The Long Run Quarterly Letter: October 2007
“The Great and Powerful Oz has spoken!” It has been with just such bravado that major financial institutions have dismissed the concerns about investment quality within the global credit markets over the last few years. Supported by business-hungry rating agencies and armed with elaborate algorithms and risk analytics, banks, brokerages and funds have taken full advantage of low interest rates and lowly credit standards to securitize and leverage all matter of collateral – winning mind-boggling profits along the way. Now, with foreclosures accelerating, funds disappearing and banks initiating the long process of writing down historic losses, Toto (in the guise of sub-prime borrowers) has pulled back the curtain on the frail reality behind the confident façade.
History will remember this period as a time when investors sacrificed transparency for the hollow comfort of institutional “sophistication” and the promise of higher returns. Structured products have taken the place of core investments. Quantitative models have replaced common sense. Assets are recognized only for their collateral value. A major segment of the investing herd certainly isn’t in Kansas anymore.
It shouldn’t be too much of a surprise that we find so many transported to such a fanciful environment. After all, the products that have been at the center of the credit hurricane are the most profitable on Wall Street:
- Investment firms and banks, starved for revenue after the major stock market declines early in the decade, sold the advantages of illiquid, high-fee hedge fund investments to shell-shocked investors. Sales of hedge fund products – with 2% management fees and 20% profit participation – provided regular and powerful revenues and revitalized income statements on Wall Street. Once the panic of the tech downturn had subsided, expensive hedge funds were sold as the only way to access the “best” managers. Profits sailed higher, and yet the Hennessee Hedge Fund Index has underperformed the S&P 500 over the last four years.
- Low interest rates increased the use of leverage to bolster returns and, in the words of Henry Kravitz, led to a new, “Golden Age” of private equity investing. While the performance numbers can look impressive in the newspapers, private equity has historically returned more to managers than to investors. A recent Wharton School study of 238 private equity funds raised between 1992 and 2006 found that 60% of expected revenue came from fixed fees that had nothing to do with fund performance making managers’ interests less aligned with investors than many would think.
- To respond to demand for higher yields across the investor universe,
bankers have created structured products that promise certain
returns and offer apparent protections based on the expected behavior
of derivative instruments and on the construction of underlying asset
portfolios. Wall Street has been able to spin the weakest credits
into AAA gold through securitization and repackaging, providing powerful
yields with little apparent risk. As demand for structured products (like CDOs)
has expanded exponentially, banks and investment banks have required less
and less backing for the actual assets being securitized, culminating (perhaps
famously) in the advent of the paperless mortgage.
History has continually shown that, when the potential to generate extraordinary, immediate profits presents itself, the bonus-driven culture of large financial institutions discounts the sanctity of investor capital. Even with the tarnish that the summer credit crunch has left on Emerald City, many investors continue to suspend their disbelief. But very real structural problems in the alternative asset universe spell trouble ahead. This summer demonstrated that investments that rely on leverage are surprisingly correlated – aligning risks across a wide swath of asset classes. The credit crunch also confirmed that the crush of money into hedge funds has limited the potential return on arbitrage opportunities and effectively disabled much of the short-side “insurance” that hedge fund investors have counted on to mitigate risk.
As long-term readers of the Long Run well know, we have committed significant editorial time over the last 18 months to discussing the likelihood of a credit crisis, and we have judiciously avoided investments in lending institutions. But, perhaps more importantly, we have also been firm in our belief that growth – driven by an expanding global economy – would continue through these challenges, urging clients to invest in the stocks of well-managed companies doing business all over the world. We still feel that many core stocks with compelling long-term growth prospects are valued reasonably.
Our job as contrarian investors is to recognize and define conventions where others don’t see them and to defy them for the benefit of our clients. So, when the financial sector grew to dominate the S&P 500 index, we saw danger and found opportunity elsewhere. As capital flows rode prevailing winds into fanciful products and another new paradigm of promised returns, we focused on low-debt companies with clean balance sheets and transparent income statements that were working to build regular earnings growth by serving the demands of an expanding global economic and social infrastructure.
In the end, of course, there’s no place like home. While others have chased Technicolor dreams, we have tended the soil we know best and produced a bountiful crop over the last 18 months. And we have planted seeds that we believe will provide a sustainable harvest for years to come.
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In Reynders, McVeigh news, we are proud to announce the addition of Ashley Petrillo to our administrative team. Ashley is a recent graduate of Salem State College. She will be helping us with client service and communications. So, if you hear a new voice on the phone, be sure to say, “Hi.
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