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Good Reading -- November 2013

Facts and Figures

  • U.S.-listed ETFs went from 113 in 2002 to 1,194 in 2012

  • U.S.-listed stocks went from 5,685 in 2002 to 4,102 in 2012

  • Sources: ICI, World Bank, Horizon Kinetics

  • After-tax corporate profits hit 10.9% of GDP for the 12 months ended June 30, 2012, an all-time high in records dating to 1929. Yet the percentage of corporations less than five years old continues to fall. (Source: U.S. Commerce Department; see article below)


  • The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy, by Michael Pettis -- see below

  • The Map and The Territory: Risk, Human Nature, and the Future of Forecasting, by Alan Greenspan -- I haven't finished this yet, but I can It's like Greenspan woke up and discovered behavioral economics. "September 2008 was a watershed moment for forecasters, myself included. It has forced us to find ways to incorporate into our macromodels those animal spirits that dominate finance." (emphasis added)

  • If your head's not spinning enough, read this review from -- wait for it -- Burton Malkiel.

  • "Bubbles and crashes will always be characteristics of free-market systems..."

  • "Effective models of the economy shouldn't assume that most people exhibit completely rational behavior and that outcomes are contained within predictable bell-shaped ("normal") distributions. With such adjustments in place, models will inevitably show that outcomes in financial markets will be far more extreme than suggested by normal probability distributions. Moreover, the extremes of the distributions will tend to be asymmetric—extreme negative outcomes are particularly likely: Fear is more potent than euphoria. Ignoring these implications, Mr. Greenspan argues, blinded government policy makers and business practitioners to the full extent of the risks that were revealed during the 2008 crash and the crisis that followed."


  • "Revisiting My 2011 Predictions" -- Michael Pettis is an excellent source of perspective and clear thinking. His excellent blog and recent book "The Great Rebalancing" are also recommended, but this essay about China and his outlook from two years ago is highly recommended.

  • "Jain Feeds Buffett's Hunger" -- Insider Quarterly profiles ones of the brightest minds in insurance and a leading succession candidate.

  • "...A Look at Forces that Shaped the Washington Post Sale" -- An in depth look at the history of the company and its leadership. The accompanying graphic is also worth a look.

  • "Bill Gates, Inside the Gates" -- A fascinating look at Bill Gates's college days.

  • China Bilateral Investment -- I'm late on this too, but this is definitely worthwhile. Recorded in June, this roundtable features Victor Fung of Li & Fund, Charlie Munger, and Jim Sinegal of Costco talking about China.


  • "The 20 Smartest Things Jeff Bezos Has Ever Said" -- Now that the Washington Post sale has closed the Bezos bandwagon should slow down for a while. But these quotes are worthwhile either way.

  • "Nobel Needs Grounding in Reality-Based Economics" -- Roger Lowenstein weighs in on the recent Nobel Prize in economics. If, like many, you were understandably confused as to how one person who denies that bubbles can exist can win alongside another who has made a career out of identifying bubbles in progress -- with the Committee praising both for work that shows "it is quite possible to foresee the broad course of [stock and bond] prices over…the next three to five years" -- read on. Jason Zweig and the Economist "Free Exchange" columnist also weighed in on the matter.

  • "The Dark Side of Fat Profit Margins" -- A brief but insightful look at the current corporate landscape that features record-high profit margins from increasingly old companies. (I'd also note that the article doesn't explain a key point. That the majority of the difference in after-tax margins is due to interest rates and taxes; operating margins aren't so different from their historical averages.)

Nobel Needs Grounding in Reality-Based Economics

By Roger Lowenstein - Oct 16, 2013

The Flat Earth Society has all but disappeared, but the efficient-market hypothesis is alive and well. This week, the Nobel Memorial Prize in Economic Sciences was awarded to its most tenacious advocate, Eugene F. Fama of the University of Chicago.

The hypothesis posits that the stock market is an “efficient” calculating machine, and that stock prices are rational computations of observable facts. It follows that future prices are unpredictable.

As Fama wrote in a version of his doctoral thesis 48 years ago, “If the random walk theory is valid and if security exchanges are ‘efficient’ markets, then stock prices at any point in time will represent good estimates of intrinsic or fundamental values.”

This idea is contradicted by the view that human behavior is often irrational (or imperfect) and that, therefore, the market not infrequently gets it wrong. It is also contradicted by the many investors who have exploited mispricings to beat the market and by the many examples of investor folly or bubbles.

Robert Shiller of Yale University dubbed the efficient-market hypothesis “the most remarkable error in the history of economic theory.” (Whoops: Shiller was one of three Nobel economics laureates this year, along with Fama and Lars Peter Hansen.)

By trying to have it both ways, the Nobel committee missed a chance to confirm that observed experience has undermined a beguiling but simplistic theory that has charmed the economics profession.

Irrational Passions

The efficient-market crowd contends that successful investors such as Warren Buffett are merely lucky; let enough people flip coins and someone will keep rolling heads, even over a period of decades. Behaviorialists (including me) point out that when the same people, following the same discipline -- patient, long-term searching out of underpriced stocks -- keep finding profitable opportunities, it means the market is imperfect.

For those in thrall to efficient markets, no such opportunities can be determined in advance, because if they could, smart people would have exploited the opportunity until it disappeared. (You know the joke: An economics professor stoops to pick up a $20 bill, and his colleague says, “Don’t bother; if it were really $20, it wouldn’t be there.”)

At root are two contrary views of human nature. One sees investors as counting machines, the ever-rational subspecies known as Homo economicus. But people succumb to irrational passions in love and war and religion and politics -- so why not in economics?

Behavioral economists such as Shiller and Richard Thaler, Nobel-winning psychologist Daniel Kahneman, and others have demonstrated that there are repeated patterns to people’s irrationality. One of the most common is that most people simply follow the crowd instead of calculating the intrinsic value of a stock. This is why bubbles occur.

The controversy has huge ramifications. If markets are perfect, stock-picking doesn’t make sense. Everyone should just index their portfolios.

It also affects government. If you believe in rational actors, there is no need to regulate against mass folly (only against chicanery).

This belief in rational actors has handcuffed the Federal Reserve. Former Chairman Alan Greenspan slept through the investor folly of the late 1990s, when the stock market put multibillion-dollar valuations on dot-com companies that were nothing more than business plans.

Bubble Resistance

Greenspan refused to try to deflate the bubble because he didn’t believe that masses of investors would be foolish, or that such manias could be identified in advance. The current Fed chief, Ben S. Bernanke, then a Princeton University scholar, took the same position. Both repeated this mistake during the mortgage buildup. Neither placed emphasis on regulating mortgages because neither believed that bankers would succumb to mass folly.

The 1987 stock market crash, when the Dow Jones Industrial Average fell 22.6 percent in the absence of major news, should have dealt a death blow to the efficient-market hypothesis. But it didn’t. Fama and others argued that the crash reflected a rational repricing of expected corporate values. Similarly, after the mortgage meltdown, Fama was quoted in the New Yorker as saying, “I don’t even know what a bubble means.” In other words, the market wasn’t -- and couldn’t be -- wrong. The high price was as rational as the new one. Shiller, who surveyed investors after the 1987 crash, spotted something other than rationality: mass hysteria.

If behavioral theory, with its messy, imperfect view of investors, has won in the real world, the efficient-market hypothesis has long been trumps in academia as an elegant theory that offers a pleasingly ordered view of the world. People are deductive; prices are rational. Modern finance is built on mathematical models designed around a presumption of efficient and random markets.

Defenders of rational markets often point out that most investors don’t beat the market indexes. There is less to this observation than there initially seems. First, it is a truism that the average investor will have average performance. Second, the existence of occasional inefficiencies doesn’t mean that beating the market is easy. It requires work, analysis, patience and the fortitude to resist trends. Most stocks are probably priced about right most of the time. It’s the investor’s job to find the ones that aren’t.

Then there is the claim that markets are random “in the short run.” This is true but also not very important. For instance, even at the height of the dot-com bubble, no one could say what would happen over the next hour, day or week. But investors could nonetheless calculate that tech stocks were overpriced and would crash sooner or later.

‘Serious Doubt’

Robert C. Merton, who won an economics Nobel in 1997 for his work in options theory, recognized how incompatible the two views are. “If Shiller’s rejection of market efficiency is sustained,” he wrote in 1986, “then serious doubt is cast on the validity of this cornerstone of modern financial economic theory.”

Merton was rudely validated some years later, when he was a partner at Long-Term Capital Management LP, which, like many other hedge-fund managers, used an assumption of randomness in its risk-exposure models. Those calculations turned out to be way off. Markets moved in the wrong direction, in very nonrandom ways, and the fund collapsed in 1998.

The fact that markets can move nonrandomly was documented in 1965 by none other than Eugene Fama. In that research, he observed that stock prices exhibit many more extreme movements than would occur in a normal, random distribution. Extreme changes that should occur every 7,000 years, Fama wrote, “seem to occur about once every three to four years.”

How many market shocks have to occur before people are no longer shocked, one might ask? But at long last, the prevalence of market bubbles seems to be denting the once-worshipful belief in efficient markets.

Academic textbooks once preached the hypothesis with religious fervor. Now, doubt is creeping in. N. Gregory Mankiw’s “Principles of Economics” asks “Is the Efficient Markets Hypothesis Kaput?”

Even Janet Yellen, who has been nominated to succeed Bernanke, said recently that the Fed should reconsider its traditional view that it shouldn’t attempt to pop or restrain market bubbles. Can the Nobel committee be far behind?

(Roger Lowenstein is writing a book on the origins of the Federal Reserve System.)

The 20 Smartest Things Jeff Bezos Has Ever Said

By Morgan Housel September 9, 2013 (NASDAQ: AMZN ) was once the poster child of what happens when excitement about a company detaches from reality. The headlines "Amazon founder named TIME magazine's Person of the Year," and "Analysts Fear Amazon Is Going Bankrupt" appeared within 14 months of each other around the year 2000. Short of fraud, there little precedent for this in business history.

But 13 years later, Amazon is thriving. It is dominating, in fact, including in lines of business having little to do with its original undertaking of selling books. Shares now trade for three times what they did at the peak of the dot-com bubble.

Thank Amazon's quirky CEO, Jeff Bezos, for this success. He created a culture that's not only different from, but often totally at odds with, how most business leaders think. He's also quite quotable. Here are 20 smart things Bezos has said over the years.

1. "All businesses need to be young forever. If your customer base ages with you, you're Woolworth's."

2. "There are two kinds of companies: Those that work to try to charge more and those that work to charge less. We will be the second."

3. "Your margin is my opportunity."

4. "If you only do things where you know the answer in advance, your company goes away."

5. "We've had three big ideas at Amazon that we've stuck with for 18 years, and they're the reason we're successful: Put the customer first. Invent. And be patient."

6. "I very frequently get the question: 'What's going to change in the next 10 years?' And that is a very interesting question; it's a very common one. I almost never get the question: 'What's not going to change in the next 10 years?' And I submit to you that that second question is actually the more important of the two -- because you can build a business strategy around the things that are stable in time. ... [I]n our retail business, we know that customers want low prices, and I know that's going to be true 10 years from now. They want fast delivery; they want vast selection. It's impossible to imagine a future 10 years from now where a customer comes up and says, 'Jeff I love Amazon; I just wish the prices were a little higher,' [or] 'I love Amazon; I just wish you'd deliver a little more slowly.' Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it."

7. "If you're not stubborn, you'll give up on experiments too soon. And if you're not flexible, you'll pound your head against the wall and you won't see a different solution to a problem you're trying to solve."

8. "Any business plan won't survive its first encounter with reality. The reality will always be different. It will never be the plan."

9. "In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts."

10. "We've done price elasticity studies, and the answer is always that we should raise prices. We don't do that, because we believe -- and we have to take this as an article of faith -- that by keeping our prices very, very low, we earn trust with customers over time, and that that actually does maximize free cash flow over the long term."

11. "The framework I found, which made the decision [to start Amazon in 1994] incredibly easy, was what I called a regret minimization framework. I wanted to project myself forward to age 80 and say, 'OK, I'm looking back on my life. I want to minimize the number of regrets I have.' And I knew that when I was 80, I was not going to regret having tried this. I was not going to regret trying to participate in this thing called the Internet that I thought was going to be a really big deal. I knew that if I failed, I wouldn't regret that. But I knew the one thing I might regret is not ever having tried. I knew that that would haunt me every day."

12. "We innovate by starting with the customer and working backwards. That becomes the touchstone for how we invent."

13. "When [competitors are] in the shower in the morning, they're thinking about how they're going to get ahead of one of their top competitors. Here in the shower, we're thinking about how we are going to invent something on behalf of a customer."

14. "A company shouldn't get addicted to being shiny, because shiny doesn't last."

15. "I think frugality drives innovation, just like other constraints do. One of the only ways to get out of a tight box is to invent your way out."

16. "If you double the number of experiments you do per year, you're going to double your inventiveness."

17. "If you never want to be criticized, for goodness' sake don't do anything new."

18. "If you're long-term oriented, customer interests and shareholder interests are aligned."

19. "Invention requires a long-term willingness to be misunderstood. You do something that you genuinely believe in, that you have conviction about, but for a long period of time, well-meaning people may criticize that effort. When you receive criticism from well-meaning people, it pays to ask, 'Are they right?' And if they are, you need to adapt what they're doing. If they're not right, if you really have conviction that they're not right, you need to have that long-term willingness to be misunderstood. It's a key part of invention."

20. "You want to look at what other companies are doing. It's very important not to be hermetically sealed. But you don't want to look at it as if, 'OK, we're going to copy that.' You want to look at it and say, 'That's very interesting. What can we be inspired to do as a result of that?' And then put your own unique twist on it."

The Dark Side of Fat Profit Margins



Oct. 23, 2013

It's natural to worry about what might happen if companies' extraordinarily high profit margins slip. The more troubling thought may be what happens if they don't.

Never before have American companies seen so much of their sales drift down to the bottom line. In 12 months that ended in the second quarter, U.S. after-tax corporate profits as a share of gross domestic product, a measure of profit margins across the entire economy, came to 10.9%, according to the Commerce Department. That was the highest level according to records going back to 1929. Nor are there signs of erosion: S&P Dow Jones Indices estimates profits at companies in the S&P 500 as a share of sales hit a high in the third quarter.

The Tribune-Star/Associated Press

It isn't hard to find reasons why margins are so high. The share of sales going toward workers' wages and benefits has declined precipitously. Companies have kept a tight lid on capital spending. Effective corporate tax rates have fallen. Interest rates are sharply lower.

Although such factors help explain why the environment has been so good, they leave unanswered an important question: Why aren't historically wide profit margins getting competed away? One reason may be that there isn't a lot of up-and-coming competition.

Even before the financial crisis struck in 2008, the environment for young firms appeared far less dynamic than in the 1990s. Back then, a hot market for initial public offerings created an easy environment for finding funding and a strong economy made it relatively easy to stay in business.

Since the recession, things have been moribund. In 2011—the last year for which there is data available—35% of firms operating in the U.S. were five years old or less, according to the Commerce Department. That compared with 40% in 2007.

Meanwhile, despite the well-publicized successes of a number of Silicon Valley companies, start-up activity remains muted. The Labor Department's establishment birthrate, a proxy for the pace of new-business formation, last year matched the record low it plumbed in 2009.

To some extent, the dearth of young businesses reflects an environment in which keeping your day job seems wiser than starting something new. But in a lending environment in which funding for newer, smaller businesses is constrained, many would-be entrepreneurs are willing but not able. Facing fewer newcomers, established businesses have one less reason to spend more on wages and equipment; why put effort into building a moat that isn't needed? This is great for profits but not the long-term health of the economy.

"One of the things we count on is this dynamism and competition we get from entering and expanding firms," points out University of Maryland economist John Haltiwanger. New businesses have historically been the most important source of jobs, as well as a key driver of innovation. The fewer there are, the worse off the economy will be.

Fat profit margins are nice, for now. But a world in which companies don't have to worry about their profits getting competed away is also one where investors can't expect to fare well.

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