We pack our own parachute
March 31, 2008
Market Summary – 1st Quarter, 2008
The Dow Jones Industrial Average peaked at 14,164 on October 9, 2007. Since then, stocks have declined over five consecutive months (through March). Throughout that period, the popular media has showered us with negative economic news reflecting the damage done by the financial sector. This information reinforced one of our core philosophies – don’t let conventional wisdom, “expert” opinions and popular trends overwhelm your own instincts, knowledge and viewpoints. In other words, “pack your own parachute,” (PYOP).
History is littered with numerous examples of people losing money because they failed to pack their own parachute. The technology bubble of the late 1990s and 2000 is one of the most dramatic examples in recent times. Too many investors adopted as conventional thinking the idea that paying an excessive price for technology stocks was acceptable. Today, the financial engineers drove financial powerhouses to ignore the true underlying risk of securitized subprime loans. The biggest names in the industry, those perceived as being the best in the business, threw billions of dollars at securities that proved to be illiquid and lost substantial value.
Fortunately, we trusted our better judgment and followed a PYOP philosophy that steered us away from the technology bubble in the late 1990s and early 2000s and the financial sector in the past few years. In other words, we did not follow the herd mentality, for the betterment of our clients.
Which brings us to a red-letter day in the current economic malaise, March 13, 2008. On that date, a hedge fund operated by the esteemed Carlyle Group, a powerful and prestigious firm, one that has some of the most famous and respected people in the world associated with it, collapsed. Carlyle’s publicly traded hedge fund, Carlyle Capital Corp., was once valued at $22.7 billion. At the close of the day on March 13, it was down 97% for the year.
This event was significant for a couple of reasons. The Carlyle Group is the largest private equity firm in the world, with assets estimated at over $80 billion. A veritable who’s who of luminaries are connected to the company. The list includes George H.W. Bush (the 41st President), former British Prime Minister John Major, members of the Bush 41 and Clinton cabinets, the brother of French President Sarkozy, and the former editor-in-chief of Time Magazine. The chairman is Louis Gerstner, ex-CEO of IBM, often credited with guiding IBM’s comeback in the 1990s. All of the power and sterling reputations that gave Carlyle such cache in the marketplace was for naught in the face of poor management and a highly questionable investment strategy.
Prominent names and reputations can’t save poor investment decisions. It is one thing to see unqualified homebuyers accept mortgage terms they may not fully understand. It is another to see companies filled with big name, highly educated and well-connected people, buying into a (pardon the pun) house of cards like subprime mortgages. The conventional thinking was that housing values would always rise, which would bail out investors in one way or another.
The hubris went so far that managers at Carlyle Capital Corp., the failed hedge fund, used $31 of borrowed money for every one dollar invested. In fairness, they were not alone. Other hedge funds used leverage in a comparable fashion. Hence, the news of the fund’s collapse in mid-March may have contributed to a “run on the bank” of troubled hedge funds managed by Bear Stearns, and what may be a landmark event in the current economic downturn – Bear Stearns brush with oblivion.
The troubles facing Bear Stearns and the Carlyle Group are symbolic of what has become an epidemic of excess. From mortgages granted to individuals who lacked the creditworthiness to qualify for a home loan to extreme financial alchemy, the excesses almost seemed to feed on each other. Problems were exacerbated by outrageous degrees of leverage used to invest in securities of highly questionable value and with little or no comprehension of the underlying assets.
The fallout from all of this for hedge funds is that investors are trying to cash out, but discovering that it isn’t so easy. As Business Week reported in its March 17th issue (in an article titled “Hedge Funds Frozen Shut”), no less than 24 hedge funds are restricting redemptions. They are enforcing fund bylaws that allow them to stop, or at least slow down, redemptions by investors. Investors caught in this find they have little choice but to ride the storm out.
The recent demise of some hedge funds has a lot to do with the significant downturn in the financial sector of the stock market since last summer. It isn’t just brokerage houses, but banks too that are feeling the impact. They are closely intertwined in this highly-leveraged enterprise. Both banks and brokers sponsor hedge funds, and in cases where brokers are the sponsors, banks also profited by providing loans to underwrite the intensive leverage strategies. So both, along with their investors, are suffering today, depending on the extent of their involvement.
Management according to Garp
Far too many people who should have known better, but didn’t, seemed to take on the philosophy of “Garp” (portrayed by Robin Williams in The World According to Garp.) At one point in the film, when a small plane slams into a house he and his wife are touring with a realtor to consider for possible purchase, Garp’s reaction after the crash was that he was ready to buy the badly damaged house. “The chances of another plane hitting this house again are astronomical,” he reasoned.
That same type of thinking seemed to permeate the financial markets in the recent era of excess. Start with Alan Greenspan, former Fed chairman and widely considered the genius behind the great economic rise of the 1980s and 1990s. He kept interest rates extremely low, even in the good times, and touted the benefits of adjustable-rate mortgages. What were the odds that there would be abuse by lenders to qualify too many undeserving homeowners for mortgages with terms the borrowers had almost no hope of meeting?
The Street’s financial wizards created new investments that, many were told, had virtually eliminated the risk from investments in low quality credit like subprime loans. What were the odds that everything could go wrong and market liquidity (for these investments) could dry up? Even the ratings agencies like Moody’s and Standard & Poor’s contributed to the problems. They placed high quality (AAA) ratings on debt vehicles that went bad in short order. Just what were they thinking?
The result of this Garp-like mindset is today’s harsh reality. This includes, to date, $200 billion in writedowns by financial giants related mostly to investments tied to bad subprime loans, and worse, the Bear Stearns disaster that has required unprecedented government intervention to save a one-time financial giant. Defenders of the system may say these were “once-in-a-lifetime” events. But why do they seem to happen at least every seven years?
It’s Always Something
The message for investors to remember was one we learned from the late Gilda Radner, in her guise as Roseanne Roseannadanna on Saturday Night Live. “It’s always something,” she would exhort at the end of her commentaries. In the current context, the point is that no matter how certain the experts might be, the tables can always turn. Packing your own parachute is highly recommended.
Here are just a few of the most notable examples that remind us “it’s always something:”
• Nobel prize-winning economic thinkers could create a system that beat the market. In 1998, the geniuses behind Long-Term Capital Management nearly took down the entire financial system until central banks stepped in.
Tried-and-true standards of market valuation, like the S&P 500 – typically priced at around 16 times earnings – were a thing of the past. Sure enough, P/E ratios topped 40 times earnings in the technology bubble of 1999 until reality stepped in.
Index investing is all you need to succeed as an investor. This passive approach looked like a winner when 10-year average annual returns were typically in double figures, as high as 19% at times. In case you hadn’t noticed, over the past ten years, the average annual return for the S&P 500 is just 3.5% – in other words, barely keeping pace with inflation. The chart shows the S&P 500 average annual return for each 10 year period ending from 1980 through 2008.
The new master of the utilities universe, Enron, forced most other utility companies to expand, even if there was questionable logic behind it. Of course, Enron turned out to be a mirage, and a number of utility companies faced a financial catastrophe as a result.
It is always something that can bring down what seems like the most surefire investment theory. Yet not all is lost. We also believe the mantra, “it’s always something,” applies to the positive opportunities that exist regardless of the market environment.
Looking up from the bottom
Our basic approach starts with avoiding overpriced investments. By staying focused on assets we believe are priced right (value investing), our portfolio tends to be more protected from the kind of whiplash that can affect those who prefer to chase what appears to be rapid growth. If a declining market sinks all boats (like the type of market we’ve experienced since October), the fall tends to be less dramatic for an investment that was not overpriced in the first place. This has been reflected in our performance through the current bear period. It illustrates the importance of the PYOP approach.
We continue to work at protecting against the market’s downside while striving to remain fully invested. History tells us that a significant percentage of the market’s gains occur in short bursts. If you aren’t on board before those happen, you are too late. Just missing the ten best months in the market over the past 20 years (that means missing one good month of performance every 24 months, on average) meant you missed out on about 40% of the profits.
The message here is clear – in certain periods, impossible to predict ahead of time, the bulk of gains are made. Our philosophy, which might have looked less intriguing to some compared to the “go-go” excitement of hedge funds in recent years, has another advantage. We are in a position to capitalize on the attractive opportunities that exist today. The market’s recent correction adds potential names to our list of securities worth considering.
We see many positive signs in the market despite its current doldrums.
Here are seven “points of light” for investors today:
1. Interest rates are low – this tends to be beneficial for equity markets.
2. The Fed is engaged – Ben Bernanke is clearly taking the situation seriously and appears determined to head off any negative event that could destabilize the markets.
3. Pessimism abounds – a more somber attitude is a good way to help investors view the markets a bit more realistically, which can only be a good thing for fundamentally sound investments.
4. The rise of the global middle class – this is a secular trend that bodes well for growing consumer demand worldwide.
5. The true emergence of emerging markets – developing countries now represent approximately 30% of the world’s Gross Domestic Product (GDP).
6. Securitization of mortgages is dead – that’s the word from famed investor Wilbur Ross, who suggests the end to this fantasy world and a return to the real world will better suit investors in the long run.
7. Value exists in the market again – as of the end of March 2008, the S&P 500 lost 14.6% since last Halloween. From a value perspective, there is lot more opportunity today than existed six months ago.
These factors combined give us reason to think that, while volatility may still be around, stocks are well positioned for a recovery in the near future. Much of the bad news is probably already priced into the market.
On a broader scale, the thought that “it’s always something,” also relates to the world of opportunities that are apparent in the global marketplace. Nobody can deny there are sore spots in the markets and segments of the economy where real people are feeling real pain. However, it is costly to overlook the fact that new opportunity abounds – as it always has. Keep in mind that capitalism is stronger than ever around the world.
With that thought in place, consider these astounding forecasts:
• Morgan Stanley analysts estimate that $21.7 trillion will be spent on infrastructure in emerging markets over the next decade
• Investment banker Matthew Simmons, author of Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy, projects 100,000 miles of new pipeline needs to be constructed to handle 50 million barrels a day of new refining capacity, a $30 trillion investment
• The International Energy Agency predicts $22 trillion will be invested in the global energy supply through 2030, $12 trillion of that focused on distribution and transmission of power
• The consulting firm Booz Allen Hamilton reports that $40 trillion will be invested in the world’s urban infrastructure by 2030, $23 trillion of that used to modernize the world’s water systems.
Add it up, and that’s investment opportunity for decades! Just as “it’s always something” in terms of downside risk that can spoil a red-hot investment, “it’s always something” that offers profit potential in any market environment. Today, some of the greatest opportunities can be found in connection with those staggering amounts listed here.
Success going forward begins by looking beyond the barrage of today’s bad news and seeking out the next great wave of opportunities. Because our parachute helped us achieve a soft landing during the recent market downturn, we are able to hit the ground running and actively pursue great investments. We see a world that is becoming more prosperous, with significant demand for infrastructure and resources. As has always been the case in the long history of capitalism, investors can benefit by putting money to work in businesses that are in a position to meet this demand. The market offers significant opportunity today, and we are actively positioning our portfolio to capitalize on these world trends.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.