Weekly Insider (A Tiger & Zebra in Crisis)
Here’s a long one, making some new “calls” and revisiting some prior “calls” written here. All tickets sold for the Lux Executive Summit. See you Monday with Dean Kamen, John Kerry, Bob Metcalfe, Shai Agassi, Nobel Laureate, Sir Harry Kroto and many more.
Meanwhile: according to myriad market commentators, we seem to have hit more bottoms than an abusive orphanage. There was the SocGen bottom in January, the Bear Stearns bottom in March, the Feddie & Frannie bottom in July, the Lehman bottom in September, the bailout bottom of October.
You can’t call bottoms.
The only thing you can know is that you have no idea what Mr. Market will do day to day, week to week or month to month. Investors that claim they manage volatility or investors that demand it are being proved wrong daily. “Managing volatility” is like managing the emotions of the deranged homeless man on the corner. He might be well-fed and calm, or have low blood sugar and be dangerous. Your choices: cross the street and avoid him (ie. not be in the market) or you can keep a safe distance (ie. a margin of safety)—nearly every other strategy is a post facto explanation of how you “managed” to walk past him unscathed when you might’ve just gotten lucky.
The only thing you can control is doing the work to get a reasonable estimate of a company’s worth, realize that by buying a share of stock you’re buying an ownership stake in that business and know that Mr. Market will knock on your door erratic and emotional every day, jubilant or depressed and offer to buy your share or sell you his share at a price. That price is only a price—it may be much more, much less or a fair approximation of what your business is worth. Buy when the price being offered is much lower than your approximation of what its worth—a margin of safety.
As Mark Twain said, it ain’t what you don’t know that kills you—it’s what you know for sure that just ain’t so. What does everyone know for sure that just ain’t so? Inflation is abating. A global slowdown? Sure. But mark my words: forget Al Gore, the award of “Most Green” goes to the Fed with its unprecedented “emissions” of the dollar variety. The cost of capital for a brief period was infinite (nobody would lend money at any price). The cost of capital will rise, the massive issuance of Treasuries, and the anticipation of it, will further steepen the yield curve (allegedly a favorite trade of legendary hedge fund manager Julian Robertson) with long-term rates rising with greater anticipation of inflation. Julian runs Tiger Management, which has spawned the most successful hedge fund managers in history.
Here’s what “Tigers” and Zebras have in common and how Zebras connect to interest rates and investment returns.
Primatologist Robert Sapolsky has lived with animals for decades. He wrote a book called why “Zebras Don't Get Ulcers”. We get ulcers because we are under constant and continuous self-imposed stress (mostly psychological) that didn’t exist in our evolutionary history. Here's why Zebra’s don’t get ulcers: they have short intense bursts of stress—more like a lightning bolt—as a lion gives chase. They run, their heart rate increases, adrenaline floods their system, emotion runs high (for fear is a great motivator) blood is quickly pumped to the muscles and in a few moments either it’s over or the Zebra is.
Everything that matters to the Zebra long-term basically shuts down. Their reproduction and maintenance of their immune system are deferred. Who needs to worry about sex drive or fending off microbes in days or weeks if you might not live in minutes.
Here's the connection to markets. When there's stress and panic—all long-term focus shuts down. The Zebra runs for safety. So do investors. They flood into short-term debt, willingly accepting negligible yields. Famed hedge fund manager Julian Robertson recently said his favorite trade is curve steepener, shorting long term rates and buying short term, or at least betting the yield curve gets steeper.
Julian is betting long term rates go up. He’s not alone: Fed funds futures show increases into next year.
Think about it: at moments in recent weeks, the cost of capital was basically infinite. People wouldn't part with cash at any price. Dangle a lure with shiny metal and feathers and neon and you couldn't catch cash. There was no 'river running through it'. The river was frozen—with fear.
When things are good, forecasting periods go far and wide. When the sun is shining and times are good, people can see far and wide. Visibility is measured not in miles but decades. When you're in the storm, good luck seeing not feet but days ahead of you. Short-term liquidity, short term interest rates plummet—people seek near-term safety.
What it means is this: far out projects need big discount rates—now much bigger. Because with less visibility the risk has grown. And the bigger the risk, the lower the confidence and the higher the hurdle to jump over to compensate you to take such a risk. Discount rates rise. Interest rates rise. And project finance: it gets crushed. Caveat emptor for anyone still chasing sunbeams or moonshine constructing large capex intensive solar installations or ethanol distilleries. Things that made sense when you had low borrowing costs and massive government subsidies just don’t when borrowing costs skyrocket and states have record deficits. They can’t give tax breaks when they need to raise taxes.
Consider California, in a major fiscal crisis. They just issued billions in debt through a bond called “a revenue anticipation note”. That’s a nice way to say interest coming from taxes paid in. Know what that means? Government revenue means taxes. The people that just lent the government money (at record high short-term muni rates) expect to get paid back, with interest. That interest comes from collecting tax dollars. Do you think alternative energy companies are likely to see more or less tax rebates? Yeah, me too.
The slowdown will test their green commitment. The state has to raise money, or run out of it by the end of the month. So the federal government might have to bail it out too. Which means YOU might bail it out. Nobody liked AIG taking their bailout and spending it on manicures and martinis. And nobody is going to like CA coming up short because it chose not to anticipate revenue by shutting down nuclear plants, subsidizing millions in inefficient solar cells. What should the governor do? Cut education? What about healthcare? Green is about to turn red.
Here’s a check on the accuracy of some of my quips meant to serve you over the past few months:
12 months ago--November 16, 2007: “The Future, Predictors & Inventors”
So running with the herd was the absolute logical and rational thing to do in our evolutionary past—when our biggest threat was being eaten by Pleistocene felines. Today your biggest risk is more likely to be not having cash when you need it (whether in the form of owing too much credit card debt, owning a mortgaged condo in Miami, having a Northern Rock or maybe E-Trade account, or running a U.S. business with Euro denominated inputs). But all these things and then some are known. They are priced in. Some more than should be (oversold); some less than should be (overbought). Like a pendulum, expectations can swing to excess of true north.
Which got me thinking: what does everyone take as given that would shock them if it weren’t true? Here’s a few to chew on. Everyone touts oil surpassing $100. With Iran showing its nuke blueprints to UN, could it be the first of many components of fear residing and price deflating? Could speculators (accounting by some estimates for some 20-40% of the current price) get left holding the barrel?
Could the China growth story be oversold? Could government spending for the Beijing Olympics artificially prop things up? Could a report emerge that shows the size of the China economy is just a fraction of what everyone thought it was? Sound crazy? Remember the telecom stats that the Internet was doubling every 90 days which instantaneously dropped the cost of capital to near-zero and fueled the dot-and-tele-com boom on an entirely erroneous assumption? Could bio-fuels prove to be bio-fools?
8 months ago--Feb 15, 2008: “Cynic’s Conference Guide…”
The cost of capital for any technology for which there’s sufficiently high enthusiasm is close to zero. The two are inversely correlated. This means the marginal entrant has low barriers—which means the number of entrants grows exponentially. This characterizes “solar” today. The ecosystem cannot support the sheer number of companies competing to turn sunbeams into electrons, along the same points of differentiation: cost per watt and efficiency. Companies that got public early will use their stock currency to acquire those with interesting technologies as they postpone their own IPOs, face investor fatigue and eventually falter. It is a predictable pattern in capital markets. And the four most dangerous words are “this time it’s different”. It never is.
8 months ago--Feb 22, 2008: “Imagining Improbable & Friedman or Goldman”
Of course: today's disasters are tomorrow’s safeguards. Insurance, material safety data sheets (in chemistry labs), laws all came respectively from explosions, corrosions and corruptions.
So, what disasters loom? Start with what everyone takes as granted? What would take people by surprise? Will Gold, oil and every other commodity you can name continue their ascent? Is it more likely the Chindia demand narrative and gospel keeps people in the pews? Or do already high expectations and fewer incremental buyers on the margin mean vulnerability for surprise? Why is their virtually no media coverage of the rise in Oil as primarily a function of dollar decline and speculation? Over time, commodities approach their marginal cost of extraction. And being commodities: they’re undifferentiated and compete on price. When have VCs ever in history made money chasing ways to produce a commodity? Why do people keep insisting that solar is attractive when Oil is at $100 when we barely produce any electricity from oil? 50 years ago, sure—but oil is a declining piece of our energy pie as more and more things become electrified. What effect would an “unexpected” decline in commodity prices have on emerging markets? I’ll return to this in a moment.
The same thing holds for emerging markets. Given their higher risk and uncertainty they’ve historically traded at discount. Not so today. And as I note above: gold, oil, copper and the commodity cabals are all currently through the roof. But the roof of housing has caved in. Commercial real estate appears to be next. Demand slows. Prices fall. And if prices fall, then those emerging markets so heavily dependent on the outrageous prices for commodities (benefiting the owners of capital, yet crippling the population) will begin losing money. As they say of emerging markets: it’s where emergencies emerge. All the same people claiming “decoupling” were claiming “globalization” before. You can’t have both. You must choose: Friedman or Goldman (ie. Thomas Friedman (the world is flat) or Goldman Sachs, which started the “decoupling” meme).
6 months ago—April 18, 2008: “Timeless Space & the Mismeasure of Risk”
Of course we have terrible innate grasps of very low probability things, vastly over inflating the salient and available and under appreciating the unimagined.
Consider in markets what I’ve now dubbed “The Mismeasure of Risk”: volatility. Price movement isn’t risk (the real risk is that you don’t have money when you need it). Volatility is opportunity. And it allows for more rapid transfer between people with vastly different expectations of the future. The wilder the price swings, the more likely you are to bump into someone who completely disagrees with you and is willing to trade their claims on the future for yours. And this overreaction of counterparties allows you to either buy pieces of businesses (which are in your opinion attractively priced with even higher expected returns—from someone with the precisely opposite view) or conversely sell pieces of business you already own at much higher prices to people with much higher expectations. Volatility increases the odds you can do both.
Time is what matters most. Just as time is the friend of the great business and the enemy of the not-so great business, so to time, like volatility, makes friends with the long-term investor and antagonizes the short-term one.
I predict (nay, hope) lots of things will change in investment management in the coming years. The way risk is measured for one. Just because everyone else uses the same wrong measure doesn’t mean it’s worth anything. Sharpe Ratios and Beta are the opposite of fax machines. The more people that use them, the worse the system is. I enjoy taunting my friends at hedge funds and fund-of-funds who report monthly numbers or allow their investors to withdraw every month. How can you possibly make long-term decisions when your investors expect and demand steady linear performance? Expecting the implausible leads to attaining the inevitable—blow-ups and permanent loss of money. And that is the real risk.
5 months ago--May 2, 2008:
Meanwhile as I’ve been tirelessly quipping, the “biofools” and “commodidiots” are starting to feel pain. I’m hearing claims of biofool boondogglers having committing crimes against humanity for the poorly thought out unintended consequences and the resulting food crises their swindle has caused. And the latter have startups and investors chasing commodity markets that they mistook for technology problems (when they’re simply just US dollar problems). Most of the so-called ‘drivers’ justifying crazy startup valuations aren’t really a technology thing—it’s a dollar thing. The US government’s plan is clear: inflate our way out of debt crises. When you owe a fixed number of dollars to someone, that lender loses when those dollars become worth less in real terms. But be sure by year end 2008 interest rates will be higher. And remember the flood of speculative and easy money that's flown into 'green' could just as easily go from ‘green with envy’ to ‘green with nausea’.
4 months ago--June 6, 2008: “Devolving Rackets & Evolving Kudos”
Bob Metcalfe said, "I call it the global warming bubble. What bubbles do is they're an accelerator in technological investments to be made; they cause the status quo to be questioned. The trick of course...is to have a chair when the music stops."I’ve also spilled a lot of ink on the foolhardy behavior in chasing moonshine and sunbeams (ethanol and solar). As Eric Hoffer said, “Every great cause beings as a movement, becomes a business and eventually degenerates into a racket.” Or as 18th century French philosopher Voltaire said, “It is dangerous to be right in matters on which the established authorities are wrong”.
3 months ago—July 25, 2008: “Beliefs, Severed Tetherballs, Adventures…”
For the pursuit of truth might be noble social currency but it’s far harder to spend than the green paper or metal coin variety. I look upon a great deal of the cheery consensus and righteous rhetoric with a heaving not a helping of cynicism. Years from now you will look back, past the Web, past the Homes, past the Hedges, past the Oil Fields at much of the present day ‘Greenery’—and regret being a sucker.
Meanwhile: according to myriad market commentators, we seem to have hit more bottoms than an abusive orphanage. There was the SocGen bottom in January, the Bear Stearns bottom in March, the Feddie & Frannie bottom in July, the Lehman bottom in September, the bailout bottom of October.
You can’t call bottoms.
The only thing you can know is that you have no idea what Mr. Market will do day to day, week to week or month to month. Investors that claim they manage volatility or investors that demand it are being proved wrong daily. “Managing volatility” is like managing the emotions of the deranged homeless man on the corner. He might be well-fed and calm, or have low blood sugar and be dangerous. Your choices: cross the street and avoid him (ie. not be in the market) or you can keep a safe distance (ie. a margin of safety)—nearly every other strategy is a post facto explanation of how you “managed” to walk past him unscathed when you might’ve just gotten lucky.
The only thing you can control is doing the work to get a reasonable estimate of a company’s worth, realize that by buying a share of stock you’re buying an ownership stake in that business and know that Mr. Market will knock on your door erratic and emotional every day, jubilant or depressed and offer to buy your share or sell you his share at a price. That price is only a price—it may be much more, much less or a fair approximation of what your business is worth. Buy when the price being offered is much lower than your approximation of what its worth—a margin of safety.
As Mark Twain said, it ain’t what you don’t know that kills you—it’s what you know for sure that just ain’t so. What does everyone know for sure that just ain’t so? Inflation is abating. A global slowdown? Sure. But mark my words: forget Al Gore, the award of “Most Green” goes to the Fed with its unprecedented “emissions” of the dollar variety. The cost of capital for a brief period was infinite (nobody would lend money at any price). The cost of capital will rise, the massive issuance of Treasuries, and the anticipation of it, will further steepen the yield curve (allegedly a favorite trade of legendary hedge fund manager Julian Robertson) with long-term rates rising with greater anticipation of inflation. Julian runs Tiger Management, which has spawned the most successful hedge fund managers in history.
Here’s what “Tigers” and Zebras have in common and how Zebras connect to interest rates and investment returns.
Primatologist Robert Sapolsky has lived with animals for decades. He wrote a book called why “Zebras Don't Get Ulcers”. We get ulcers because we are under constant and continuous self-imposed stress (mostly psychological) that didn’t exist in our evolutionary history. Here's why Zebra’s don’t get ulcers: they have short intense bursts of stress—more like a lightning bolt—as a lion gives chase. They run, their heart rate increases, adrenaline floods their system, emotion runs high (for fear is a great motivator) blood is quickly pumped to the muscles and in a few moments either it’s over or the Zebra is.
Everything that matters to the Zebra long-term basically shuts down. Their reproduction and maintenance of their immune system are deferred. Who needs to worry about sex drive or fending off microbes in days or weeks if you might not live in minutes.
Here's the connection to markets. When there's stress and panic—all long-term focus shuts down. The Zebra runs for safety. So do investors. They flood into short-term debt, willingly accepting negligible yields. Famed hedge fund manager Julian Robertson recently said his favorite trade is curve steepener, shorting long term rates and buying short term, or at least betting the yield curve gets steeper.
Julian is betting long term rates go up. He’s not alone: Fed funds futures show increases into next year.
Think about it: at moments in recent weeks, the cost of capital was basically infinite. People wouldn't part with cash at any price. Dangle a lure with shiny metal and feathers and neon and you couldn't catch cash. There was no 'river running through it'. The river was frozen—with fear.
When things are good, forecasting periods go far and wide. When the sun is shining and times are good, people can see far and wide. Visibility is measured not in miles but decades. When you're in the storm, good luck seeing not feet but days ahead of you. Short-term liquidity, short term interest rates plummet—people seek near-term safety.
What it means is this: far out projects need big discount rates—now much bigger. Because with less visibility the risk has grown. And the bigger the risk, the lower the confidence and the higher the hurdle to jump over to compensate you to take such a risk. Discount rates rise. Interest rates rise. And project finance: it gets crushed. Caveat emptor for anyone still chasing sunbeams or moonshine constructing large capex intensive solar installations or ethanol distilleries. Things that made sense when you had low borrowing costs and massive government subsidies just don’t when borrowing costs skyrocket and states have record deficits. They can’t give tax breaks when they need to raise taxes.
Consider California, in a major fiscal crisis. They just issued billions in debt through a bond called “a revenue anticipation note”. That’s a nice way to say interest coming from taxes paid in. Know what that means? Government revenue means taxes. The people that just lent the government money (at record high short-term muni rates) expect to get paid back, with interest. That interest comes from collecting tax dollars. Do you think alternative energy companies are likely to see more or less tax rebates? Yeah, me too.
The slowdown will test their green commitment. The state has to raise money, or run out of it by the end of the month. So the federal government might have to bail it out too. Which means YOU might bail it out. Nobody liked AIG taking their bailout and spending it on manicures and martinis. And nobody is going to like CA coming up short because it chose not to anticipate revenue by shutting down nuclear plants, subsidizing millions in inefficient solar cells. What should the governor do? Cut education? What about healthcare? Green is about to turn red.
Here’s a check on the accuracy of some of my quips meant to serve you over the past few months:
12 months ago--November 16, 2007: “The Future, Predictors & Inventors”
So running with the herd was the absolute logical and rational thing to do in our evolutionary past—when our biggest threat was being eaten by Pleistocene felines. Today your biggest risk is more likely to be not having cash when you need it (whether in the form of owing too much credit card debt, owning a mortgaged condo in Miami, having a Northern Rock or maybe E-Trade account, or running a U.S. business with Euro denominated inputs). But all these things and then some are known. They are priced in. Some more than should be (oversold); some less than should be (overbought). Like a pendulum, expectations can swing to excess of true north.
Which got me thinking: what does everyone take as given that would shock them if it weren’t true? Here’s a few to chew on. Everyone touts oil surpassing $100. With Iran showing its nuke blueprints to UN, could it be the first of many components of fear residing and price deflating? Could speculators (accounting by some estimates for some 20-40% of the current price) get left holding the barrel?
Could the China growth story be oversold? Could government spending for the Beijing Olympics artificially prop things up? Could a report emerge that shows the size of the China economy is just a fraction of what everyone thought it was? Sound crazy? Remember the telecom stats that the Internet was doubling every 90 days which instantaneously dropped the cost of capital to near-zero and fueled the dot-and-tele-com boom on an entirely erroneous assumption? Could bio-fuels prove to be bio-fools?
8 months ago--Feb 15, 2008: “Cynic’s Conference Guide…”
The cost of capital for any technology for which there’s sufficiently high enthusiasm is close to zero. The two are inversely correlated. This means the marginal entrant has low barriers—which means the number of entrants grows exponentially. This characterizes “solar” today. The ecosystem cannot support the sheer number of companies competing to turn sunbeams into electrons, along the same points of differentiation: cost per watt and efficiency. Companies that got public early will use their stock currency to acquire those with interesting technologies as they postpone their own IPOs, face investor fatigue and eventually falter. It is a predictable pattern in capital markets. And the four most dangerous words are “this time it’s different”. It never is.
8 months ago--Feb 22, 2008: “Imagining Improbable & Friedman or Goldman”
Of course: today's disasters are tomorrow’s safeguards. Insurance, material safety data sheets (in chemistry labs), laws all came respectively from explosions, corrosions and corruptions.
So, what disasters loom? Start with what everyone takes as granted? What would take people by surprise? Will Gold, oil and every other commodity you can name continue their ascent? Is it more likely the Chindia demand narrative and gospel keeps people in the pews? Or do already high expectations and fewer incremental buyers on the margin mean vulnerability for surprise? Why is their virtually no media coverage of the rise in Oil as primarily a function of dollar decline and speculation? Over time, commodities approach their marginal cost of extraction. And being commodities: they’re undifferentiated and compete on price. When have VCs ever in history made money chasing ways to produce a commodity? Why do people keep insisting that solar is attractive when Oil is at $100 when we barely produce any electricity from oil? 50 years ago, sure—but oil is a declining piece of our energy pie as more and more things become electrified. What effect would an “unexpected” decline in commodity prices have on emerging markets? I’ll return to this in a moment.
The same thing holds for emerging markets. Given their higher risk and uncertainty they’ve historically traded at discount. Not so today. And as I note above: gold, oil, copper and the commodity cabals are all currently through the roof. But the roof of housing has caved in. Commercial real estate appears to be next. Demand slows. Prices fall. And if prices fall, then those emerging markets so heavily dependent on the outrageous prices for commodities (benefiting the owners of capital, yet crippling the population) will begin losing money. As they say of emerging markets: it’s where emergencies emerge. All the same people claiming “decoupling” were claiming “globalization” before. You can’t have both. You must choose: Friedman or Goldman (ie. Thomas Friedman (the world is flat) or Goldman Sachs, which started the “decoupling” meme).
6 months ago—April 18, 2008: “Timeless Space & the Mismeasure of Risk”
Of course we have terrible innate grasps of very low probability things, vastly over inflating the salient and available and under appreciating the unimagined.
Consider in markets what I’ve now dubbed “The Mismeasure of Risk”: volatility. Price movement isn’t risk (the real risk is that you don’t have money when you need it). Volatility is opportunity. And it allows for more rapid transfer between people with vastly different expectations of the future. The wilder the price swings, the more likely you are to bump into someone who completely disagrees with you and is willing to trade their claims on the future for yours. And this overreaction of counterparties allows you to either buy pieces of businesses (which are in your opinion attractively priced with even higher expected returns—from someone with the precisely opposite view) or conversely sell pieces of business you already own at much higher prices to people with much higher expectations. Volatility increases the odds you can do both.
Time is what matters most. Just as time is the friend of the great business and the enemy of the not-so great business, so to time, like volatility, makes friends with the long-term investor and antagonizes the short-term one.
I predict (nay, hope) lots of things will change in investment management in the coming years. The way risk is measured for one. Just because everyone else uses the same wrong measure doesn’t mean it’s worth anything. Sharpe Ratios and Beta are the opposite of fax machines. The more people that use them, the worse the system is. I enjoy taunting my friends at hedge funds and fund-of-funds who report monthly numbers or allow their investors to withdraw every month. How can you possibly make long-term decisions when your investors expect and demand steady linear performance? Expecting the implausible leads to attaining the inevitable—blow-ups and permanent loss of money. And that is the real risk.
5 months ago--May 2, 2008:
Meanwhile as I’ve been tirelessly quipping, the “biofools” and “commodidiots” are starting to feel pain. I’m hearing claims of biofool boondogglers having committing crimes against humanity for the poorly thought out unintended consequences and the resulting food crises their swindle has caused. And the latter have startups and investors chasing commodity markets that they mistook for technology problems (when they’re simply just US dollar problems). Most of the so-called ‘drivers’ justifying crazy startup valuations aren’t really a technology thing—it’s a dollar thing. The US government’s plan is clear: inflate our way out of debt crises. When you owe a fixed number of dollars to someone, that lender loses when those dollars become worth less in real terms. But be sure by year end 2008 interest rates will be higher. And remember the flood of speculative and easy money that's flown into 'green' could just as easily go from ‘green with envy’ to ‘green with nausea’.
4 months ago--June 6, 2008: “Devolving Rackets & Evolving Kudos”
Bob Metcalfe said, "I call it the global warming bubble. What bubbles do is they're an accelerator in technological investments to be made; they cause the status quo to be questioned. The trick of course...is to have a chair when the music stops."I’ve also spilled a lot of ink on the foolhardy behavior in chasing moonshine and sunbeams (ethanol and solar). As Eric Hoffer said, “Every great cause beings as a movement, becomes a business and eventually degenerates into a racket.” Or as 18th century French philosopher Voltaire said, “It is dangerous to be right in matters on which the established authorities are wrong”.
3 months ago—July 25, 2008: “Beliefs, Severed Tetherballs, Adventures…”
For the pursuit of truth might be noble social currency but it’s far harder to spend than the green paper or metal coin variety. I look upon a great deal of the cheery consensus and righteous rhetoric with a heaving not a helping of cynicism. Years from now you will look back, past the Web, past the Homes, past the Hedges, past the Oil Fields at much of the present day ‘Greenery’—and regret being a sucker.
Labels: Bob Metcalfe, bottom, credit crisis, Fanni, financial crisis, Freddie, interest rates, Shai Agassi, volatility index
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