Going Home

By Andrea Zacher

Connected To Home

As Thanksgiving approaches I notice excitement and enthusiasm everywhere for returning home.

In Robert Frost’s poem, “Death of the Hired Man”, Silas, an itinerant handyman, comes home to die at Warren and Mary’s farm. Even though they are not family and he has a rich brother, home for Silas is where he is connected by the dignity of work in Warren’s hay fields and a memory of teaching a college boy how to find water with a hazel prong. Warren’s harsh and judgmental vision of home “is the place where, when you have to go there, they have to take you in”. But Mary with her mercy calls it a place “you haven’t to deserve”.

Connections To Home

However, Thanksgiving is more than going home. It has to be about understanding the important things for which we should all be thankful. For me, that means connections like family, friends, church, work, grade school, high school, neighbors, day camp, and the corner bar. As a nation, the further we get from home the less connected we become and more uncertain of the things for which we will take a knee.

As you carve your turkey and watch NFL football look at who and what connects you to home. Cherish it, nurture it and remain eternally thankful for a place you don’t deserve where they have to take you in.

 

Andrea ZacherGoing Home

Death By Compounding

By Rob McCreary

The Congressional Budget Office usually does a good job of predicting the financial future for our country. Its 2017 Report looks out over the next 10 years and predicts many trends that we all know:

  • Budget deficits will grow and accelerate
  • Interest rates on 10 year government debt will rise from 2.4% to almost 4% in 2027
  • Government debt will grow from $14 Trillion in 2017 to $25 Trillion in 2027- that does not include entitlements
  • Inflation will be a tame 2%

Based on $25 Trillion of debt in 2027 each 1% increase in the rate creditors demand for government debt after 2027 is $ 250 Billion increase in the budget deficit. If the world suddenly decides it will not finance our deficits at 4% and instead charges 10%, the incremental interest bill will be $1.5 Trillion. The total interest bill in 2027 under that scenario would be $2.5 Trillion. The CBO acknowledges that after 2027 interest rates are likely to accelerate.  Here is a 700 year chart showing the average “real” interest rate ((interest in excess of inflation) is 4.8%.  Today “real” interest rates on government debt are close to 0% and they would have to rise to 7.2% just to revert to the 700 year norm and 6% to reach the last 200 year norm.

Default, currency debasement, massive inflation and financial Armageddon are possible. According to Gene Epstein in a Barron’s article dated Oct 23, 2017 entitled “There’s No Easy Fix For Our Mushrooming Debt” The US Balance sheet can’t be liquidated for more than $8 Trillion. He thinks the Parks System could fetch $2.1 Trillion, Federal Lands could get $5.0 Trillion, the Strategic Oil Reserve could get $136 Billion. Student loans are $1.5 Trillion but Mr. Epstein does not put any liquidation value on that asset class. Maybe you could collateralize our defense systems with the Chinese and Japanese creditors? In any event the holders of US Debt are woefully under collateralized.

 An Article V Convention

I never realized that prior to the Trump election 30 state legislatures had approved a call for constitutional convention to enact a balanced budget amendment. At the beginning of 2017 you only needed 7 more states to make the convention a reality. Since the Trump victory, however, the legislatures in Arizona, Maryland and New Mexico rescinded their prior calls for the convention. Many fear the Convention would be a “free for all” with agenda items reflecting the huge divisions in the country. What starts as a balanced budget inquiry might become a national referendum on transgender bathrooms.

Death By Compounding

I don’t know which we should fear more: (a) An Article V Convention in 2018 to decide the future of the United States including a balanced budget; (b) Chinese and Japanese faces on Mount Rushmore in 2020; (c) $20 Starbucks coffee and $500/BBL price of oil in 2024 or (d) a one time “Your Fair Share” assessment equal to 50% of your net worth in 2027. Death by compounding, however, is certain. Even with a balanced budget in 2027 and all years thereafter compounding interest at 10% on $25 Trillion would lead to $50 Trillion of debt by 2034. After $50 Trillion I can no longer do the math.

 

Rob McCrearyDeath By Compounding

Margin of Safety

By Rob McCreary

Margin of Safety

 

I admire Seth Klarman for his investment discipline and his realistic view of business models and securities analysis. As I have written before, his book “Margin of Safety-Risk Adverse Strategies for the Thoughtful Investor” is out of print but can be purchased online for slightly more than $2000. I have read it and gleaned some useful observations, most important of which is Mr. Klarman’s distinction between speculators and investors: “Just as financial market participants can be divided into two groups, investors and speculators, assets and securities can often be characterized as either investments or speculations…But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not.” His small cohort of value investors includes Howard Marx, Mitch Julius, Glenn Greenberg, Liu Lu, Jeremy Grantham and Warren Buffet. With the exception of Warren Buffet who has rock star status and can convince people like Jimmy Haslam to sell Pilot Flying J to him, their ability to put money to work in this investment environment is dwindling as almost all markets make new highs.

Value Investing Is Intellectual Humility

Their investment premise, however, is so right and fundamental that we all should pause and reflect on what is really happening in the Wall Street casino. At its core value investing is intellectual humility. It recognizes the need for a margin of safety in all investments because the future cannot be known. Once the intrinsic value of a business is determined, there has to be a further discount to account for uncertainty. Given the proliferation of collective products like ETFs and mutual funds, the retail investor wrongly believes that he mitigating risk because he is buying a low fee, low volatility product. Risk and volatility are easy to confuse but true value investors will tell you they are unrelated. Because the ETF product is meant to mimic an index or a sector, the important investment strategy is to compile a portfolio that accurately tracks collective performance. In market capitalization ETFs, winners are over weighted and losers are underweighted even to the point where 4 or 5 stocks like Amazon. Facebook, Google and Apple are providing all the juice. For example, just 59 stocks account for 50% of the market weighted value of SPX which is the S&P500 ETF.

Concentrate On The Losers

The value investor would be more interested in the losers. General Electric (NYSE,GE), for example, should be a target for value investing inquiry. It has lost 35% of its market value in the last 12 months and has become less important and least represented of all the Dow stocks making it an afterthought to ETFs. It has a 4.5% dividend yield but no free cash flow. An activist investor has been elected to the Board and a new CEO, John Flannery, who ran GE’s healthcare operations is ready to unveil a plan of reorganization on November 13. Speculation about a big dividend cut and a sale of assets is pervasive. Since GE has no free cash flow and has limited debt capacity, the dividend probably should go to zero. Instead it is more likely that the new management will liquidate assets to pay a reduced dividend. This is just a slow liquidation plan reminiscent of Sears. Reducing overhead expenses for shared services as you shed operations is always a lagging problem and GE has plenty of shared services.

If the new CEO has any guts he will eliminate the dividend at which point the stock will likely fall by another 30% and a value investor like Seth Klarman may be interested. The break-up value of GE net of debt and unfunded pension should exceed $15 per share. The likelihood of a break up is enhanced because the institutional sellers who are following analyst recommendations will sell and will be replaced by more activists who can wage a proxy contest to force a full break up.

Pit Boss Advice Is Suspect

The intellectual conceit about GE is evident, however, in the number of reputable analysts who have rated it a sell. Of the 17 analysts covering GE Yahoo Finance reports 5 are strong buy, 4 are buy, 6 are hold and 2 are underperform. Only Deutche Bank issued a sell recommendation earlier this year. Apparently none of the analysts, having ridden it down ,think it is risky enough to sell. This is like a casino suggesting a gambler on a losing streak substitute keno for craps; they stay in the game but with worse odds. Seth Klarman would not find any margin of safety in rigorous and well intentioned securities analysis. He would look for the free cash flow and, finding none, would move on to the next opportunity.

 

 

Rob McCrearyMargin of Safety

Take Control of Your Credit Proflie

By Rob McCreary

 

 

I am amazed at the number of highly profitable business models focused on monetizing individual identity, location and movement, credit, socialization, and dating. The internet has allowed many companies to leverage you for their gain and profit. But one of them stands out as extraordinary. The three Credit Reporting Agencies. (Experian, Equifax and TransUnion), have built a data trove of information about you without any input from you. Your financial identity is crafted by participating third parties who share their opinion about your credit worthiness. This industry has been around since the 1800’s and it is so important that, until recently, you even had to pay to get a copy of your own credit report. These three businesses are oligopolies that make huge amounts of cash by monetizing your credit interactions.

Getting Bad Advice

I got a sense of how important these three credit bureaus are when I started to read articles and hear advertisements advising the 143 million people whose credit profiles were stolen in the Equifax hack not to freeze their credit information. Freezing your credit information is so obviously the right thing to do for you and me, that I had to ask myself why would so called experts advise against it? More to come about that question later in the blog, but it has something to do with the $1 Trillion credit economy and maybe a Wall Street firm that owns a big stake in one of the three colossus of the credit economy.

Control Your Own Profile

When Equifax was hacked your personal profile compiled from telephone companies, banks, auto leasing companies, mortgage lenders, cable companies, credit card companies and hospitals was stolen. You didn’t have any input in its creation, never got paid one cent for third party use of your personal information, never consented to sharing your credit information, and had no recourse against Equifax for allowing that information to be stolen. Even if you never accessed the credit world, you still have a profile that is being monetized over and over again.

At least Facebook allows you to shape your own profile and gives you the satisfaction of making your timeline available to your friends. Even though it is shamelessly monetizing you and destroying your privacy, it is at least giving you a tool for socialization. Similarly, Google Maps may be compiling a data trove on your movements and matching you to retailers as you move around, but it is helping you find your way. In the case of most men it is also restoring marital harmony often dashed by a guy’s chemical inability to ask for, or listen to directions. That’s enough for me even though I know I am being used.

Follow The Money Trail

The money trail behind the three credit bureaus is interesting. All three of the “bureaus” are publicly traded even though the man on the street probably thinks these credit reporting agencies are either government controlled or not for profits. The whole credit economy also relies almost exclusively on them and their credit scoring system. For a few years before the big Recession, your credit profile and score was probably more important than your W-2 or personal balance sheet in obtaining a mortgage.

Equifax (NYSE,EFX) has a market cap of $13 Billion, Experian PLC trades on the London and Nasdaq exchanges (OTC, EXPGY) and has a market cap of $18.4 Billion and Trans Union ( NYSE,TRU) is the smallest with a market cap of $9.2 Billion. All three are extremely profitable. All three are still endorsed by Wall Street analysts and Jim Cramer even though, after the Equifax hack, if I were them, I would fear Elizabeth Warren, Bernie Sanders and wholesale regulation that might destroy my oligopoly. If these three firms were not the handmaiden of the credit industry, might you even see the kind of privacy protections that medical records are accorded? The analogy is heath care providers creating your health profile based on medical encounters and then sharing it with insurers and employers.

Goldman Has A $1.6 Billion Position

Finally, Trans Union’s biggest shareholder is Goldman Sachs (20.5%) and if we learned anything from The Big Short, the price of Trans Union won’t decline until the insiders get out. So even if a tsunami of problems are heading its way, the savvy shareholders in the big three credit bureaus will do fine. Keep your eye on how Goldman wriggles out of this one

Rob McCrearyTake Control of Your Credit Proflie

Cloning Private Equity With An Index Fund?

By Rob McCreary

Taking a page out of the Austin Powers movie “The Spy Who Shagged Me” the financial world has introduced its own Mini Me clones of the Private Equity Asset Class. The August 26 edition of The Economist unveils these two new offerings. One is offered by State Street Investments using their own database of private equity performance over the last 30 years, and the second is offered by DSC Quantitative Group using performance data on private equity from Thomson Reuters. The former does not add leverage, but the DSC product utilizes 25% leverage.

I was fascinated by these products. What we do in private equity is not formulaic so I was interested to learn how these two firms could replicate our outstanding performance as an asset class over the last 20 years. Often our returns rely on a strange brew of leverage,accretive acquisitions, expense management, debt pay down and superb management. It is hard to replicate with a synthetic product.

I looked at the website where  DSC/Thomson Reuters and State Street discussed their Mini Me process. The DSC index is shown below:

 

 

The blue line is their index performance compared to the S&P500 and Cambridge Associates PE index. The product has then been back tested to 2007 for high correlation. Both products then utilize a mix of individual stocks, derivatives, leverage and exchange traded funds from seven industry sectors.

According to the research on their own website, the secret sauce for the DSC product is the weightings for those seven sectors determined by econometric models that are way above my pay grade to explain:

 

So if I am understanding these products correctly, they will provide private equity returns for a fraction of the fees and expenses by using a mix of sector ETFs, derivatives, individual stocks and some leverage.  It is like asking Sherwin Williams what mixture of paint would have been necessary on a monthly basis to match blue walls as they fade in hue from 2007 to 2017 and then applying that formula to the future blue walls.

Wouldn’t it be a lot easier and a whole lot more representative just to buy a basket of publicly traded companies that act like leveraged buy outs? They already have managers. They utilize real leverage proportionate to PE capital structures and that debt has to be repaid. They have valuations expressed as a multiple of enterprise value to EBITDA that are comparable to PE valuations. They report and consolidate the tuck in acquisitions they have made. They incent managers with performance plans that are tied to stock performance. They compete in real industries and are benefitted and hurt by the same industry dynamics as their competitors. The product would have to be a mutual fund, but it would certainly come closer to mimicking private equity’s actual business model.

Create Your Own Mutual Fund

Here are a few suggestions for the basket by sector:

Consumer Non-Cyclical:

Constellation Brands (NYSE,STZ); wine and spirits;3.65x Debt/EBITDA; 20x EV/EBITDA

Consumer Cyclical:

Ply Gem (NASDAQ; PGEM); siding, windows and doors;3.8x Debt/EBITDA; 6.8xEV/EBITDA

Technology:

First Data Corp (NYSE FDC); Information Technology; 6.56 Debt/EBITDA; 12.3x EV/EBITDA

 Industrials:

Deere (NYSE,DE); diversified industrials; 6.6x Debt/Ebitda; 17.0xEV/EBITDA

Healthcare:

Kindred Healthcare (NYSE KND) general hospitals; 7.07x Debt/EBITDA; 8.36x EV/EBITDA

Derivatives May Disappoint

In any event, the last time theoretical derivative products (collateralized mortgage backed securities) were intended to give AAA protection to people buying a pool of substandard mortgages we had a Great Recession. I would bet right now that these two new products will not replicate private equity returns. In fact, I will bet they will not even beat the S&P 500. Why buy a derivative when you can create your own portfolio of real companies that act just like private equity? You can buy them for the price of the stock plus $4.95 per trade.

Rob McCrearyCloning Private Equity With An Index Fund?

Why Is This So Hard?

By Rob McCreary

 

 

The most important ingredient of success in private equity is not capital.  It is people. After 40 years of working in mergers and acquisitions as a lawyer, investment banker and private equity owner I come back to people as the biggest variable in my success and failures. Why is it so hard to find good people beyond the small group you really know?

My brother had a career as a management recruiter and he had a good nose for a fraud. He would always ask me “if this candidate is so good why is he on the beach?” What he usually meant was the good candidates have a job and will always have a job. So if you want to recruit the person for your job try to recruit someone who is working.

There always will be exceptions like the CEO we recruited because there was a health problem in his family and he retired until it passed and we had the luck of landing him. Or the person who has experience and gas in the tank but he is forced to retire because of an age requirement. But my experience with finding good leaders has certainly been below .500.

We work with some of the best recruiters in the Midwest so I reached out to them to weigh in on this topic anonymously. Here is what they had to say about why getting the right people is so hard.

Retired VC Recruiter: “It’s an arduous task and necessity that consume the likes of Jeff Bezos and Tim Cook.  They demand they meet the right people quickly and don’t have time nor interest with process and details. Usually, they make their decisions within 15 minutes. Nothing has replaced “gut” decisions. Having great “gut instincts” is an ART, not science and the very best hiring managers are more right than wrong.”

Cleveland Middle Market Recruiter: “It is a common fact in PE; the “win” moves with the executives, and candidly does not stay with the business. Today a challenge is more and more executives are making “life changing” money, and are very reluctant to take a next assignment, unless the payday is outsized. This will continue to be a major problem in attracting experienced C-suite executives, and lead to a dwindling talent pool.”

Chicago Middle Market Recruiter: He wrote a thoughtful memo about the funnel for getting to a successful candidate as requiring the timing to be right. Then the prospect has to have the right location, fit and experience and specific industry experience. Finally, the compensation and equity package has to be compelling and the candidate has to survive an arduous interview process: “Through this process you can see how hard it is to find the perfect executive and why it can take time to do so, and then think about not only the top executive, but then all their direct reports.  You have to go through this process on every search.

Getting and keeping talent is one of the unrecognized attributes of successful private equity firms. Those with a record for fair dealing, good communication and management support get most of the good candidates and a track record of successful exits does not hurt.

 

 

Rob McCrearyWhy Is This So Hard?

First Do No Harm

By Rob McCreary

Freakonomics has really interesting podcasts, and the last one of a three part series on August 20, entitled “Bad Medicine” did not disappoint.   The long standing view of the big three causes of death was Heart, Cancer and Respiratory.  According to The Center For Disease Control, here is the list for 2014 sorted by the number of deaths:

  • Heart disease: 633,842
  • Cancer: 595,930
  • Chronic lower respiratory diseases: 155,041
  • Accidents (unintentional injuries): 146,571
  • Stroke (cerebrovascular diseases): 140,323
  • Alzheimer’s disease: 110,561
  • Diabetes: 79,535
  • Influenza and pneumonia: 57,062
  • Nephritis, nephrotic syndrome, and nephrosis: 49,959
  • Intentional self-harm (suicide): 44,193

This was before researchers at Johns Hopkins actually began to question the data. It turns out that the third leading cause of death in the US is not respiratory related at all, but rather medical error. Think of the millions of decisions including NIH funding, charitable giving, medical school curriculum, hospital protocols, career choices, doctor reputation and malpractice insurance premiums that were all predicated on faulty data.

Medical Error Was Not A Choice

This occurred because the death certificate process has an international code that does not include medical error as a cause of death and the medical profession, medical examiners, and funeral directors often controlled the answer. For decades the medical person filling out the death certificate usually listed the problem you were being treated for rather than the proximate cause of death. So if you were being treated for a heart problem, but the surgeon nicked an artery during a heart valve repair and you died on the table, the cause of death was heart disease.

Medical error includes a spectrum of mistakes both passive and active, ranging from misdiagnosis to acts of negligence like a surgical mistake, or injecting the wrong dosage of insulin. Johns Hopkins research also showed that the more experienced the doctors were, the more likely to cause your death than the least experienced. As the number of procedures increase so does the possibility of medical error.

Business World Has No Equivalents

The analogy to the business world would be faulty reporting on 10Ks and 10Qs because management selected the accounting treatment they were using, without disclosing how it impacted the result and without oversight from auditors or SEC. I am sure there are thousands of CEOs who would have supported a reporting category called gross revenue that was selected by the sales team! In that case an investor, lacking the true information might lose money on his investment, but at least he would not have lost his life.

The greater issue raised by this massive misclassification is why did it take so long for someone to figure it out? I wonder how many times a week some medical person was aware that the Center For Disease Control classification codes did not allow truth to be told? I am also shocked that the tort industry did not figure this out but it is probably because the misclassification helped their chances at trial. If a medical expert had a choice of medical error and did not mark it, that evidence from an expert would be hard to rebut. The trial lawyers were actually benefitted by the conspiracy of silence.

Unfortunately, the Freakonomics podcast missed an opportunity to explode the myth of expertise. There is too much fake news, bad science and intentional deception based on shaky experts who want to promote a social or political point of view whose opinion also serves a financial interest. We should all bring a healthy dose of skepticism to any point of view that cannot be tested, debated or validated, and an even a more suspicious eye when a lot of money is involved.

Experience Trumps Credentials In My World

For me, an expert must pass the Lisa Vito test. Lisa is Vinny’s fiancee in “My Cousin Vinny” and introduced by Vinny as an expert witness on general automotive matters. Given she is a woman in a southern courtroom and she speaks with a New Jersey accent, the prosecutor, Jim Trotter, objects to her expertise. Evidently working in her father’s garage was not enough. Prosecutor Trotter thinks he can disqualify her by asking a tricky question on ignition timing:

Jim Trotter: Now, uh, Ms. Vito, being an expert on general automotive knowledge, can you tell me… what would the correct ignition timing be on a 1955 Bel Air Chevrolet, with a 327 cubic-inch engine and a four-barrel carburetor?

Mona Lisa(scoffing) That’s a bullshit question.

Jim Trotter: Does that mean that you can’t answer it?

Mona Lisa: It’s a bullshit question, it’s impossible to answer.

Jim Trotter: Impossible because you don’t know the answer!

Mona Lisa: Nobody could answer that question!

Jim Trotter: Your Honor, I move to disqualify Ms. Vito as a “expert witness”!

Judge Haller: Can you answer the question?

Mona Lisa: No, it is a trick question!

Judge Haller: Why is it a trick question?

Vinny(to Bill) Watch this.

Mona Lisa: ‘Cause Chevy didn’t make a 327 in ’55, the 327 didn’t come out till ’62. And it wasn’t offered in the Bel Air with a four-barrel carb till ’64. However, in 1964, the correct ignition timing would be four degrees before top-dead-center.

Jim Trotter: Well… um… she’s acceptable, Your Honor.

 

Rob McCrearyFirst Do No Harm

Disrupting Trust and Validation Business

By Rob McCreary

When Luca Pacioli introduced double entry bookkeeping in the 15th Century that single idea spawned acceptance of the modern corporation as a vehicle for collaborative business because it created an auditable trail of financial entries. The third party trust and validation business was soon to follow and has blossomed and grown ever since.

Until I read the July 15 issue of The Economist I had never thought about what a big part of the world’s economy is devoted to proving ownership, validating compliance, keeping a perpetual record and managing lists.  “The Long Arm of the List” by the editorial board of The Economist points out that blockchain technology may disrupt a huge part of world GDP.

Validation Is A Huge Business

Now you find validation business everywhere; real estate title agencies, accounting firms, vehicle license bureaus, corporate trust companies, forensic auditors, notary publics, depositary trust corporation (“DTC”), Federal, state and local permits, product warranty registrations, Visa, Amex and MasterCard, art auction houses, central banks, commercial banks, international passport control, chip readers, password protectors and birth certificate . These businesses thrive by managing the complexity of validating credit, ownership, title or identity. They are the foundation of an integrated world of commerce and they are indispensable for now. They are also massively expensive, but worth the cost.

The Cost Of Friction Is High

Imagine a world where you only paid pennies for a real estate title search (now $80 per transaction), or a real estate title policy (now $300 per house transfer). Think about a ledger keeping community for the entire stock market and bond market that is paid in ETF units to validate every single change in ownership and is not owned by Wall Street. Think about an independent registry for collectibles and precious gems that is 100% accurate in proving a real Monet and the identity of the Hope Diamond. Think about not having to rely on bureaucrats for licenses and permits. What if you did not need Visa, MasterCard or American Express to vouch for your credit? According to The Economist, and many other futurists, the blockchain technology that underpins bitcoin may threaten to disrupt all these expensive third parties.

Computing Power and The Distributed Ledger

To understand the blockchain technology I use the analogy of real estate titles. It is possible to search the ownership of some pieces of property in England as far back as 1066. So if you are a Australian retiree who wants to buy a country farm in Essex, you can hire a title examiner to look at the ownership ledger for that specific legal description going back to the first owner. For a fee the title examiner validates the seller’s chain of ownership and ability to convey clear title to the Aussie retiree.

The blockchain technology does the same thing for every bitcoin transaction by researching its title back to the original issuance. According to people who really understand the underlying technology and business model, it can be adapted to validate anything with a unique signature. That could be a fingerprint, gem coloring, an artist’s signature, a CUSIP number, an iris, a bank account or a digital currency. The business model or rules for the community that is utilizing the blockchain technology can be customized to the particular industry.

For example, bitcoin only has two signatures. It has a receiving account number that is used to receive and hold bitcoin. It also has a super secret sending number that allows any party who has the sending number to transfer bitcoin from the holding account. Successful hackers must have both numbers to steal your bitcoin. It is almost like a bearer bond that is ripped in half and must be reunited to trade. Crooks can’t bribe someone to validate a theft because the ledger for every bitcoin transaction is distributed among thousands of independent “miners” whose computers compete to validate every single transaction. If one miner is ready to approve a heist but there is no match of sending and receiving numbers, 40 other computers will not validate and the transaction will not be approved. The miners are also paid in bitcoin so they have no incentive to undermine their own currency.

Will New Business Models Emerge

The same concept may work for gems, stock and bond ownership, bank and trust accounts, licenses, permits and even databases. What if database giants like Facebook, Amazon and Google did not have a complete record of your friends, what you buy and what you are searching on the web? It certainly would be a lot more private. Blockchain technology also has the potential to disrupt powerful incumbents like governments. The editorial board of The Economist questions whether politics will stop the distributed ledger:

“Each time we use a distributed ledger we participate in a shift of power from central authorities to non-hierarchical and peer-to-peer structures.”

While for profit incumbents will keep trying to discredit this new technology and politicians will find ways to legislate against it by predicting massive job losses and disruption of the current order, technologies like blockchain that can cut costs and simplify and protect consumers always get adopted in the long run.

Rob McCrearyDisrupting Trust and Validation Business

Invest Like Pooh and Eeyore

By Rob McCreary

Extended time with the grandchildren always leads to the irresistible logic of A.A. Milne and his principal spokesperson, Winnie the Pooh. One of Winnie’s most insightful observations is about doing, or in his case, doing nothing:

“People say doing nothing is impossible, but I do nothing every day.”

The investment world has apparently not heard of the House of Pooh preferring the more action oriented House of Morgan or The Rothschild Bank. In fact, if Winnie the Pooh visited any investment web site or read any financial publication he would find the incessant bias for action a long way from “doing nothing” at Pooh Corner.

Eeyore Investment Philosophy

His gloomy friend Eeyore reminds me of the host of value investors who are predicting the end of days or, at least, the end of the stock market going up. But Pooh’s advice to Eeyore is the same advice that Grantham, Mayo’s James Montier, a big fan of Winnie the Pooh, gave Barron’s in a recent interview by Leslie Norton:

“You can’t stay in your corner of the forest waiting for others to come see you. You have to go to them sometimes.”

So GMO, a value oriented investment firm, actually suggests how you act if you are an Eeyore and want to stay in your corner:

  1. Build a robust portfolio where you can survive many different outcomes
  2. Concentrate your investments in one thing that will generate returns
  3. Look at alternative assets that are not correlated to the stock market
  4. Consider the option value of having cash when dislocations occur

For James Montier this means emerging markets, merger arbitrage, TIPS, and short duration bonds. He suggests taking your equity risk where you are getting paid the most for it. Use leverage but not to the point where it forces you to sell a perfectly good investment at the wrong time. James Montier sees a stock market reversion in a short period of time (over 7 years), but Jeremy Grantham, his partner and the eponymous founder of GMO, does believe it is different this time and we will see a slow, 20 year reversion to the mean in the stock market.

Private Equity Can Learn From Pooh

In the private equity world we have remained disciplined around Winnie the Pooh advice as well. We try to understand the intrinsic value of industrial and service businesses in the lower middle market. We look for strong and predictable cash flows. We stress test optimistic growth assumptions; if you are surprised on the upside it will take care of itself. We use leverage, but rationally. We return capital to investors when leverage falls below the chicken index-1.5-2x EBITDA. We own 6-10 companies in a diversified portfolio. We are actively bidding in a sellers’ market and succeeding by patiently waiting for reversion through “busted deals” or a seller’s preference for co-investing with us.

We have our own recipe for successful investing that both Pooh and Eeyore could endorse:

  1. Buy at a reasonable valuation
  2. Have a margin of safety
  3. Align your rewards with investors
  4. Be transparent
  5. Partner with management teams
  6. Engage knowledgeable limited partners
  7. Do hard things early
  8. Sometimes do nothing
  9. Don’t be afraid to change your mind
  10. Challenge convention

These principles are not flashy but they are the foundation for our own House at Pooh corner.

 

 

Rob McCrearyInvest Like Pooh and Eeyore

Better Than Ohio Sweet Corn

By Rob McCreary

Writing a weekly blog is a privilege and I usually have more ideas than I can handle, but this week all the news was old news and all the problems were old problems. There wasn’t anything new and exciting until I saw this morning’s edition of The Wall Street Journal, “ObamaCare For Congress” by the Editorial Board of The WSJ. This opinion piece has restored my enthusiasm for politics and my hope for fairness:

Over the weekend Mr. Trump tweeted that “If a new HealthCare Bill is not approved quickly, BAILOUTS for Insurance Companies and BAILOUTS for Members of Congress will end very soon!” He later added: “If ObamaCare is hurting people, & it is, why shouldn’t it hurt the insurance companies & why should Congress not be paying what public pays?”

The WSJ” actually is giving Trump the game plan. It points out that many aspects of the ACA were legislated by executive order. That includes a provision that treats Congress as a small business allowing its employees to buy on exchanges meant for poverty level people:

The law did not specify what would happen to the employer contributions, though Democrats claim this was merely a copy-editing mistake. A meltdown ensued as Members feared that staffers would be exposed to thousands of dollars more in annual health-care costs, replete with predictions that junior aides would clean out their desks en masse. 

Mr. Obama intervened in 2013 and the Office of Personnel Management issued a rule that would allow employer contributions to exchange plans, not that OPM had such legal authority. One hilarious detail is that OPM certified the House and Senate as “small businesses” with fewer than 50 full-time employees, and no doubt the world would be better if that were true. This invention allowed Members to purchase plans on the District of Columbia exchange for small businesses, where employers can make contributions to premiums. This is a farce and maybe a fraud.”

Hope For Equal Treatment

I am completely overwhelmed by the hope that Nancy Pelosi’s staffers will have to pay the same premiums and penalties, and suffer the same frustrations, as the rest of us. This is the alpha and omega of populism. Congress is universally viewed as a smarmy group of elitists who often dine on K street sushi while the rest of us go to Taco Bell for chalupas.

Privileges Are Not Popular

We pay their minimum wage ($174,000). We pay their generous retirement ($139,000 per year for 32 years of service). Their eponymous boss allowed them to circumvent ObamaCare (buy on exchange intended for people under poverty level). They are exempt from traffic laws while traveling to and from Congress (think DUIs). They are not subject to the same insider trading rules that put Martha Stewart behind bars. They have a franking privilege which means they can send you endless solicitations for money without paying postage (why fix the post office). They get free airport parking at Regan National. According to the Motley Fool they can get up to 239 days off each year but the consensus is they get 110 “recess days” where they are allowed to work from home.  If they die in office they get $74,000 more than a Navy Seal.  They get a nice budget to form their staff ($1.2 mil for Congress and $3.3 mil for Senate).  I am not sure they have accountability to a boss other than lobbyists who get them elected (why reform campaign finance).  They don’t pay change fees on airlines. They don’t live where they work, and we usually pay their commuting expenses.

No wonder their approval rating is 20%.

Even Trump Can Execute This Plan

Trump has little media or bi-partisan support so far.  When the only guy you can recruit for replacement Press Secretary is nicknamed “Mooch” you know things are not going to change. But The WSJ is throwing Trump a bone by serving up an Executive Order game plan for reforming health care by making staffers eat the same drek they are serving us. Who is going to support Congress? They are more hated than Trump (39% approval rating). While this would mean Trump taking on venerable institutions that form the bedrock of our governance system I think a Trump Executive Order would force bi-partisan health care reform because ACA premiums are predicted to rise 30% next year. Self-interest will prevail.

Even if there is no reform, the consolation prize would be wholesale resignations by the army of junior staffers who have no real world experience but are doing all the big thinking for their rock star bosses. For me that would be better than Ohio sweet corn in August.

 

Rob McCrearyBetter Than Ohio Sweet Corn