Scuttlebut

Running your own money from home is great. Set up in the garden, a glass of rosé on a sunny day, reading and writing about markets, - it’s a good way to be spending time.

And even better, I don’t have to listen to the ravings of lunatic risk managers – who are worried about whether commodities will get delivered, and who want you to cut your equity exposure at the point of maximum volatility. The point, in other words, when you should be raising your stake. Risk managers are happy, almost try to persuade you to add risk at points like this, when the risk reward has deteriorated. But I didn’t intend to pen a rant about VAR and its disciples – I wanted to talk about running money at home.

The problem of course, is that there aren’t so many people around. So it’s hard to sniff out when there’s real fear in the air – something that was clear in mid-January – when I moved back to the long side. Hard to know when folks are getting complacent. Something I suspect is happening right now.

And it’s harder to keep in touch with contacts. That was something I did all the time when I was a commodities strategist. And on occasion it paid off big time. I heard about the collapse in aluminium orders from the horse’s mouth in October 2000 - around three weeks before the data came out. That set up some very profitable trades.

Now what I heard over the weekend reminded me of that time. I was chatting to a guy who runs a major global ad business. And what is interesting is not that things are slowing – but just how diverse everything is. Russia and India are going gangbusters – with Western companies, even banks, buying ads aggressively. The US of course, is weak. No surprises there. But Western Europe is doing a swallow dive.

Now that is intriguing. It’s certainly not consensus. And it’s the kind of scuttlebutt that shows up later in the data. It also supports some of the leading indicators – such as business confidence – that have been coming out much weaker than the activity data itself.

Now I like the negative call on Europe. It was Europe, much more than the US, that benefitted from easy money and the credit boom. It was Europe that saw the most aggressive house price inflation. And it was the European banks that went furthest down the rabbit hole of structured credit derivatives, convergence trades and other esoterica. They will be the ones most hamstrung in the great unravelling of the shadow banking system that is still to come.

Now, of course, the German Mittelstand and the French engineers are, and will, continue to be beacons of strength. But it is precisely because they are strong that rates have stayed too high for too long for the rest of the economy. And it is now, according to the scuttlebutt I’ve heard, that the chickens are coming home to roost.

Now I’ve thought a bit about how to trade this. And it looks to me like Dec 08 Euribor is ripe for a bid – after a vicious 120 point sell off from early February. I’m long Dec08 Euribor with one risk unit, looking to build up to a maximum of four units long if the trade is successful – in line with my standard practise for my leveraged fund.

Compounded

Many of the investment greats – Charlie Munger among them – claim to have no sense of market timing.

Now that is anathema to many active money managers. After all, if you call the timing on the two or three big turning points in a year, and you put your money where your mouth is, you can likely clear 20% – more than enough to stay in business.

So what are the big guys doing, if they’re not market timing.

The one thing they’re not doing is buying stuff that Graham & Dodd would buy. Two relatively little known facts reveal a lot about the Graham & Dodd legacy. The first is that Ben Graham destroyed most of his funds under management after the 1929 crash. Second, a large chunk of his strong performance thereafter is attributable to GEICO, which didn’t comply with his own stringent valuation requirements.

Warren Buffet himself had a lot of trouble in the textile business, even though he bought in at what looked to be staggeringly cheap valuations. Berkshire Hathaway might not exist if Buffet had no more ‘game’ than a Graham & Dodd valuation screen.

The turning point at Berkshire Hathaway may well come down to a single insight – and it was Charlie Munger’s insight; A great business at a fair price is superior to a fair business at a great price.

That doesn’t sound like the talk of a partner in the most successful value investing team in history. But as soon as Munger explains the power of compounding returns, that simple statement turns out to be one of the great investment insights.

Here’s a simplified example, and to make it really simple, let’s assume no depreciation, and an expectation that all free cash is reinvested in the business at the same rate of return. So here are two companies – one that makes 20% a year free cash, and is trading at two times par (two times price to book), the other that is making 10% a year free cash, and is trading at par. The first company is a great company at a fair price, the second a fair company at a great price.

The question Munger asks; if I buy both, and I’m sitting here in ten years’ time, what will each be worth? The fair business we assume rises from par to 2x par and reinvests its spare cash. What’s that worth in a decade? 2x1.1^10 = 5.2 times your initial stake.

With the great business – we assume it still trades at 2x par in ten years – and reinvests its 20% free cash – that’s 1.2^10 – or 6.2 times your money.

So even with something as extreme as a par price on the fair business, and even assuming that the fair business rerates, but the great business does not, even then, it’s still better to buy the great business. And if you reduce the discount of the fair business to say 1.5x par, or alternatively let the great business get re-rated some– the great business is worth about double the fair business in ten years time.

Most of Buffet & Munger’s time is spent working out whether a company can sustain high returns, and whether it can grow sufficiently to be able to reinvest at those same high rates of return. In other words, they spend their time working out whether businesses are great.

And you have to admit that the maths is pretty startling. No wonder Einstein called compound interest; ‘The eighth wonder of the world’. No wonder, also, that there are no trillion dollar commodity funds, but there is a Capital in equities. A friend told me about one of Capital’s greatest investors. He started in the 1960s. By the time he retired, the annual dividends on several of his stocks were greater than his total investments in those companies.

Now, I tend to invest thematically – I tend to believe that long running global themes can lead to a sustained change in returns in specific sectors or companies.

I think that the global infrastructure theme, and possibly the global resources theme, has several years to run. And when I say several years to run, all I mean is this; the fundamental forces in play will tend to keep returns high in infrastructure and resource businesses. As I described yesterday, it will take a long time to get capital and labour back into line.

Now, of course, I’m going to try like heck to get my timing right. But when I’m thinking about value, rather than just price, well, I bought the stocks I now own because I think the value will compound at 20% over the next five years. And if that is right, I’m happy to take a chance on their price.

I can’t say the same for banks. Can you?