My Last, Final, Very Last Post for 2008

Bugger Thy Neighbor

One of the links I had yesterday noted the importance of global coordination for fixing our finacial global mess. Well, that is a nice goal but reality is likely quite different. The EU cannot even agree on a response within its ranks, so the likelihood of a coordinated global response is rather slim, to say the least.

Beyond coordination, there is the real prospect of international trade friction escalating. As Yves at Naked Capitalism points out, every country is trying to boost exports to salvage their failing economies. Only problem is there is no country anxious to be the importer. As much as the U.S. government is trying to get the U.S. consumers to return to their over-spending, debt-laden, ways, consumers (out of choice or otherwise) are not spending. They are deleveraging, which is what they need to do. Meanwhile, their deleveraging is causing some pain to countries like China, addicted to our spending ways. These countries are taking steps to alter this and expand their exports again, but this is just folly in today's economy. In any event, imbalances are developing fast. Countries are pursuing the wrong remedies and will hopefully realize this in time to avoid a prolonged global recession. I, for one, am planning on no such realization. Hunker down; this will be long and nasty.

http://www.nakedcapitalism.com/2008/12/groundwork-for-trade-conflict-being.html

Bearfund Comment

Some of my posts are occassionally posted on Seeking Alpha, where I am a contributing author. One of my more recent posts published there resulted in a rather lucid, and worth mentioning, comment from "Bearfund." I quote it here in full:

" 'A third way to benefit stockholders is for the company to do a good job, spend its capital wisely, invest in prudent growth, avoid complicated financial instruments that no one understands and make a profit. Having excess capital sitting around is not a bad thing after all...'

"Doing fine right up until the end there. In fact, having excess capital sitting around is definitely a bad thing. When I buy a business, I want the returns from that business and only from that business. I do not want exposure to arbitrary other assets. When a company builds up excess capital, it usually does so in its home currency or in one of the world's major reserve currencies (dollars, yen, euros). These assets typically earn very little yield, dragging down the company's return on equity.

Compare with dividends: the company retains enough of its earnings to pay off any debt and operate normally through a recession, and pays the remainder of its earnings to its shareholders. They can, in turn, put those earnings to use in whatever fashion they like. If you want to own, say, 3 units of exposure to AAPL's business and 1 unit of US Treasury bills, you're free to do so by taking the dividends AAPL should be paying you but isn't and buying your T-bills with them. If you would rather own 3 units of exposure to AAPL's business and 1 unit of gold, you could do that too. And, if the managers really have a great idea for growing the company, they can sell shares in the new company on the open market and use the proceeds to fund it. If the existing shareholders want to own the new venture, they can benefit from a European-style rights issue in the new shares, or they can agree to suspend the dividend to fund the new business line as an integrated unit.

AAPL is of course only one particularly egregious example, but the point is clear: give the shareholders the flexibility to decide how to save, invest, or reinvest the profits from their holdings. Don't try to turn business managers into asset managers; most of them are not very good at the latter and will consistently underperform.

In the time period of interest, you are correct that holding excess capital was profitable. But these are relatively unusual times: there has been a short squeeze in money of zero maturity; despite plentiful supply, the size of the short positions outstanding simply became too large and forced covering resulted. Under such circumstances, those T-bills did pretty well (though not, I should mention, as well as much more leveraged instruments like the Long Bond, or - curiously - the base unit of stored value, gold). If you as an investor chose to buy assets like Treasuries or gold with your earnings, good for you. If you chose to buy more shares, not so good for you. But your choice shouldn't have been made by management or the board of directors. You should have been handed a dividend check and told to fend for yourself.

Buybacks, funded by debt or not, deserve only a brief mention: most publicly traded companies provide their senior managers with most of their compensation in the form of restricted stock and/or stock options. Under such circumstances, buybacks should be strictly prohibited, especially if any senior manager also serves as a director. The main reason for buybacks is the incestuous nature of boards of directors, which usually consist of executives from other companies. Doing buybacks simply allows them to feather one anothers' nests at the expense of shareholders.

It is true that paying out substantially all earnings every year will expose marginal businesses to severe pressure during downturns, because they will mostly be forced to take on tremendous debt to provide an adequate return on equity. The solution to this is not to limit dividends but to limit debt, and encourage marginal businesses - especially mature ones in decline - to shut down. The result will be a smaller economy in notional terms, but one which is far less volatile and allows investors much greater freedom to start new enterprises (since their capital will not be tied up on the balance sheets of poor-performing companies). In short, the economy would be much more dynamic, with fewer zombie companies and more new ventures. If the money is sound as well (i.e., it is gold or silver and no central bank is on the scene) then interest rates will be low all the time (no need for an inflation premium since there's no inflation, and little demand since debt is used sparingly) and the speed of money will be high as paid-out earnings are forced to search for returns.

Who can lenders trust? A tough question to be sure. But maybe the answer, as I've outlined it here, is that it shouldn't matter so much. A more dynamic, less leveraged economy would offer all of us quite a lot - except, ironically, those who take, and introduce, only systemic risks: the large-scale leveraged borrowers operating underperforming businesses and the lenders who enable them with the help of a flood of money from the ever-devaluing central banks."

I have no qualms with Bearfund's comment. What I need to do is add a caveat to my own. When I wrote my pience I had in mind companies like Berkshire Hathaway, who do in some respects act like asset managers. They make their money investing moreso that through a typical business model. Berkshire stored away over $50 billion in capital during the bubble to take advantage of this crash. And while not all companies are oriented to investing like this, I do think most should have a CFO who is looking at the economy, determining whether a bubble might pop soon, and deciding how to perhaps build capital and take advantage of it. Even if you are of the school that this bubble was not predictable - despite dozens of very vocal voices predicting it - you might at least subscribe to the Taleb Black Swan principle and put some bucks away for the completely unpredictable. Putting something aside to take advantage of once-in-a-lifetime events can lead to once-in-a-lifetime gains. Gains that might be unthinkable otherwise. And I am not just talking gains in profit, but gains in market share, taking over competitors, and the like. Right now there are companies out there just sitting on piles of cash and they will come out of these "relatively unusual times" with opportunities unheard of in usual times. They can achieve gains on the competition that would take decades otherwise.

So Bearfund, I hear what you are saying and agree that what you have to say is sage advice, but if you have not read Taleb's book on Black Swans, I recommend it. It opens a new door to investing - the preparing for the unexpected events side - that is worthwhile exploring. Your advice is well grounded in usual times, but my comment on maintaining excess capital (which was admittedly not properly stated) is oriented to those that migh like to take advantage of less than usual times, which we can expect for some time to come.

Disclosures: None