Portfolio manager’s Letter October 2008
Currently there has been a lot of talk in the media referring to the current market gymnastics as a generational events. This is a term I like because I have felt for a long time that there are long term cycles in the financial markets, and that these cycles are more a function of human behavior than business fundamentals.
Hyman Minsky, an economist popular in the nineteen seventies, held that the capitalistic economy has an inherent tendency to develop instability. This instability eventually erupts into a in severe economic crises. In his words “stability unstable“. He said in the 1970’s that the key mechanism that pushes the economy towards a crisis is the accumulation of debt. During periods of prosperity intelligent people will tend to act as though they have become collectively stupid.
Competitive market forces will eventually encourage participants to will do things they know to be foolish, because the guy across the street is doing it, and because the guy across the street is making a lot money doing what he is doing (investment managers buy tech stocks in 1999, loan officers make loans without proper documentation or down payments in 2006). During “good” times, businesses in profitable areas of the economy are handsomely rewarded for raising their level of debt. In short, the faster a banker lends money, the more profit his bank shows at the end of the quarter, and the bigger his bonus will be at the end of the year.
Banks are richly rewarded for creating cash by ratcheting up their leverage. The rising profit encourages banks and borrowers alike to raise the level of debt. Since the economy is doing well and borrowers’ financial health shows visible improvement, this makes lenders more and more eager to lend. This Process takes time because it is effectively a generational event. People tend to remember and use the lessons learned during the crisis phase of the cycle, and so a new cycle peak must wait for the old players to be replaced.
Hence we have long cycles that tend to last 30 to 40 years. Buffett wrote an article for Fortune Magazine in 1999 identifying a long cycle at the end of the 20th century as consisting of seventeen lean years (1966 – 1983) and seventeen fat years (1983 – 2000). So if we fit this fact pattern into Minisky’s theory, about generational event, we can say that it took seventeen lean years for the economy to get smart and then seventeen more fat years for it to get dumb again.
These cycles are not caused by exogenous generational events or are they likely to be eliminated by regulatory tinkering. They are a function of the hard wiring of the human brain. While it is true that the corrective part of the cycle is long and painful, it is probably also true that the without the pain we would never learn the lessons that propel the growth cycle. I would even argue that the reason that the market economy works and socialism does not, is the things we learn in the down cycles, and that absent the pain we learn little.
It accomplishes little to attempt to assign blame. This is the politician’s endless quest to affix blame for Black Swans. The difference being that while economic cycles are eminently predictable, and their damage is avoidable for the individual that understands human nature (Buffett). Still it seems just as obvious that these cycles are not now and never will be preventable.
It has by now become painfully obvious that all you needed protect your assets from the current economic meltdown was portfolio heavily weighted toward Berkshire Hathaway and cash. This was not a hard choice if you were paying attention to what Buffett was saying and doing, but I would be lying if I did not admit that the above strategy has worked out better than I expected.
I do not think that we have seen the bottom of this market cycle. It is certainly possible that T bills will out-perform Berkshire Hathaway in the next six months but for the last year Berkshire Hathaway is up 11% and the S&P 500 is down 24%. (Note this letter was originally written before October first. Since then the market is down 19% and certainly closer to a bottom. Values are now more attractive than they have been for years, and we are now close to fully invested for the first time since 2003, so your portfolio will look a lot different in November).
There is short term risk in Berkshire Hathaway today as there is in any equity, but balancing that risk is the fact that no other company has the architecture that has been carefully designed to benefit from this type financial crisis. Buffett has been able to use not only Berkshire Hathaway’s cash but also its reputation to great advantage. It is impossible it estimate the impact on intrinsic value of Buffett’s recent purchases, because it will take a couple of years before they will begin to show up in earnings, or the two column valuation approach.
But if you assume that he has committed $36 billion to long and medium term investment, and if you assume they will earn 12% on this new investments (some will earn more some will earn less), further let’s say the cash was earning 1% in t bills. The 11% difference would add about $4 billion to Berkshire Hathaway’s earnings. If you capitalize $4 billion at 12 times it could eventually add $40 to $50 billion to Berkshire Hathaway’s intrinsic value. While Berkshire Hathaway’s cash pile is certainly smaller than is was at the first of the year, the balance sheet at the end of the second quarter showed $70 billion in bonds.
Since much of these fixed income investments are short term, and since Charlie has said more than once that they would just not own any debt, I think that we can assume Buffett has enough cash left to have a lot more fun.
Certainly the fact that GE was willing to pay up for Berkshire Hathaway’s cash is scary when you consider what it is telling us about the equity market, but on the other hand you have to also consider the magnitude Buffett’s recent commitments and what this tells us about the values available in the current market. No, we cannot as individuals get the same value Buffett can, and while the bottom is probably not in yet, I think it is time to get serious about deciding about when and where to start committing cash. (Little did I know!)
I believe that the rapid growth world economy in the last twenty years is at least partially the result of the lessons learned from the pain of the seventies. During the seventies the primary driver of inflation was labor costs. Outsourcing, and the movement of manufacturing offshore was the response of American business to out of control labor costs. In this sense it can be said that the bear market of the 1970’s has changed the face of the world in the twenty-first century. While the end result may not have been wholly satisfactory for the American labor market, its impact of the world economy has been beyond anything that could have been imagined in the 1970’s.
Living standards have increased though-out the world, and they have exploded in the emerging markets. Bureaucrats and politicians tend to see regulation as the answer to all economic problems (to the man with a hammer everything looks like a nail). So they tend to see our current problems as regulatory failures or maybe deregulation failures. Yet regulations tend to result from past problems and are of very little help in dealing with today’s crisis. As Charlie says “all human systems are gamed”, by the time that new problems pop up people will have learned how to game the old regulations. The current level investor sentiment is as negative as anything that I since the seventies.
As a devout contrarian I have to feel that this panic will eventually bring us at least temporary bottom. This coupled with the fact the Buffett has reverted to his over-sexed teenage stage, it is at least time to think about getting bullish. Any sharp correction of financial markets from current levels will likely provide investors with a generational event in the form of a buying opportunity similar to that which was experienced in late 1974.
The creative destruction provided by our current economic crisis is likely to provide economic progress for the present generation that is just as unimaginable today as globalization was to the generation of the seventies. It is even possible that because wage scales around the world have risen so much in the last thirty years, that the next thirty may provide some relief to American workers.