RTCrawford’s Weblog

2002 Nobel laureates Daniel Kahneman and Vernon Smith used computer simulations to study behavioral finance, demonstrating that speculative bubbles arrive with greater frequency than most of us would otherwise expect. Those bubbles can be hedonistic or pessimistic, defying the “efficient market theory” — which argues that the market fairly prices openly-traded equities, commodities, and other goods and services with near-instantaneous accuracy. The mispricings associated with speculative bubbles often follow from a “herd mentality,” and this leads to the trading approach known as “technical analysis.” Eventually, however, bubbles deflate, no matter how analytical the technician.

Our current economic woes began with a housing bubble and are exacerbated by an assortment of other bubbles – banking and investment-house leverage, collateralized debt obligations, credit default swaps, petroleum prices in excess of $140 a barrel, household debt, the current account deficit, the deregulation of the financial industry (including the repeal of Glass-Steagall and the up-tick rule), and excesses of regulation (mark-to-market and Sarbanes-Oxley). This prompted investors to enter and exit positions based on nothing more fundamental than price direction and volume, rather than the underlying intrinsic value of companies or the economic forces of supply and demand. It appears that, of the species in nature, the investor class is a herd animal, with hedge funds serving as the alpha male and daytraders populating their compliant flock – begging to be screwed (pleasantly or otherwise) by the leader of the pack.

There are, however, different types of herd. The relatively mild-mannered guerrilla, the even-more sedate three-toed sloth, and the pleasant panda are different from the wildebeest, wild boar, and the various forms of bovine, in that the latter group is prone to stampeding if provoked. The investor class is clearly a herd animal capable of stampeding, and this places a further nail in the coffin of the efficient market theory. The Wilshire 5000 was not worth double its current value last year, nor is it worth today appreciably less than half last year’s value.

The current disconnect between intrinsic value and the price at which companies are selling represents a speculative bubble, as well, and, eventually, it too will burst. The intrinsic value of a company is nothing more and nothing less than the net present value of the cash that can be taken out of it over its lifetime. Economies fluctuate, porpoising between boom and recession, and companies are not as strong as the earnings they post in good times, nor are they as weak as the earnings posted in bad times. And, yet, we persist in the practice of valuing firms based on their price-to-earnings multiples. PE ratios based on the trailing-twelve-month results are, by definition, nearsighted and backwards looking, while PE ratios based on projected earnings over the next year are, by definition, shortsighted and beer-belly-button gazing – unless expecting the firm to go bankrupt at the end of that year. Even if estimating earnings over the next decade or longer, earnings represent a poor proxy on which to base valuation, since earnings take into account a number of non-Cash items in the financials. This leads me to conclude that, like the other herd animals, the investor class is abundantly ignorant – prone to false beliefs and decision-making based on inadequate information or justification.

If that were the limit and extend of our collective follies, investing would be a akin to sitting down at a high stakes poker table—where each participant would take the measure of his neighbors, seeking to identify the “Mark” (the fool who will soon be parted from his money). The investor class, as a stampeding herd, has more in common with the slow-moving lemming than with cattle, in that we can hardly pass a cliff without acting on the urge to jump off it.

In today’s New York Times, Stephanie Rosenbloom’s article “Retailers Report A Sales Collapse” describes this cliff-seeking behavior. It notes that consumers have been abundantly spooked by a worsening economy and the drumbeat of news reports heralding the economic “end of times.” Concerned about job losses, no longer able to tap into home equity lines of credit, and discovering that credit-card limits have been met, retail customers are guarding their wallets with uncommon vigor, as though fiscal responsibility and savings were new concepts and Aesop’s “Ant and the Grasshopper” was the fable equivalent of a newly-discovered Dead Sea Scroll. The consumer’s reticence to purchase, however, is self-defeating, since it is likely to exacerbate the feared job losses prompting their newly-frugal behavior.

Complexity theory, at its core, is about a domino effect, where one action leads to a sequence of other actions and each subsequent action, in turn, leads to others still. In this complexity of action and response, there are, invariably, unintended consequences. The impact of the consumers’ purchasing reticence on their own job stability is not an example of this, however, since this is predictable. We’ve seen it with prior recessions. Instead, the unintended consequences come in other forms.

The corporate practice of providing guidance on a quarterly basis (by executive leadership) follows from the shortsighted perspective of Wall Street – the same perspective that has investors purchasing stock based on PE multiples. Before the market collapse starting in late September and extending through October, any company failing to meet guidance would confront a stock selloff that would hammer the equity value of the company – angering stockholders who, after all, own the company. This prompted corporate leadership to, both, manage expectations and massage results. As we began to enter into bear market territory, stockholders urged management to increase dividends and repurchase shares in order to maintain equity values – consuming cash stockpiles that might sustain companies during a cyclical recession. On investment message boards throughout the Internet, stockholders agreed with each other on the wisdom of dividend increases and share repurchases, arguing that a company need retain only as much cash as was necessary to survive an average recession – with some contending that taking on debt to repurchase shares or increase the dividend was warranted, given the recent declines in equity value, the comparative return to the investor (asserting the stock would increase at a rate of return in excess of the cost of debt capital), etc. They even argued that Warren Buffett would approve, referencing his advice given in the 1970s and 1980s to Katharine Graham and Roberto Guizueta of the Washington Post and Coca-Cola, respectively – advice given in a different time and economic environment, to uniquely capable corporate leaders, heading companies with financial strengths and prospects unique unto themselves. On the Internet, every writer has an opinion, believes every other participant to be ill-informed, and believes themselves better positioned to make strategic management choices than the executives leading the corporations in which they are equity participants. The problem is not that the uninformed made recommendations but, rather, that corporate leaders took that advice.

This should not suggest that I am ignorant of the benefits for stockholders when shares are repurchased. The practice increases earnings per share and raises returns on assets and equity. It allows the firm to raise dividends per share without increasing the total amount paid in dividends. And the shareholder is shielded from capital gains taxes until the higher-valued shares are sold.

The problem is with the reduction in deployable cash as a nest egg to weather cyclical downturns, and, worse, with management listening to self-serving shareholders possessing a short-term perspective – looking for a pop in the stock price in order to sell with a 10 percent or 20 percent gain. This phenomena is associated with day trading, but it should also be more prominently linked with retirement accounts – where the capital gains consequences of such a short-term perspective are absent. In fact, I recall a remote broadcast of CNBC’s Power Lunch from Cleveland several years ago where an attending small-time investor held up a sign proclaiming “Day Trading Your IRA Is Cool.”

Well, it is cool, but it is also short-sighted. Why are small businesses the primary engine of job growth in the US? I can’t prove it, but, if every firm managed with a short-term perspective, only new market entrants would represents engines of growth (for jobs, profits, and sales). Abraham Lincoln had it right when he asserted that the function of a nation is not to promote its own demise, but this seems lost on the average investor – enamored with the legacy of Ivan Boesky, Carl Icahn, and Gordon Gekko.

The net effect in retailing was the creation of firms lacking the capital necessary to survive a worse-than-average market downturn, including Linens ‘n Things, Sharper Image, Steve & Barry’s, Circuit City, Pier 1, according to this NY Post article, CompUSA, Levitz Furniture, Bombay Company, Charming Shoppes, PacSun ‘Demo’ Stores, Talbot’s Kids and Mens stores, Ethan Allen Interiors, Movie Gallery Stores, according to this Retail Info Systems News article, and, most recently, Mervins, per Market Watch.

This, however, was predictable. During recessions, the economy becomes Darwinian – where the strong survive and the weak disappear. It is even predictable that, in an increasingly competitive and depressive economy, inventories would exceed demand. This, in fact, was one of the most significant problems confronting the US economy during the last recession. Just as the military tends to fight the last war, however, retailers managed their inventories more closely in the months leading up to the current market downturn. Many even went so far as to increase their cash positions in anticipation, but they confronted a dilemma of timing.

Throughout Retail Land, the lionshare of earnings arrive in the fourth quarter, when the holiday season prompts consumers to satisfy the inherent greed of their offspring, mates, friends, and family. We are, after all, a generous species. Retailers, therefore, found it necessary to simultaneously reduce and increase inventories – taking markdowns on summer inventories while ramping up for the holidays. As the economy worsened and expectations declined, markdowns became deeper, and retailers sought to start the holiday season earlier, before the consumer became too fearful and the unemployment rate made buyers frugal. Naturally, discount retailers (especially, Wal-Mart) benefited, but even Wal-Mart confronted the competition’s markdowns, and, while not described as such in the press, we are in the midst of a price war, and this is where the unintended or unexpected consequences come into play.

Specifically, the weakest retailers, undertaking closeout pricing in advance of, either, bankruptcy or store-closing retrenchment, are directly competing with Wal-Mart and the other discount retailers in their price-cutting. This serves to further undermine miniscule margins for marginally stronger retailers, seems likely to promote a further round of price-cutting and margin reductions, and, for all the world, is taking on the tone and character of “adverse selection.” Adverse selection, which is feared throughout the insurance industry, represents a reinforcing-loop death-spiral. Under this model, cash-strapped consumers purchase less from retailers, who markdown prices and lay off workers/consumers, who purchase less and prompt closeout pricing, leading to increased unemployment, jeopardizing the financial stability of stronger retailers, generating further pricing reductions and lower margins, … .

Of course, you may argue that all this was predictable, since we’ve seen it with prior recessions, and you would be right. What is different and unpredicted is the role of a stockholder in all this – those demanding that management provide guidance, live up to that guidance, repurchase shares, and increase dividends in order to secure short-term gains at the expense of long-term strength and solvency. What is new is not the common stockholder owning a small number of shares but, rather, the degree to which he has become a vocal influence on management decision-making – with the Internet message boards serving as megaphone for his stridently self-serving and self-defeating demands and pronouncements.

“We have met the enemy and he is us.”

We do not, however, execute the insane. So, it is reasonable to ask whether the common trader, the activist investor, or the hedge fund manager (greedy bastards all) could have behaved differently. Of course, we do not execute the stampeding herd of lemmings, since, blessedly, they save us the trouble and mess by doing the deed themselves. Garrett Hardin’s “Tragedy of the Commons” provides a non-quant game-theory model explaining why we some of us are compelled to place self-interest ahead of the collective good, even when it is clearly at odds with our individual self-interest. It is a model that explains the defoliation of Easter Island and Dr. Seuss’ “The Lorax” – a similar tale with cartoons and poetry.

Indeed, it appears that, like the lemming, we could not have done differently – it was the Wall Street equivalent of the technological imperative (the compulsion we are incapable of avoiding). It is like Bill Cosby’s description of his children’s nighttime ritual of increasingly wild and annoying behavior, leading to a meltdown of order, until, finally, Mrs. Crosby would announce, “Let the beatings commence!” It is entropy, and, strangely, it is good for value investors.

Why? Because this is when Wall Street goes on an “everything off” sale. To be sure, the Pet Rocks are marked down to rock bottom prices and the self-imploding “investors” will flock to them in an orgy of wealth destruction. But, amongst the Pet Rocks in the 80 percent off bin, are a small number of Faberge Eggs. In other words (using a different euphemism), the market is purging, eliminating the accumulated sepsis, and now is when the world’s wealth returns to its rightful owners – those who view equities as proportional ownership of real and tangible companies.

So, value companies based on their fundamentals – a combination of proven performance, accumulated assets, and future prospects –, purchase when the discount is mouthwateringly attractive, and become invested in the company in the same way you accord loyalty to a favored sports team, by getting to know the products, the competition, and, most importantly, the management.

Finally, let me bring you up to date on my portfolio. As previously mentioned, I’ve sold out of my Swiss Francs position and proportionally increased the S&P 500 short position while adding to existing holdings in AEO, BHP, FCX, PCU, JNJ, PG, XOM, and MCK. Most are out of favor and have been hammered more strongly than the broader market. None represents a bankruptcy threat, and each gives every indication of managing their businesses for the long-term. Additionally, I’ve taken new positions in MSFT, EMC, NVDA, QSII, and SLP. Each are tech firms, with strong cash and strategic positions. And cash remains a significant position – roughly, 25 percent –, and that will increase at the end of the year when checks from several consulting projects will arrive. So, even in this down market, I’m shopping, and, when the VIX returns to reasonable levels (and stays there), I’ll need to put a further 25 percent (the short position) to work somewhere. As of the closing bell today (11/07/08) the portfolio is down 12.87 percent since the end of October 2007, versus -34 percent for the Dow 30, -38 percent for the S&P 500, and -42 percent for the NASDAQ.