New-look blog

Woah! Shock and awe. We’ve woken up to a gleaming new blog. It’s almost as much of a surprise to me as it is to you; the IT department works in mysterious ways. Aside from being prettier now, the blog is on a faster server and a number of technical problems are fixed.

If you notice any gremlins: things not being where you expect, say, or you’re not receiving posts by RSS, anything, please let me know at richard.beddard@iii.co.uk.

Regular blogging will resume when I’ve found my way around.

Easy on the austerity George

Nightfall

Tomorrow George Osborne unveils his emergency budget. Amid calls for him to cut, come what may, I’d like to put forward an alternative view.

Isaac Asimov, a writer most famous for his science fiction, but who wrote about almost everything, a child prodigy who raced through the educational system devouring subjects like the cards in a football trading game, could not understand economics. I’m not surprised. Asimov was a scientist who also loved the humanities, but economics sits uneasily between them, neither a science nor an art, but a confusing mish-mash of variables and possibilities.

Like Asimov, I struggle with economics, but I follow the economists. One in particular is frightening me.

Paul Krugman is both a serious economist, and a polemicist. He’s been a consistent advocate of economic stimulus since the financial crisis started, a policy that seems to have worked, and he regards with accelerating alarm recent austere pronouncements by the European Central bank and governments including ours.

Responding to a G20 communiqué calling for cuts in government spending, Krugman argues that cutting while unemployment is rising and economies are growing weakly or contracting is both expensive and ineffective in reducing future debt. The cost in terms of jobs and reduced taxes outweighs the lower cost of debt repayments.

The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered — specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity.

Later, in other words, when they are growing strongly and they can lower interest rates to stimulate more growth, over-extended governments can cut. Now, with interest rates so close to zero, they shouldn’t, unless they have no choice like the poor Greeks. Here in the UK, and in the US, governments can still borrow at low interest rates, so they should.

Some people reading this will be thinking if we keep borrowing more, we’ll end up like Greece. At some point we would, but if Krugman’s right that point isn’t now, so in the topsy-turvy world created in the financial crisis the right policy is to spend, even though it is spending that got us into trouble.

George Soros likens this to controlling a skid (pdf). Your inclination is to turn away from the skid (cut spending), but to regain control you must turn into it (spend). Then you try to restore balance.

Paging through Krugman’s blog and others, you’ll find examples of when austerity allegedly brought about a recovery but actually impeded it. The most pertinent, because the coalition government has drawn inspiration from it, is Canada in the 1990’s. In the USA in 1937 an attempt to balance the budget choked off a recovery that might have ended the Great Depression, and in Japan premature austerity stymied recoveries throughout that country’s two lost decades according to The Bank of England’s Adam Posen (pdf). Krugman, also a student of Japan, believes premature austerity would presage a lost decade in the US and UK too.

Although I struggle with economics, I think I understand the stock market better. Investors are divided. Some assume financial markets are governed by the rational expectations of individual investors and others think sometimes markets are driven by ‘animal spirits’, investors are subject to bouts of enthusiasm and panic and generally, at these times, overreact. The term ‘animal spirits’ was coined by an economist and investor, John Maynard Keynes, and that is the reason I follow Krugman, who pays homage to Keynes.

As an investor who is all too aware of animal spirits, I think it’s likely  politicians and economists overreact too. To preach austerity, ‘savage cuts’, is tough, virtuous, even cathartic now we know we’ve been naughty.

But I don’t think playground psychology should apply to economies, however good it feels. So I hope the government is playing a craftier game and in its emergency budget and subsequent spending review Osborne goes easier on immediate austerity than we expect. Instead he might use the political capital the government has engineered in bracing us for tough times to begin to tackle the problems that will drag us down, not this year, or next year, but in ten years time; public sector pensions, say, the cost of the health service, and the lack of alternative sources of energy. The Office of Budgetary Responsibility and a commitment to transparency looks like a good start.

One of Asimov’s famous short stories is Nightfall. Every few thousand years the inhabitants of a planet near the centre of the galaxy experience collective madness when there’s an eclipse. All knowledge is lost as people burn down their cities in desperation for light, but eventually a new civilisation flourishes and the cycle repeats.

Krugman, who was inspired to be an economist by Asimov, thinks our lust for austerity is collective madness brought on by the economic cycle, when (Keynesian) economic knowledge is forgotten and animal spirits take over.

Perhaps ours is an economic tale Asimov would have understood.

-

Black swan lauds great white hope

David Blanchflower warns that now is not the time to cut. It could be the greatest economic policy error in a century:

Nassim Taleb says David Cameron is extraordinary and Obama doesn’t have a clue: “You have to take some pain to remove the tumour.”

By imposing its own standards on the rest of the euro zone, German fiscal discipline will cause recession, says George Soros.

JP Morgan has discovered a new feedback loop affecting BP’s share price. The share price falls, so the cost of credit insurance rises, so the share price falls more, so the cost of credit insurance rises…

Where the value is…

It’s here! In the UK!

Bad news for US investors. According to Robert Shiller’s cyclically adjusted PE (CAPE) stock market prices are back in the most expensive quintile. US stocks are nowhere near as expensive as they were in 2000, say, but for more than 80% of stock market history since 1881 they’ve been lower [click for a larger, sharper chart]:

As the chart below shows, investors haven’t done well when prices are high [click to enlarge]:

Soc Gen Analyst Dylan Grice, whose reports I’ve culled for this blog says:

If history is any guide, those investing today can expect a whopping 1.7% annualised return over the next ten years.

So what’s a hapless investor to do? Well, he could sit on his hands and wait, perhaps years, for prices to fall, or go hunting for companies that appear cheap, even though the market in general isn’t.

Grice goes hunting, using Stephen Penman’s Residual Income Model¹. He only gives us a glimpse of how the model works:

…all I really do is assume that a company which earns only its required return is worth no more than its book value. By capitalising expected excess returns (defined as RoE less required return) onto book value I arrive at an intrinsic value which I can compare to the market price.

In other words, if an investor is to buy shares in a company he must cover his costs: the interest he’d lose by not investing in so-called risk-free government bonds, and compensation for the extra risk of investing in shares. This is the required return (also known as the cost of capital). Anything earned on top in the future is a bonus, and adds to the company’s intrinsic value now. The word intrinsic differentiates the price an analyst puts on a company’s shares, from its market price.

Grice, who uses consensus analyst’s estimates of future earnings, says it works. Companies with high intrinsic values relative to the market price do much better than companies with low intrinsic value to price ratios (IVPs).

Aggregating IVP ratios can tell us if markets are cheap or expensive. So what do market IVPs tell us now? The value’s here, in the UK, the only country in Grice’s survey where intrinsic values exceed market prices [click to enlarge]:

Estimating future profits and calculating intrinsic values, is a step further into the dark art of financial analysis than I’m currently prepared or able to go. But Grice’s conclusion is, to a degree, supported by my calculation of the UK market’s long-term PE (a similar measure to Shiller’s CAPE), which suggests that the UK is not cheap, but it’s not expensive either.

Globally, the value is hiding in companies exploiting natural resources [click to enlarge]:

For example, Grice says:

…integrated oils are cheap. True, they always seem to be. They’re too big and have gone ex-growth. But the long-term growth numbers I’ve used for them (e.g. Royal Dutch Shell) are actually negative so they allow for this. And if we overpay for strong growth, mightn’t we underpay for weak growth? According to Factset, Integrated Oils have been one of the best-performing sectors over the last 15 years returning 12.3% annualized, against 8.5% for the World.

Here’s a full list of larger companies worldwide with an estimated intrinsic vale higher than their market prices [click to enlarge]

Six of them:

1. AstraZeneca
2. BP
3. Kingfisher
4. Royal Dutch Shell
5. Vedanta
6. Carnival

… are listed in the UK.

I have a shorthand way of finding cheap companies, the long-term PE, a close relative of Shiller’s CAPE, which I marry to measure of financial strength. It’s relatively rare for successful multinational companies to be cheap according to this measure, and I don’t profile the ones that are, because I think generally:

1. There’s more value in smaller stocks, and…
2. …They’re too complex for an individual to appraise in, say, a day!

But here’s a list of the big UK listed companies that have recently appeared in my Thrifty 30 shortlist:

1. AstraZeneca
2. BP
3. Royal Dutch Shell
4. Unilever
5. Vodafone
6. Xstrata

Notice any similarities?

-

Footnotes

1. Described in full detail in Penman’s excellent textbook: Financial Statement Analysis and Security Valuation.

-

Stupid goodwill

UK Value Investor reckons the FTSE 100 is 15% under fair value.

In 2003, Professor Jeremy Siegel argued market PE ratios should be higher than historical norms because: “…We can avoid crises such as banking collapses, great depressions and double-digit inflation. We also have a much more liquid market. Transaction costs are much lower. We have a favorable set of taxes on equities.” I wonder if he’s still confident about that PE ratio.

Aswath Damodaran breaks goodwill down into ‘stupid goodwill’ and ‘smart goodwill’. Are you feeling smart?

Judging by Unilever’s share price, ceo Paul Polman has had a flying start, but, he says: “I’m not driven and I don’t drive this business model by driving shareholder value. I drive this business model by focusing on the consumer and customer in a responsible way, and I know that shareholder value can come.” To understand why, see John Kay’s book, Obliquity.

Why should we learn from Robert Rodriguez about the sub-prime crisis? He “… Actually did the careful, detailed work and… figured out, in real time, the dangers of what was transpiring,” says Jeff Matthews, inspired by Robert Lowenstein’s book, The End of Wall Street.

A wonderful chart [pdf] of over a hundred years of the Dow Jones Industrial Average.

Will austerity make us happier?

Smiling all the way to the bank

Karl Rabeder is happy, he’s giving away his £3m fortune and plans to have nothing left. His conviction:

I had the feeling I was working as a slave for things that I did not wish for or need.

Is a growing meme, picked up by the novelist John Lanchester (and UK blogger Monevator).

Money didn’t bring Lanchester’s father happiness, he worked in a career he hated for 30 years. His grandfather went to the Far East in search of riches, but never fully recovered from 4 years in a prisoner of war camp. Both men died young, which inspired Lanchester to live for the day and advise his readers not to:

… listen to what people say about freedom and security and money but, instead, look at the specific, actual bargains they are making with their lives.

Financial analyst James Montier dug into the research on happiness in Behavioural Investing, to discover that beyond a certain point money doesn’t buy happiness. An increase in income quickly becomes the new normal, a process known as ‘hedonic adaption’.

According to research quoted by Montier people who pursue materialistic goals are:

…1.37 times more likely to have attention deficit disorder, 1.6 times more likely to be paranoid, 1.6 times more likely to histrionic, 1.5 times more likely to be borderline [sic], 1.5 times more likely to be more narcissistic, and 1.8 times more likely to have dependency issues!

Attention deficit disorder, histrionics, narcissism – he could be describing the stereotypical investment banker…

Lanchester’s father was a banker, which is, perhaps, one of the reasons the novelist felt able to write Whoops! a non-fiction book about the financial crisis. Judging by an excerpt in the FT, he doesn’t spare the investment bankers, the so-called masters of the universe who sound at least 1.5 times as narcissistic as your average bloke:

If you go to work with money, and make money, you can be proved right in the most inhumanly pure way. This is why people who have succeeded in the world of money… seem to regard themselves as paragons of rationality, when others often regard them as slightly nuts… Richard Fuld of Lehman Brothers… was one example. Another was… Sir Fred Goodwin after the meltdown and public rescue of RBS…

These were just lurid examples of the insulating bubble of money, and the security of the cult. It wouldn’t matter, if it weren’t for the fact that the psychology of the masters of the universe played a vital role in our journey to this point. One of our culture’s deepest held beliefs is expressed in the question, “If you’re so smart why ain’t you rich?” But people in finance are rich – so it logically follows that everything they choose to do must be smart. That was the syllogism followed by too many people in the money business.

Now their collective madness (and that of politicians, regulators, shareholders, property flippers etc.) seems likely to bring a period of austerity upon us, and maybe in embracing it, we’re conditioning ourselves for what lies ahead.

But, if less materialism and, as Montier advises, more time spent on relationships, exercise, sex, reflection, working at jobs we enjoy, and sleep, is the new norm, perhaps we’ll be happier for it.

At least those of us whose annual incomes don’t sink below the $60,000 per year that behavioural economist Daniel Kahneman says buys happiness.

Paul Samuelson, another economist, put a different value on happiness:

You know what happiness is: ‘Having a little more money than your colleagues.’ And that’s not so tough in academic life.

Perhaps austerity works after all.

-

A good toilet read

The more critical reviews I read of former US Treasury Secretary Hank Paulson’s autobiographical account of the financial crisis, the more I want to read it. Max Abelson:

He concedes a fondness for locking himself “in the bathroom with Sports Illustrated to relax in quiet.”

He used to speed through his children’s bedtime stories because of his work schedule; one night, his wife, who likes to call him Pea, forced him to read with expression. “No, no!” the kids objected. “Read like a daddy, not a mommy.”

Although it’s shocking the man whose job was to dodge financial meltdown was fallible, made policy on the hoof, and can offer little ‘thoughtful analysis’ afterwards, it’s also comforting.

Before Paulson was Treasury Secretary, he was master of the universe in chief: chairman and ceo of Goldman Sachs. Despite the power and money, the repeated ‘dry heaving’ he describes, doesn’t sound particularly masterful, and it doesn’t sound like happiness.

-

Behavioural investing

Montier has just published a new book, The Little Book of Behavioural Investing.

Saving capitalism from the capitalists

In a section in the profile of Nouriel Roubini I mentioned in my last post, he acknowledges other ‘whistleblowers‘, people or institutions that warned of financial crisis early on. It contains only two:Raghuram G. Rajan, then chief economist of the International Monetary Fund:

“Raghu Rajan gave a very strong speech in 2005,” [Roubini] says, about excessive risk taking in financial markets and the possibility of a full-scale financial blowout.

The Bank for International Settlements:

…which warned in its July 2007 annual report that the world economy was in danger of a major slump

The BIS describes itself as a bank for central banks, and the IMF oversees the global financial system.

When I started looking for economists that knew what they were talking about, because they had correctly predicted the current financial crisis before it was obvious, I expected to find mavericks, loners, and nutty professors.

I didn’t expect to find two of the pillars of the financial establishment warning of impending crisis, which begs the question, why didn’t our leaders, who so often profess ignorance and surprise at the unprecedented events of 2007 and 2008, listen to them?

Perhaps they should have read Rajan’s book, published in 2004: Saving Capitalism from the Capitalists.