Thursday, October 15, 2009

40 Gigabytes and a Stool

OMG, the Titanic sank. (See Link to 2004 article Its About Time) Roughly a year ago, thousands of people killed for simple pilot error – no wonder Captains go down with the ship. Some Hedge fund managers would say that is an easier fate than what they face now in terms of high water marks, new regulations, and horrible investor relations. Few people cared five years ago when the alarms were set off, and now that the boat has sank, even fewer care to go back and see who was at fault. In fact, our federal government has chosen to put the very people responsible for the system break-down in charge of the repairs. The stampede for the market’s exit nearly killed the herd. The quantifiable logic that market forces are outside quantifiable boundaries is now plain to see, and no one seems to know what to do. Many lead steers are dead, others penned for slaughter by the Cowboys at the gate. Still others in limbo, watching the herd to determine where their best relative position will be.

The system that created unimaginable wealth is somehow unimaginably gone. Or is it? The basics of life are still produced and available at the supermarket. The electronic means of moving value p.k.a. Cash, is still in tact. As long as you don’t have to use a wheel barrow to carry your bank notes, no one can tell the currency is debased. The issue at hand is connecting the American dream with American reality. The bridge between dream and reality is and always has been the indefatigable American spirit; the ingenuity, the innovation, the entrepreneurial DNA that we inherited from our fore-fathers, who had the gumption to leave the status-quo and opt for self-reliance in the world of the unknown. The equivalent of enormous natural resources available to our fore-fathers is today’s networks and distribution systems of products and information. 40 acres and a mule is now 40 gigabytes and a stool. America will plow forward despite the lack of automatic liquidity from financial markets.

The current reality requires we deal with many significant market imbalances.

Consider the trillion dollar plus imbalances:

1) Supply and Demand for residential real estate (inning 6?)

2) Supply and Demand for commercial real estate (inning 1)

3) Supply and demand for corporate credit facilities (inning 7)

4) Government expenditure and revenue (inning 3)

Consider the $100 billion dollar plus imbalances:

  1. American Automotive manufacturing capacity and demand
  2. City and State government expenditure and revenue
  3. AIG Portfolio assets and liabilities
  4. Major Banks and Insurance company assets and liabilities – Goldman, Morgan, BOA, Merrill,
  5. Foreign governments expenditure and revenue

These imbalances will take years to level out. If real estate pricing follows the example of the 20th century, land prices paid in the 20’s were not seen again until the 1950’s. For reasons beyond explanation, today’s lenders believe they are better off to foreclose than make loan modifications that will enable productive use of the assets involved. It is tantamount to the debtor’s prison of centuries past when if a man could not pay his debts he would be locked in jail where he could never pay his debts and his family was left completely dependent on society for their support. Lenders will likely sell these properties for far less than the current debtors-in-possession would be willing to pay, expanding the imbalance of supply and demand. My sources indicate that current foreclosure recoveries are roughly 25% of mortgage balances. The truth hurts doesn’t it?

The financial market Tsunami of 2008 resulted from the issues we pointed out in January of 2004 in our pre-blogosphere article “Its about time”. The implosion of the markets resulted from significant irrational pricing of risk. The resulting wave has hit us, and now we are dealing with the ebb tide that is ripping every industry off its moorings. Successfully navigating the ebb tide will require a combination of innovation and careful risk management – not risk avoidance, but management.

What then is an investor to do? Faced with insurmountable declines in all leveraged asset prices, extremely low yields on risk free assets, and doubtful veracity in many financial instruments, is it any wonder so many are holding on to their cash? Is there any asset class that can generate positive returns with any probability?

The short term “wave action” will require steady hands at the helm and active investment management is clearly the favorable style. Serious due diligence combined with sensitive analysis of cash flows and growth opportunities will result in solid investment returns for the informed investor over the next several years. Embracing the notion of 40 gigabytes and a stool will be hard for many, but the future of capital growth is in identifying the beneficiaries of the network age and plying them with capital. The future is about information and its abundance not about legacy businesses of construction, manufacturing, and print media.

5 years ago there was literally no access to the leaders of the venture capital industry, titans who spawned Amazon, Google, and a host of other household names. Today these investment managers are readily available through secondary purchases of their funds from many of the largest portfolios in the world. New capital is generally unavailable for any team desiring to fund innovations and work with entrepreneurs. The hottest investment market is healthcare, where revenues are peaking and profitability is suspect. High returns have always resulted from where investment dollars are least likely to go. Our recommendations in 2004 provided significant returns through the Tsunami of 2008 - proxy graphs are included at the end of the article.

The havoc wreaked in the last year stems from misguided loyalty to pure capitalism, NOT capitalism with moral restraint. It is interesting to note that leading corporations are finding that by aligning their brands with socially important (and popular) causes actually improves employee productivity. The moral values of brands are actually a differentiating factor hence the popularity of being green and sustainable. The rise of Social Capitalism as an industry is remarkable and I think here to stay. As the world discovers Google Chairman Eric Schmidt is correct that “the right way to run human systems is transparency,” invalid and conflicted value propositions will diminish, and our global citizens will be better off. Just a little late, but isn't that human nature?

In the meantime investors need to “pay attention to the tension” and carefully consider the incredible spread of potential outcomes we face. Owning secure knowable cash flows needs to be a priority for every portfolio and balance it with thoughtful research and investment in innovation based businesses. I expect in 2014 you will be very glad you did.

No comments:

Post a Comment