Lessons from the Panic of 1907

Few remember that the Federal Reserve was created in 1913 because of the panic of 1907. This panic was caused by the failure of several banks that were overly indebted and had made a lot of bad loans. If this sounds familiar to you, you’re not alone.

The lessons of 1907 were that when a banking panic occurs, the smart bankers of the world need to get together, examine the books of questionable banks, draw a line in the sand on which banks are solvent and should be supported, and let the rest go into bankruptcy to be sold off piecemeal to solvent institutions and investors.

Back in 1907, the leader of the smart bankers was J.P. Morgan. Although vilified for the power he displayed in this role, Morgan managed to save the economy from complete collapse because he understood banking better than most and had the knowledge, experience, and iron will to make things happen.

The Federal Reserve was originally created to serve this purpose (so that some would-be J.P. Morgan would not have so much power), but its mandate has drifted significantly. Instead of drawing a line in the sand between solvent and insolvent bankers, it now tries to set monetary policy to provide full employment and manage inflation at reasonable levels.

Note how markets have reacted to the Federal Reserve’s policies over the last 2 years. At first, markets were assured (early 2007 to mid 2008). Now, markets are tanking because of the Fed’s actions. If you believe markets are tanking because of conditions beyond our control, you’re not alone, but I don’t think you’re right. Markets are tanking in reaction to inept policy, not because of economic circumstances, per se.

Instead of allowing bad banks to go under and supporting good banks, the Fed is doing the opposite. Its supporting the bad banks, thus punishing good banks for their prudence. Markets are tanking for good reason.

Letting bad banks go under would hammer the bond and equity holders of such institutions, but their customers need not suffer. In almost every bail-out so far, banking customers were safe. What was threatened were the bond and equity holders, including the stupid banks who had invested in such bonds and equities.

Bailing out the ineffectual at the expense of the effective is a recipe for disaster, and markets will continue to tank as long as such a policy is followed.

In the long run, the truth will out. The bad banks will go under anyway, and the day of reckoning will merely be delayed at great expense, pain and frustration.

If, instead, the government would draw a line in the sand and let the insolvent go under by effecting an orderly liquidation while supporting the solvent, the impact would be painful but over quickly.

Regardless of how the Fed and U.S. government try to solve this problem, the hardworking people of this country will provide the bailout. That bailout will come in the form of hardworking entrepreneurs, prudent businessmen, diligent workers, and rational consumers.

Inept policy will only delay recovery, it will not prevent it.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Sticking to the basics

For the last 5 months, markets have been nuts. The price swings have been awful and painful to watch.

During times like this, it’s hard to focus on the fundamentals because watching your portfolio get diced every day is very distracting.

But, getting distracted, especially when great value are to be had, will lead you to poor returns over time.

How am I avoiding distraction? I’m sticking to the basics: looking at businesses I understand, evaluating underlying business economics, evaluating management, and examining valuation versus price.

First off, I can’t get good returns by looking at businesses I really can’t understand. No amount of research will allow me to understand a biotech firm, so I don’t try to. Sometimes, I can educate myself enough to understand a firm, but it doesn’t make sense to. Why figure out how to pick ripe fruit high on a tree when the same fruit can be picked off the low-hanging branches? If I can understand the firm without having to learn particle physics, I have a good candidate for further evaluation.

Second, I evaluate a business’s underlying economics. What kind of returns will it generate over time? What competitive advantages does it have? Are those advantages stable, or does technological innovation and industry shifts make predicting the future almost impossible. Businesses with good economics are great candidates for potential investment.

Third, I evaluate management. Are they honest? Do they speak plainly and describe their business and its dynamics well? Are they compensated rationally? Do they own a chunk of the business themselves with shares purchased on their own (not options or restricted stock grants)? Do they do what they say over the years? Do they measure the business’s performance rationally? A business I understand with good economics and management is an excellent candidate for potential investment.

Last, I examine price versus value. What is the company worth to a rational, long-term investor? What are the discretionary cash flows relative to the price of the business? What kind of growth rate and return on equity can be generated in a normal environment? Does the business carry too much debt making it susceptible to insolvency during difficult times (boy is this important)? If value is significantly above price, then the business is a very good candidate for purchase.

When the economy is in the tank and stock market prices are gyrating wildly, it’s best to focus on the fundamentals. Right now, I’m focusing on businesses I understand with good economics and good management selling at cheap prices. There are a lot out there right now, so I have a lot of work to do. And, that’s a nice “problem” to have.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

In praise of idleness

When the economy is in the tank and the stock market is down 40% and going nowhere, there is a great temptation to do something–anything–to improve short-term results. This is almost always folly.

In almost any field, action is the mark of progress. An architect waiting for inspiration to hit is a slacker. A manager waiting for problems to solve is a buffoon.

But, an investor who doesn’t trade frequently is an enigma. He’s seen as being a slacker buffoon, but in reality may be doing a lot of thinking and research, and deciding that acting is a poor choice.

You see, stock market prices move much more than underlying values. Any attempt to chase these almost random price movements leads to poorer returns than doing nothing.

Because the common paradigm is that activity equals progress, most people are confused by an investor who isn’t trading. When things aren’t happening, progress doesn’t seem to be achieved. Right?

That’s why idleness in an investor is virtue. Doing research, comparing alternatives, watching underlying fundamentals of current investments, but infrequently trading denotes a capable investor.

Frequent trading is like chasing fog: a lot may seem to happen, but little is achieved.

Patience is truly a virtue in investing. If you’ve invested in the right businesses at the right prices, the best thing to do is not to trade.

Research alternatives? Yes. Study more deeply current holdings? Yes. But, don’t mistake such work, and lack of trading, for lack of progress. In this case, idleness is praiseworthy.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.