Tuesday, August 07, 2007

When those who didn't care meet those who didn't think

What happens when the one who doesn't care meets the one who doesn’t think? It is a recipe for mischief and ultimately disaster in the field of investment.

In investment, who is the one who doesn’t care and who is the one who doesn’t think is clearly distinguishable. As Warren Bufett remarked, “First, many on Wall Street – a community which quality control is not prized – will sell investors anything they will buy. Generally, many market participants will not think what they will buy. A public opinion poll will usually replace thoughts for them which is the first step towards disaster. Obviously, no single event works per se can cause destruction to the world of investment. It’s usually a chain of events that lead to it. And we will try to unravel some of the critical events and key players that lead to it.

And of course, simply by following a contrarian approach is just as foolish as a follow-the-crowd strategy. Just because a stock or business is unpopular does not make it an intelligent purchase. What’s required is thinking rather than polling. In reality, unfortunately, Bertrand Russell’s observation about life in general applies with an uncanny truth in the financial world: “Most men would rather die than think. Many do.”

Originally, bonds that were initially investment-grade and downgraded were termed as “fallen-angels.” But yet again, Wall Street is full of illusionists.

Then, in the 1980s, a new kind of bastardized fallen angel burst onto the investment scene – “Junk bonds” that were far below investment grade when issued. As the decade passed, new offerings of manufactured junks became ever junkier and ultimately the predictable outcome occurred: Junk bonds lived up to their name and obviously it was started promoted by those who didn’t care to those who didn’t think. In 1990 – even before the recession dealt its blows – the financial sky became dark with the bodies of failing corporations.

The preacher of debt assured us that this collapse wouldn’t happen: Huge debt, we were told, would cause operating managers to focus their efforts as never before (remember when you were a student, it is so easy to come up with dozens of positive reason for doing something but then most of it are illusions), much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. With such attention given, a very alert driver will be produced. But another certain consequence would be a deadly – and unnecessary – accident if the car hit even the tiniest pothole. The roads of business are riddled with potholes; a plan that required dodging them all is a plan for disaster.

In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: “Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” The failure of investors to heed this simple message caused them staggering losses as the 1990s began.

At the height of the debt mania, capital structures were concocted that guaranteed failure: In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. Many businesses, good or bad, then bought with a mountain of debts could not service the interest with the gross income. Many of the bonds that financed the purchase were sold to the eventual failing savings and loan associations. And guess again who pick up the tabs for this folly? Again, it is the taxpayer.

When these disservices were done, however, dagger-selling investment bankers or rather promotees pointed to the “scholarly” research of academics, which reported that over the years the higher the interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high-grade bonds.

But, there was a flaw in the salesmen’s logic – one that a first-year student in statistics is taught to recognize. An assumption was being made that the universe of newly-minted junk bonds was identical to the universe of low-grade fallen angels and that, therefore, the default experience of the latter group was meaningful in predicting the default experience of the new issues.

The universes were of course unlike in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked towards that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing ones.

Wall Street cared little for such distinctions. As usual, the Street’s enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn’t care to those who didn’t think – and there was no shortage of either.


fishman said...

wah very chim leh! haha

But i think I get the message..."think more, do less!"

right? ;=)

Berkshire said...

Haha, partly correctly that is to think more before doing. Doing less is also important which I think the saying goes, as motion increase, returns decrease.

As for the other part of the message is to chose carefully on what and who to put your trust in.


Interesting views on something else that you do not hear much about.