Portfolio manager’s Letter September – October 2012
This excellent book “This Time it is Different” written by two professors from Harvard, Carmen M. Reinhart and Kenneth S. Rogoff, while not exactly a beach read is an important book for anyone that seeks an understanding of economic history. The title “This Time it is Different” of the book is based the fact that investors, businessmen and bankers in the midst of an economic expansion assume that the expansion will continue indefinitely.
But, in the real world, as economist Hyman Minsky pointed out, “stability unstable”. Long periods of prosperity feed hubris and greed, and encourage excessive risk taking. In a free market environment, each period of economic expansion carries with it the seeds of its own destruction. So that “this time it is different” never really applies.
“This Time it is Different”, published 2009, contains a huge database of 800 years of country defaults, banking crises, and currency debasements. Much of the material is new, having been compiled and consolidated by the authors from statistics collected all over the world. The point is, of course, that this time it is different never happens. This may not be a particularly profound conclusion, but the statistical evidence presented by the authors is nonetheless quite surprising both in terms of the number of the events chronicled, and the shape of the patterns that develop from these data.
Rather than being black swans (uncommon and unpredictable events) financial crises are the inevitable result of economic cycles in a free market economy. While the timing of a banking crisis may be hard to predict, they are nevertheless unavoidable, and this time it is different does not apply. While I am certainly not opposed to regulation, many attempts to regulate are doomed from the start.
The notion that we can eliminate market cycles is born of the same sort of hubris that says, “this time it is different”, and more likely to make things worse than it is to prevent disaster. Much of the fertilizer that feeds the hubris that inflates the bubbles comes from the belief that legislation passed after the last crash will make, “this time it is different” apply to the next crisis.
One statistical table shows that for the 66 countries covered for the period from 1800 to 2008, there were 268 banking crises. None of these events caused the sky to fall or brought an end to capitalism. Instead, throughout this period, the world economy survived, and living standards increased. Granted, the rate of GDP increase varied substantially from country to country. Significantly the rate growth of personal income and per capita GDP was significantly higher in the countries with the most banking crises. Proving that efforts to make “this time it is different” apply in the future where counterproductive. The number of disasters in a particular country is indicative of the length of Time the country operated with free markets.
If we break the numbers down by region, African countries averaged 1.7 crises per country, Asia 3.7 per country, Europe 5.8 per country (7.4 per country if you ignore Russia, Romania, Poland, Hungry and Turkey), Latin America 2.9 per country, and North American wins with an average of 10.5 per country.
The top ten countries in the world in the number of banking crises during this 208 year period were:
There is a strong relationship between free markets and the number of banking crises. But, if we admit this relationship, then are we not faced with the conclusion that the price of trying to make “this time it is different” and eliminate the economic cycle will not improve the world’s living standards. Reducing these crises has, in the past, resulted in slower growth in GDP and per capita and living standards.
It seems one of the central ironies of life is that economic pain promotes growth. The authors do not see this relationship probably because it is too antagonistic to their liberal Harvard prejudices. The result is that they have missed one of the most essential points of their research.
It is easy to understand how Authors raised in the privilege that gets them to Harvard and the cultivated in that environment do not understand the benefit of knowledge gained by learning from your mistakes.
This form of learning is, after all, the way things operate in the real world, not so much in our institutions of higher education. The authors believe that with the proper supervision of highly educated, there will be a time when this time it is different applies. Maybe this is hubris, or perhaps they know something that we do not, but their failure to understand the constructive value of the business cycle will leave me skeptical.
The United States has survived 13 banking crises since 1800 – not only survived but prospered, while Russia, Kenya, Angola, Hungry have had two, Romania, Angola, Algeria, and Zimbabwe, one. It is Time to look at the business cycle as a natural function of a market economy. While we may not like the pain of the consolidation, it is creative destruction looking for ways to make the economy work better, and we should accept the fact that there is nothing we can to eliminate the pain.
Just as long periods of prosperity inevitably lead bankers and investors to take on stupid risk, so no matter how hard we try to make sure that this time it is different, the more our cycles repeat. It is what we learn from the pain of the consolidation that propels the next period of prosperity.
Will it be “this time is different” happen this time? Will this significant contraction be the end of our prosperity? Have we reached the end of our period of dramatic growth? Or will this Time follow the same pattern as our previous 208 years and this significant contraction be followed by a couple of decades of double-digit growth in corporate earnings and PE ratio expansion?
In August of last year, I wrote about Leucadia National Corporation’s holdings in Fortescue Metals Holdings. Fortescue is an iron mining company located in Western Australia. Since that letter, there have been further interesting developments. In 2011, Leucadia sold 117.4 million shares of Fortescue for $732.2 million.
In January of 2012, the company sold another 100 million shares for $506.5 million, and in July of this year, its remaining 30 million shares for $152 million. So, for its 2006 investment of $325 million in Fortescue’s stock they received a total return of $1,513.1 million. This nets Leucadia a gain of $1,188 million on its investment in the common stock. Sounds good but its piker’s compared to their Fortescue note.
It should also be noted that Leucadia’s timing in selling the common stock is looking pretty outstanding, as economic trouble in China is having a negative impact on Iron ore prices and the price of Fortescue’s is down 25% so far in 2012.
Leucadia still holds a $100 million Fortescue note with a coupon that pays 4% of the revenue of certain of Fortescue’s mines. The mines have now been in full production for two years. So far that 4% of revenues has paid the followings sums (in millions):
So the $100 million note is currently paying interest of about 170% per year which beats the hell out of most current interest rates, and Leucadia has received a total of $2.1 billion total so far on the stock and the note. Better yet, the note has seven more years to run, so could generate another $1.1 – $1.3 billion.
Mr. Market in his infinite wisdom however is not impressed, and during the two years that Leucadia has collected this $2.1 billion he has reduced Leucadia’s market value from $7.4 billion to $5.5 billion. So apparently Mr. Market thinks that this time it is different.
On September 19, Fortescue entered into an agreement with Leucadia National Corporation (LUK) to redeem its 2006 royalty notes for a total cash consideration of $715 million.
So, in place of the 1.1 – 1.3 billion bird in the bush, Leucadia has accepted a $715 million bird in the hand. This looks like a great deal for Leucadia, when you figure the present value of the $715 million compared to annual payment on the note for the next six years. This brings their return from its $425 million investment in Fortescue to $2.8 billion. If you plug these numbers into an investment return calculator Leucadia’s return for their six year investment comes to about 37% per year, but maybe this time it is different.
Since Leucadia sold its Fortescue stock, the common has corrected about 50% because iron ore prices are crashing in response to a sharp drop in demand from China. Fortescue had been using debt to expand aggressively, and now faces the possibility of operating losses if ore prices do not recover.
Fortescue recently was saved from cash flow problems with a new $4.5 billion credit facility, but near term prospects for the Fortescue stock look a tad shaky given the problems developing in China. So, maybe this time it is different.
Meanwhile, Leucadia is now completely out, and their timing on this series of transactions looks masterful. The announcement has sent Leucadia’s price up $.75; an interesting reaction in view of the fact that this latest transaction will add $2.00 to their book value.