Investing

INTRODUCTION
The Sense of Investing in Others’ Businesses

How do successful investors get to be that way? The steps they take to increase their wealth make up a taxonomy of talents and goals. So much of the literature on how to make money in stocks and bonds, real estate, antiques, art, autographs, and more is about details and histories of prices of this and that. It is looking backward to go forward, which is a dangerous practice if you are driving.

We have a much simpler idea: Run your portfolio as though it were small business you know well. Even though you are buying into others’ businesses, ask this fundamental question any time you give somebody your money: What makes the business function as a tradeoff of people giving it their money for whatever the business will return as income or capital gains?

In the complicated books on stock and bond analysis, little discussion is directed to answer that basic question. Why throw money into somebody else’s business? If you understand the business well enough to answer the question — how does this thing work? — you are off to a good start.

In the bulletins stock brokers send to their clients and in press stories of how businesses are faring, much attention is given to earnings formulations and price-to-sales ratios. In bonds the focus is on macroeconomics and credit ratings. In commercial real estate, it is on ratios of rent to cost. All that matters, of course. But the main thing that you need to be able to answer is that question of what makes the profits. From the top line of how much money they ring in as sales to the bottom line of what is left for the owners — that is, those who hold the common stock — you need to be able that question: How does it work? Next question: If I throw my money into their pot, what do I get? What’s in it for me?

These are basic and essential questions, yet the answers are often made complex by fancy numerical analysis done by men and women with fine academic diplomas and lavish resumés attesting to their acumen. The unspoken secret of the academic/professional analyst biz is that they stick together. And when these well-bred and well-educated analysts work for investment banks, they know that saying unkind things about client companies is not going to advance their careers. Thus, the vast majority of analysts’ reports from the so-called sell side of the investment business are positive. For the would-be private investor, a dose of cynicism is in order.

Our plan, and this book’s plan, is to cut through the complexity of conventional financial analysis and its invocations of mathematical formulas and statistics to what amounts to common sense. We’ll show that paying too much for assets that are always under conditions of uncertainty — after all, nobody knows what trouble a company can get into — is unnecessary. Many of the analysts who hype stocks that are unreasonably expensive work for investment banks that sell the very same shares. There is safety in calculating your own figures.

We should tip our hats to the literature that defines success and traces the steps to it. Financial magazines are often awash with stories of billionaires, their original Renoirs, and their yachts. There is nothing new in this form of envy. It is Biblical, in that it’s critical in making the distinction between the realms of God and of Caesar. It is literary, appearing from Greek drama to the modern stage — think of Oscar Wilde’s The Importance of Being Earnest and the pathology of failure captured in Arthur Miller’s Death of a Salesman — and in the current fascination with the careers of Steve Jobs, Warren Buffett, Bill Gates, and other capitalists whose businesses have thrived on what could be called a single idea. The problem with the latter literature is that it represents the successful explaining how they got to be that way. It is backward looking. Each tycoon’s story is distinct and not necessarily repeatable. In any event, you can’t start out being General Motors.

We propose that growing one’s wealth by investing in others’ businesses by buying stocks and bonds and by buying real estate for development or rental can be done with manageable risk and good prospects for gains. The more you know about your market — in other words, your portfolio, your costs, the achievability of profit targets, and the risks you face — the better your prospects for gain.

Many people, seeing the vast number of choices of stocks and bonds, real estate projects, and even collectibles, give up. We think that’s wrong. You cannot understand the world of finance the first time you see it, but you can grow into it, much as you might open a small store and see its sales and profits grow and turn eventually into a larger business with diverse lines of activity. You cannot have it all at once, but you can learn the ropes and climb them.

TIME AND REALIZATION
How do you judge the success or failure of an investment? A stock may fall after purchase only to rise to astounding heights a few months or years afterward. The investor who expects instant gratification is likely to be disappointed. Even Amazon.com took four years from 2013 to rise from US$275 to the recent price of about US$1,626. If you want faster outcomes, you should go to a casino. Stocks and bonds and real estate seldom have the swift resolution of gambling tables.

Cynics say that buying stocks on tips or even on trends, which are collective tips of winners asking others to join them, is a form of industrial gambling. We concur. The difference between this kind of gambling, which is little more than a play on price, and informed investing is understanding the stocks’ business much as you would understand your own business, and earning dependable income flows that can pay you back even if the stock tumbles and stays down. All this may seem boring, but it is caution put into practice. Be humble about what you know, for in most cases, you will know less than what you do not know. This is humility. It is also honest.

The advice that teaches success tends to be variously inspirational and technical. There are attitudinal books, many rooted in the 1970s, when reforming the self was seen as vital in such neo-theological themes as Rolfing, Esalen, and the cults of various swamis and gurus, not to mention the tongue-in- cheek distillations of business wisdom from the writing and attributed sayings and doings of Genghis Khan (“Don’t negotiate, conquer”), Machiavelli (“It is better to be feared than loved, if you cannot do both”), Abe Lincoln (“Better to be silent and thought a fool than to speak and remove all doubt”), and so on. This is transitory wisdom — clever, but not necessarily applicable to managing money. As well, there are skill-based advisory books that seek to transfer wisdom and investing technique from applications in such things as engineering.

We take the view that fundamental human traits measured by commitment, patience, focus, and a deep understanding of one’s endeavours, which are the foundations of successful lives, can enlarge one’s fortune. The top-line concept is that investors should stay within their circles of competence. Don’t buy what you do not understand, and certainly not because a friend or relative is buying it. Swift jabs into things of which one knows little, such as investments in flavour-of-the-moment companies on the web, are likely to fail. It is the greater fool theory gone digital. Then, however, as one’s knowledge and expertise, experience, and acquired sense of self-preservation grow, one can invest further afield. None of this should seem startling. What is shocking, on the other hand, is how swiftly novice investors pile into bad ideas.

There is a simple numerical test for how well ideas pay. In stocks, the ratio of price per share to earnings per share (the p/e ratio) is a key guide to value. Canadian chartered banks typically have p/e ratios of twelve. That means a dozen years of future earnings will repay your investment in that time or less if you add in the dividends. Some hot web stocks have p/e ratios of two hundred or more. You will have to wait two centuries for the return of your money if there is no dividend, and there usually isn’t. Even if earnings double, you will have to wait a century. If earnings quadruple, you’ll need to wait a more modest fifty years. Investors in these hot stocks are not betting on earnings trends. They are betting on the enthusiasm of other investors. We think that’s industrial gambling, not so far from shooting craps in Vegas.

Investors in dot-coms in the last years of the twentieth century threw money at companies labelled “digital” that had no sales, no profits, no business plans, and no experience in markets and that, to top it all off, were prized for burning up other people’s money. No corner grocer would invest in goods their customers do not want. Paradoxically, in the investment world, unfamiliarity with assets seems no barrier to casting money to the winds. Compared to a casino, stock market bubbles large — the ones we know — and small — they happen every day — are like games the players do not know how to play with odds they cannot fathom. This is idiotic. We think the small shopkeeper knows their own business best. The task of this book is to help transfer that innate, experienced-based knowledge to the larger and more complex world of investing in capital markets.

Chapter 1
Canada’s Housing Bubble Defies Gravity

The market for real estate, particularly individual homes, would seem likely to display speculative booms from time to time, since the psychological salience of the price of the places we see every day and the homes we live in must be very high, and because homes are such a popular topic of conversation.
— Robert Shiller, Irrational Exuberance, 2000

One of the earliest uses in recorded history of the word bubble in relation to financial speculation was in reference to the South Sea Bubble — the South Sea Company was a joint-stock company founded in England in 1711. It issued shares to the public in 1719 and in less than a year increased its stock market value ten-fold. A short time later, its stock price had dropped back to close to the original listing price, a crash that reduced the value of the company by 90 percent. Fortunes were made and lost. Despite the huge devaluation in the share price of the company, it continued to exist; indeed, it eventually took over responsibility for the debt of the Government of the United Kingdom.

The Bubble Company, as it was known, copied the Banque Royale, a company that was formed in France in 1716, which was also organized as a joint-stock company and used to finance government debt. Both of these companies were created for the purpose of converting government debt into shares of stock in a listed company. This idea of paying off government debt with shares sounds crazy today, but, at that time, it fired the public imagination and many ordinary people got caught up — speculators would eventually lose their life savings. These two companies and other similar copycat companies became known as the bubble companies. The concept became so popular that the U.K. parliament passed the Bubble Act in 1720 to control them.

Another, more famous, instance of financial insanity and speculative fever was a period known as the tulip bulb mania, which started in Holland in 1634–37. It seems that this mania wasn’t referred to as a bubble, perhaps because of the difficulty for the human tongue in saying “tulip bulb bubble.” Some people, wealthy and poor alike, became besotted with the idea of owning and trading tulip bulbs for financial gain. Bulbs were listed for trading like a stock on one of the earliest stock exchanges, the Amsterdam Exchange. Prices soared to the equivalent of an average person’s life savings for one rare bulb. The fad spread to England and many other countries. Even today, in Holland rare species of tulip bulbs trade at lofty prices, although nothing like the ridiculous values that were common four hundred years ago.

The principal attributes of these activities, whether called bubbles or not, were a degree of excessive speculation, inflated prices, and a subsequent crash, along with widespread public involvement and fascination.

Many writers and historians have tried and failed to make sense of the innumerable instances of inflated values for commodities, stocks, real estate, and other speculative vehicles caused by excessive greed and speculation. Economic theory doesn’t do any better in providing explanations, since bubbles don’t readily allow analysis using advanced mathematics. Modern economic theory avoids the difficulty of understanding bubbles and mania by assuming that all human participants in economic activities are rational at all times under the efficient markets hypothesis. Even Canadian-born economist John Kenneth Galbraith — who discussed many of the most extreme bubbles in A Short History of Financial Euphoria, and provided analysis that does a much better job of explaining economic cycles than do most of his peers and successors — fails to come up with a suitable definition of the bubble phenomenon. Galbraith merely states that they are recurring episodes of collective financial insanity, fuelled by greed, and that they are inevitable.

Given the difficulty of experts who have studied bubbles in detail in coming up with a coherent explanation regarding the origin of bubbles, their nature, or patterns, it’s not surprising that it’s next to impossible for the average person to detect when they are in the grips of a manic episode of excessive speculation. The only defence is to develop a healthy degree of skepticism, an attitude that comes naturally to few people.

One such person is Jeremy Grantham, the founder of the large investment firm GMO, who manages over $120 billion of investments for institutional investors such as pension plans, endowment funds, and companies. I first met him in New York City after he presented at a conference in 2003. He opened his remarks by stating, “I’ve never been wrong.” The room went completely silent as two hundred investment experts and portfolio managers mulled that over. After a very long, awkward pause, he continued, “I’ve been early,” and the room erupted into laughter.

Grantham captured in a very succinct manner the universal difficulty of talking about bubbles and the inevitability of them bursting. Any prognosticator who calls for a crash in a bubble asset invariably looks like a fool for a period of time before eventually, perhaps, being proven right. In the interim, the forecaster predicting the collapse is contradicted by higher and higher prices leading to greater and greater wealth for the bubble participants who ignore the warnings. Inevitably, the public (and clients if the advisor is in the investment business) develops disdain for the person making the unfortunate “early” prediction. As Grantham says in an April 2014 GMO quarterly letter, “the pain will be psychological and will come from looking like an old fuddy-duddy.” However, in the big picture of cycles, those who were forecasting a collapse in the U.S. housing market in 2004 and 2005 were only a year or two early. In real estate, one or two years is a short time. It takes that long sometimes to get a house ready to sell, put it on the market, and wait for the right buyer to offer the right price. Grantham was very early in 2003 with his predictions about a stock market crash, but eventually he was more than right. When the financial crisis hit in 2006, it began with housing, and the next year spread to the financial industry, eventually resulting in the collapse of Bear Stearns, and, in 2008, Lehman Brothers.

Grantham described his research into bubbles. His research showed that “all [ twenty-eight] major bubbles … eventually retreated all the way back to the original trend, the trend that had existed prior to each bubble, a very tough standard indeed.” The definition used for a bubble was any event that was two standard deviations from the mean. Standard deviation is a statistical tool that tells how unusual an event is. Bubbles of that size, according to Grantham, are expected to occur at a frequency of once every forty-four years. The U.S. housing bubble exceeded 3.5 standard deviations from the mean, an event that would be expected to happen very rarely, only once every five thousand years. The U.S. housing bubble started to take shape in 2000, reached one standard deviation about the trend line around 2001, exceeded two standard deviations during 2003, and peaked above three standard deviations in 2005, going to one standard deviation below the mean in 2008. All done in about eight years, a very compact and devastating bubble and bursting that will have repercussions for the United States and the world for decades.