Financial Literacy And Capitalism

By Rob McCreary

I am surprised  so few of the millennial generation are preparing for retirement by participating in tax deferred retirement plans. My generation was introduced to the miracle of compounding returns when the retirement system was revamped in 1976. Over 40 years later $1000 invested per year compounding at 8% tax deferred is now worth $349,726.  My employers all encouraged participation in tax deferred retirement plans by offering employer matches. Sometimes that match was 1:1 up to 3%.  Even more amazing has been the introduction of the Roth IRA. You don’t get the same tax benefits when you contribute, but when you take withdrawals they are taxed at capital gains rates. Most of my peers bought into the retirement system and saved.

Millennials Are Not Using The Tax Deferral

This is not true for the millennial group who are about the same age as I was when I began contributing to my 401k and IRA plans. According to Maurie Backman, writing for The Motley Fool on March 9, 2018.  

Very few the millennials are investing anything in a retirement plan:

“ Apparently, younger workers aren’t getting the memo. In fact, 66% of millennials have no money saved for their golden years, according to new data from the National Institute on Retirement Security.  But here’s the kicker: It’s estimated that two-thirds of millennials work for a company that sponsors a retirement plan, yet only about half that many younger employees opt to participate. All told, only 5% of millennials are saving appropriately for retirement, which means the bulk of younger workers risk coming up short once their careers draw to a close.”

This Correlates To Low Financial Literacy

Interestingly, this low participation also correlates with a pretty disturbing analysis by The Wall Street Journal in their Daily Shot at financial literacy among high school students. This chart shows that only 5 states mandate education on financial matters for high school students and under 10% of the high school population has any education about financial matters. Maybe this explains how the millennials missed the miracle of compounding tax deferred returns:


There is also an implicit threat to the whole capitalistic system. If you don’t begin with some sort of financial literacy at an early age you also do not begin to understand how the capitalist system diverges from socialist and central economies. When you are invested in the capitalist system you have an incentive to promote it by protecting its fundamental principles. I fear that the central authority is crowding out an informed and financially literate population.

Student loans are a great example. The government intervened in what had been a longstanding local bank product. The result has been a disaster because students without an ability to pay have been underwritten and encouraged to pursue an education that is increasingly irrelevant to job creation. In the private system the money would not have been chasing marginal customers.




Rob McCrearyFinancial Literacy And Capitalism

Who Is Going To Do The Work?

By Rob McCreary

A lightning rod in the political world is immigration but less so in the business world.  In the lower middle market every one of our portfolio companies is looking for qualified workers who can pass a drug test, and perform entry level work.  I am not sure why Americans do not want these jobs? They come with benefits and hourly pay that is substantially greater than minimum wage. Maybe unemployment compensation, or food stamps, or workers compensation, or any other safety net work replacement is crowding out the number of citizens who really want a 40-hour work week? What happened to the dignity of work?

I cannot understand why President Trump wants to keep young immigrants who are not likely terrorists out of our country? I also cannot support the Democrat’s idea of supporting only immigration policies that lead to Democrats being elected. These political positions on both sides virtually ensure that robots will replace people, and entry level jobs will disappear. Making immigration a political issue rather than a business and lifestyle issue is a huge mistake. Here is a census of our window company work force:

These immigrants are not stealing American jobs. Portland, Maine has a 2% unemployment rate. The truth is Americans do not want to work as hard as the Somalis, Serbs and Croats who came from nothing and are thrilled to be working 40 hours a week with benefits. Many of our employees commute 2 hours a day for the privilege of working in our Portland, Maine window factory.

Another endorsement for immigration comes from a consultant we are using who specializes in manufacturing processes for window industry, and has been involved in hundreds of different manufacturing situations. He thinks our factory in Portland, Maine is one of the most productive and well managed in the country. We have our own comparison with a similar window operation in Ohio where the opioid epidemic is real problem. We simply cannot recruit a sustainable workforce, even though there is a strong supply of skilled automotive workers.

If we permit immigration to exist as a transcendent political issue we will have missed the chance to sustain America’s greatness through the marvel of our business world. The resulting diversity and ambitions of immigrants will be necessary to compete in an international business order that will reward innovation and a trained work force.





Rob McCrearyWho Is Going To Do The Work?

Do Millennials Play Golf?

By Rob McCreary

My only first-hand experience with Martians was “My Favorite Martian” which was a TV sitcom that aired from 1963-1966. Uncle Martin had special powers like the ability to disappear and levitate objects. While not quite as talented as Barbara Eden in “I Dream of Jeannie”, he was nonetheless my closest encounter with a Martian up to the dawn of the millennial age.

Don’t get me wrong. I love Millennials. They are quirky, funny, and tribal. To call them weird would minimize their importance to the price of Bitcoin, and our society’s hope for an unconventional future.

Take Out Was Pretty Challenging 

My first interaction with Millennials was a highly recommended sandwich shop in Damariscotta, Maine. My wife and I entered the shop and dutifully moved under a sign that said “Place Your Order Here”. We’ve been around long enough to know that you order under the sign, then you pay at the cashier and they bring the sandwich to your table, or package it for takeout. But that was not the business model at Fernald’s Country Store. We were the only people in line, but noted a beehive of activity among the sandwich makers, the cashier, the table servers and a few floaters who never seemed to be doing anything but circulating from the kitchen to the table space, but never with any sandwiches, or drinks: no sign of any table clearing either.

We are old and have no patience, so after about three minutes of just standing there I joked to one of the floaters, “Do we have to stand here and text our order to you?” She responded in all seriousness that “It would be a lot faster if you just made your order online.”  We were kidding, but she was serious. It then occurred to me that the sign might be just some memorabilia from the lost century that went with all the posters on the walls. Luckily, the cashier who was obviously the owner, was also old enough to know about My Favorite Martian, and she understood we actually wanted a face to face experience. Our order was taken. The money was paid. Millennials are from Mars.

Half Caffeinated Coffee Was Worse

Thinking this was an isolated incident, I found my next millennial experience even stranger. I was at a coffee house in Tremont called “The Loop”. Tremont is a trendy downtown Cleveland neighborhood and a gathering place for the Millennial Nation. I ordered a small, “half-caf” dark roast and the millennial coffee barista looked at me like “I” was from Mars. I said “You know, half decaf and half hi-test!” She blinked once, and then again and asked with doe like sincerity, “What is hi-test?”  I was stunned, but recovered quickly and explained that hi-test means fully caffeinated, just like premium gasoline. She was enthralled, but let me know that she has never pumped gasoline so she really did not know what I was talking about.

Business As Usual Was Unusual

The coffee incident was nothing compared to the seating area. There were hundreds of vinyl records on display and a turn table, I was just about to search for the lava lamp and Jefferson Airplane’s “Surrealistic Pillow” when I heard what sounded like a cross between Leonard Cohen and Boy George waft from the speakers (might have been my old Harman Kardons). Like an Alice in Wonderland cartoon, things got “curiouser and curiouser!”.  As I scanned the room full of millennial patrons, there were tats everywhere and, even though there was business being conducted, it looked like the people at the tables were texting each other rather than talking face to face.

The patrons were also checking us out because we were wearing sport coats, penny loafers and at least one of the guys was taking photos of a building site out of his briefcase. I think the Millennials thought we were probably going to take phone pictures of our photos and text them to each other, but I secretly know they were thinking we were a sub species and wanted to demand “Earthlings Take Us To Your Leader”.

I wish I had more experiences with Millennials. I want to learn about Tatoos, their interesting hair styles, their music (I think it was music), and their fascination with Bitcoin and cryptocurrencies. Most of all, however, I want to find out whether Millennials play golf.

Rob McCrearyDo Millennials Play Golf?

We used to call it Winter

By Rob McCreary

January of every year is wonderful for the prediction industry. Almost everyone who made a prediction in the prior year is taking credit for the few things they got right and, conveniently forgetting or minimizing what they missed. There are only a few groups who actually score themselves like Barron’s and certain columnists in The Economist. The rest of us rely on failing memory and a complete lack of accountability.

Almost all of the January savants are quick to point out the macro trends and tailwinds that will influence the shape of 2018 like Tax Reform, the price of oil, reversals of Quantitative Easing in the US and Europe, the weak dollar, the travails of cryptocurrencies, capital spending, deficit spending, Fed interest rate increases and the VIX.  However, based on my experience in the first 20 days of 2018 in Cleveland, Ohio Betsy Kling had more impact on our local economy than Warren Buffet, Jamie Dimon and Jim Cramer.

Our Chief Meteorologist

Betsy Kling is our favorite weather personality and she has a following that can challenge Justin Bieber, Taylor Swift and Oprah Winfrey all rolled into one. Her resume is pretty modest. She graduated from Bowling Green State University and received her Certification in Broadcast Meteorology from Mississippi State University. She has been a Meteorologist for 20 years and the Chief Meteorologist at WKYC-TV for 14 years. Like the oracle from Delphi she divines millibars and winds aloft from Doppler radar and atmospheric sensors to predict weather, and most recently, end of days.

I watched her single-handedly shut down most of greater Cleveland for about 36 hours with her prediction of a cataclysm of sleet and ice on Friday, January 12, followed by several feet of snow and freezing temperatures on Saturday, followed by more freezing and more snow on Sunday, and again Monday. As far as I know, the only event that took place was the Browns “0-16 parade” – suggesting losing is inexorable. Except for the temperature, Betsy pooched this prediction in a big way (no ice/ little snow) and probably cost greater Cleveland businesses more money on Martin Luther King weekend, than Lebron has made in his career. The other thing about her job and most of the expert prediction business, is nobody seems to care. Just think where we would be in private equity if we were as consistently wrong about big predictions as Chief Meteorologists.

They Use To Just Call It Winter

When I was a kid they called this winter and we dealt with it. I can’t ever remember anything being cancelled. Gross Domestic Product (GDP) marched forward without interruption from the weather. Weather is now entertainment. It takes on tsunami proportions and is usually accompanied with a name or acronym that makes it memorable. It is frequently blamed for quarterly earnings shortfalls.

I have learned that The Weather Channel now has a materiality standard (population or geography) for naming not just hurricanes but also winter storms. Any storm on the East Coast, especially one that touches New York City is automatically a super storm. There is no worry or mention about the middle of the country. These are Red states in the fly over zone, devoid of economic impact and deserving of all the bad weather they get because their citizens are too stupid to live in New York or California. This is certainly supported by The Weather Channel’s naming criteria:

“The Weather Channel’s winter storm naming system is based on how many people or how much real estate is affected by the worst part of a storm. A localized but extremely impactful winter storm could affect 1,000,000 people, but since it doesn’t reach a 2,000,000-population requirement, it wouldn’t receive a name.”

Bad News For The Fly Over Zone

This is bad news for Buffalo, Bismarck, and Butte where a 90-year-old who dies shoveling eight feet of snow is remembered as having died of natural causes, but his counterpart in New York is remembered as having been ravaged, and ultimately slain, by Killer storm Kyle that shut down the entire East Coast and left millions without power.

All I know for sure is I want this job, I get the power to interrupt life based on Doppler radar predictions, and I am almost always wrong and no one cares. They call me an expert and I am more popular than free cell phones.

Rob McCrearyWe used to call it Winter

I Thought Medicare Was Free

By Rob McCreary

One of the most anticipated dates in your golden years is the time just before you turn 65 when you are thinking about the government starting to take care of you.  You probably have already applied for your AARP card and also are getting senior discounts at the movies. Like me, you were probably disappointed to find that the AARP group is a combination of a slick marketing organization and a political party. They want to program what you buy and how you think.  The senior discount at the movies really is not that great because you start attending matinées like you did when your parents dropped you off on Saturdays. Our last movie savings, for example, was 25 cents below the matinée price.

Finally A Free Lunch

But your expectation for Medicare was different because you have been paying premiums for 40 years.  I was simply quivering with anticipation because it was advertised as being free. Well not really – Only Part A is free and Part A only covers hospitalization. The day-to-day interaction with the rest of the health industry and prescription drugs are covered by Part B and Part D and they are not free. Part A also doesn’t cover the medigap which is about as wide as the Grand Canyon.

I’ll Stay On My Old Plan

                 When I found out that Medicare was not free and I was not retiring any time soon I asked the logical question. Am I better off waiting to enroll in Medicare and staying on my group plan as supplemented by a company sponsored HSA account? At first I was hopeful because I found advice that suggested you can defer enrollment if you are still employed and participating in the group plan. However, that advice was like the free Medicare. You are not permitted to remain on a group plan if you are a small group employer, which means less than 20 employees. This made no sense to me because there are thousands of small businesses with the financial ability to support healthcare plans as supplemented by Heath Savings Accounts. Aside from the premiums being reasonable, the high deductible plans we have always used made all kinds of sense to me as incenting careful first dollar expenditures and, ultimately, catastrophe insurance. I guess this is exactly the reason the insurance industry convinced the government to design Medicare to force small groups to jettison sick and sicker oldsters from their “Cadillac” plans. I had no choice but to enroll in Medicare within 90 days before or after my 65th birthday or else I would be forever barred.

 Your First IRMAA

                By now you can understand why I was starting to suspect retirement healthcare was rigged, but I was still in the early hours of my education. The next thing I got from Social Security was my IRMAA adjustment. Medicare did not advertise this adjustment when I was signing up, so I had no idea that in 2007, as a stop-gap funding plan, Congress elected to slam high earners even if they are in perfectly good health by having them pay up to 3 times what a lower wage earner pays for Part B. Maybe this is why the government accepted the sick and sicker oldsters? So now Medicare is morphing from free to not so free, and I am being asked to pay my fair IRMAA share after having contributed at the payroll max for more than 40 years. At this point I was surprised but resigned. What else could I do? Surely, the surprises had ended.

Unbeknownst to me, there was more to come because in my first few transitional months on Medicare I was still covered for the gap in Medicare insurance by my employer group plan. In essence Anthem served as the medigap insurer for the 20% that Parts A and B won’t cover. In fact, they did so happily at full premium!!!! What a deal for them- 20% exposure for 100% of the old premium.

A Hole in the Donut

               Fast forward seven months and now my wife and I are both 65 and we both are enrolled in Medicare and we are off the group plan, but we have a serious gap in our coverage. Welcome to the world of medigap- those insurers who charge premiums to insure virtually everything that Parts A and B won’t cover. This is Plan F coverage, and you can get Plan F insurance without any medical underwriting during the open enrollment period. This is a big deal. If you have a preexisting condition and you miss the enrollment period, you may have to get a medical exam. Also, if you elect Plan F coverage from so-called “Medicare Advantage “ providers and later on you change insurers, you will have to pass medical underwriting. These network plans are cheaper in the beginning, but if you don’t like their group restrictions, you may never get medigap insurance if you try to switch.

A Hole in the Donut Hole

                After A, B and F there is still a hole in the coverage. You have to think about prescriptions. Parts A and B and Plan F don’t cover meds. It is an altogether separate plan design also with open enrollment but with four phases of coverage that start with the patient deductible ($400), then the patient pays 25% up to $3750, then the patient pays 75% up to $5000, then the government pays 95% above $5000. Also, because our prescriptions are different I get my meds from Walmart/Humana and my wife gets hers from Aetna/CVS.

You’ll Need A Sherpa For This Journey

                I got the final bills from the wonderful consultant, Kelly Walter, who led me through this mine field of inscrutable legislation. I ended up paying almost 2.5x what my share of the group plan would have been with my employer. I also learned that the wonderful Health Savings Account that I so carefully built, cannot be tapped to pay most of the Part B, Part F or Medigap premiums.

I thought Medicare was free and now learn that all I can buy with my HSA is band aids and hearing aids.



Rob McCrearyI Thought Medicare Was Free

Bitcoin Futures – The Grizzly and the Salmon

By Rob McCreary

Anyone who owned Bitcoin for long enough to have experienced its wild appreciation was excited to learn in December that the Chicago Board of Options Exchange (CBOE) was authorized to permit trading in Bitcoin futures (CBOE,XBT). Somehow I knew this would not be what I expected and the game would be rigged in favor of insiders. I guessed this for four big reasons:

  1. Most of Bitcoin owners are retail investors.
  2. Retail investors were basically prohibited from shorting the XBT.
  3. The CBOE was designing a “cash settled” product.
  4. Institutional owners like Winklevoss twins saw a one time chance to lock in gains without selling much Bitcoin

I was not disappointed in the final rules and I was not surprised by the result. Up to and including the first 3 days after the CBOE began futures trading the price of Bitcoin futures, XBT, spiked. The price of Bitcoin actually bounced off $20,000 in intraday trading. Any speculator who was long Bitcoin knew enough to try to hedge his gains by shorting Bitcoin on the futures exchange.

Retail Investors Can’t Sell Short

It would be just like shorting General Electric (GE,NYSE) when you owned the underlying stock! If the stock went down, you made money on your short position but if the stock went up, you lost on your short bet but made money on the appreciation in GE. Unfortunately, in early trading there was only one securities firm in America who would allow its customers to short XBT on the CBOE. That firm required a cash margin of 45-50% which meant the retail investor had to deposit cash instead of Bitcoin. I called the CBOE and talked to a trader on the futures desk. He said that only institutional customers were permitted to short Bitcoin but retail investors were welcome to buy a futures contract betting that the price of Bitcoin would rise. In a recent article in the January 8, 2018 edition The WSJ implies that the smart money (institutional) is short and the dumb money (retail) is long. What they don’t says is how nearly impossible it is for a retail investor to short XBT. The chart below suggests the little guy is choosing the long position when, in fact, it is the only side he can buy.


When I saw this chart I immediately thought of spawning salmon all stacked up trying to get back to their spawning ground and a grizzly bear catching them in mid leap.

The Winklevoss Twins Controlled The Market

The salmon were retail investors in a frenzied state of wanting to get rich quick and jumping out of their shoes as their Bitcoin bet made higher and higher levels. I then thought of the Winklevoss twins as the grizzly bear who was allowed to go short but who also owned half a billion dollars of Bitcoin and had enough clout to actually condition the market frenzy. The little guy was only allowed to go one direction but the institutional investor could be on both sides of the trade.

When the little guy saw his Bitcoin at $20,000 per Bitcoin he wanted to lock in his good fortune. However, he was quickly disappointed to discover he could not hedge. Alternatively, many tried to sell. Meanwhile the Winklevoss twins probably shorted the XBT futures contract , but as experienced traders they also timed  actual sales of Bitcoin for maximum market pressure on the downside. Then the stories about Bitcoin energy consumption and government regulation began to emerge.The price of Bitcoin cratered.

The salmon also discovered that settling in cash is different than settling in the underlying security that you already own. As the price of Bitcoin declined holders of the long position on XBT forfeited their option premium to the Grizzly and then desperately sold Bitcoin to try to compensate for their cash option premium loss on the derivative product. This assured a tax bill and their complete destruction on their futures bet.

CBOE wins big. Winklevoss twins win big and lock in gains on their holdings without selling much in the primary market. Grizzlies get the salmon. Round Two may be starting soon because there are still a lot of salmon backed up at the dam.


Rob McCrearyBitcoin Futures – The Grizzly and the Salmon

Wall Street Journal Innovation

By Rob McCreary

Wall Street Journal Innovation


For those of us who are challenged by the pace of news and information or the great majority of us who simply do not have the time to dig into anything, The Wall Street Journal has an answer. Over the last six months subscribers to The WSJ have been encouraged to sign up for “The Daily Shot”. This is a graphical summary of the current news in the form of charts and graphs with a link to the longer article. After “speed reading” the Wall Street Journal this way for several weeks I am amazed at how well it paints a picture of macro concepts like the flattening of the yield curve, the growth of debt in China as a percentage of GDP, tightening of employment markets, currency swings, trends in the M&A markets and growth of Bitcoin.

I highly recommend subscribing to The Wall Street Journal just to get The Daily Shot. Here are a few examples:



I will continue to use this convenient source of information for my blogs as well as a general understanding of trends in finance and commerce throughout the world. This is the new “Heard on the Street” column in graphs and pictures for people with attention deficit disorder.


Rob McCrearyWall Street Journal Innovation

Going Home

By Rob McCreary

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.


Rob McCrearyGoing 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