value International letter at [email protected]. You can also follow him on twitter: @timfprice.

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