The economy’s white knight

There’s been a lot of talk about what will pull the world economy out of the funk it entered a year ago.

Most of the focus has been on the U.S. consumer and what they can do to pull us out of our economic malaise. After all, consumer spending is usually 60%-70% of the economy.

Others, instead, focus on the governments of the world, whether U.S., Chinese or European. To this way of thinking, the economies of the world have come off the tracks, and only government can get them back on the again and moving forward.

But, I think this misses the most likely source of future economic growth: businesses.

Consumers are tapped out, they have to pay off debt and build up savings. Most governments are tapped out, too, they are simply borrowing from others in hopes that spending now will produce growth sooner rather than later. The financial sector, which can usually spur growth with lending and investment, is even more highly in debt than consumers or governments, so they don’t seem likely to be the impetus for growth.

Businesses, on the other hand, are in relatively good shape. Businesses faced a very tough recession in 2000-2002, and they have since lowered their debt and learned to react quickly and decisively to tougher economic times. They tend to be leaner and more flexible than they were a decade ago, and many have large cash hordes they can put to work.

In my opinion, this is where growth will come from sooner than any other place. In fact, I believe it’s already happening.

Now that demand seems to be stabilizing, businesses will start hiring again. The U.S. economy needs to shift from a consumption to a production focus. China needs to shift from a production to a consumption focus. Businesses will lead the way in this shift because they will see the most profitable ways to benefit from the new landscape. The smart businesses, the lean and flexible ones who see the future first, will expand production and meet business demand first. They will then have the profits to hire and expand more. And, thus, the upward cycle will grow and expand.

This will not happen quickly. Production won’t go from 30% of the U.S. economy to 50% overnight. And, 30% of the economy will not make up for the 70% of consumption all at once. It will be a slow, steady growth that will build a more stable, more production focused economy.

This will be a good thing. For, as Jean-Baptiste Say said almost 200 years ago, supply creates its own demand. Production, after all, must precede consumption–you can’t consume what hasn’t been produced. Having an economy more focused on production than consumption will grow more steadily and resiliently.

The economy’s white knight is riding to the rescue, and below the radar of almost everyone. Businesses will lead the way.

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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Focused investing

There are as many different ways to invest as there are stars in the sky.

And, this is why most investors are dumb-founded when trying to pick investments–the choices are limitless.

One of the key problems is that most investment managers are not terribly honest about what they do. They say they do in-depth research, they say they don’t just invest in the market, they promise the moon and stars…

The reality is that the average mutual fund owns 172 stocks. That means their average position size is 0.6%. Even if a 0.6% position doubles, you won’t feel the benefit much.

Added to this, with 172 positions, how on earth does an investment manager do in-depth research on individual companies? Just keeping track of quarterly announcements would utterly over-whelm them. They can’t possibly follow 172 companies in-depth!

The average mutual fund charges their customers around 1% a year to manage money. But, with 172 holdings, it’s almost impossible for them to beat the market after fees. Why not just buy an index fund and get charged 0.2%?

The alternative is to invest with a manager who focuses on only a few investments, let’s say less than 25. Such investors at least have the possibility of beating the market, unlike someone who owns 172 stocks.

If you look at the records of managers who have strongly out-performed the market over the long term, you will almost certainly have found a focused investment manager.

There aren’t that many managers who focus on fewer than 25 investments. Why? Because most invest managers lack the courage of their conviction. As Warren Buffett put it, “wide diversification is only required when investors do not understand what they are doing.”

Added to this, being focused on only 25 investments frequently means higher short-term volatility and requires a lot of patience because short-term under-performance is inevitable.

But, the benefits can be huge. Focused investing can lead to out-performance that can have a huge impact on your long term wealth.

It may take time, it may take patience, it may take a stomach that can handle nerve-wracking ups and downs, but for some investors, it’s well worth the effort.

Besides, what would you rather do with your time? 1) spend several hours picking a manager who knows what they’re doing, or 2) spend the rest of your life diversifying, rebalancing your portfolio, and getting mediocre results anyway?

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.

One clunker of an idea

I usually try to stay away from political commentary, but the “cash for clunkers” idea needs to be addressed from an economic standpoint.

If you haven’t heard about it, the “cash for clunkers” program gives cash to people who trade in their low mile per gallon vehicles to purchase newer, higher mile per gallon vehicles. From the way I understand it, you get $3,500 to $4,500 (depending on the mileage of the vehicle you purchase) for “cashing in” your “clunker.”

Now, let’s trace this idea from beginning to end and understand what’s going on. The government is paying people cash to throw away functioning cars. Where does the cash they are giving away come from? It comes from issuing government debt.

That means the government is raising money from someplace (China, Japan, Middle East, U.S. investors) that would otherwise have been invested in some other way, and using it to pay people to throw away functioning cars. Why?

(I’m sure it has nothing to do with the fact that the U.S. government has become a huge investor in Chrysler and GM. Note: I’m being sarcastic).

One reason is that most economists look at economic growth in terms of new things being sold instead of return on investment. Gross Domestic Product (GDP), which is the figure most economists and government employees watch, will show an increase because of the cash for clunkers program. GDP increases whenever things are sold, the government spends money, or we export more than we import.

Using this magical math, the economy grows any time consumers or the government spends, whether or not that’s positive return on investment spending.

But, let’s think further about this issue. Say you buy a car because of the cash for clunkers program. Because you are now making payments on a new car, and those payments are almost certainly higher than the payments on your clunker, then you have less money to spend on other things. In other words, spending has simply been taken from one place and put in another. GDP will show a spike because you spent a lot money today on a new car, but then you’ll have payments plus interest in the future which you can’t spend. Is that positive return on investment growth? Not likely.

Plus, the government has incurred debt to finance this spending. That won’t show up in GDP figures, so everything seems peachy. But, borrowed money needs to be paid back, with interest, and where will that money come from? It’s simply been borrowed from the future!

When I make an investment, the issue isn’t just: does growth occur? I must get a return on investment more than what was put into it.

Suppose I bought a company for $100,000 and had to put $10,000 into it in the first year. Suppose I only netted $5,000 in earnings. No one would consider that a wise investment. Suppose I put $15,000 into the business the next year and made $7,500. That would be growth, right, from $5,000 to $7,500, but I don’t think anyone would rejoice in putting in $25,000 and getting $$12,500 back over 2 years.

So, why would someone consider it a good investment to borrow money to pay people to buy something they don’t need? I don’t get it.

By such reasoning, it would make sense to burn down all the houses in my neighborhood so we could spend money to build new homes. If that’s considered economic growth by someone, then cash for clunkers makes sense.

But, to me, it doesn’t.

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.

Process versus results

Every few months, I seem to return to this subject because it’s so important to successful investing–there is a world of different between investment process and investment results, especially in the short term!

Results are what you get, process is how you get it. Confusing the two leads to all kinds of investment mistakes. Why?

The reason why, to over-simplify, is randomness. The world is so complex that you can’t possibly know all the variables that can impact a particular result. You may have a bad results, but a good process. Or, you may have a bad process, but get good results in the short term.

If you have the right process, but watch short term results too closely, you may give up before the big payday comes. If you have the wrong process, but get lucky and have a good result, you may continue to implement the wrong process leading to terrible long term results.

Let me give a concrete example because the subject probably seems way too abstract so far.

Suppose I make you an offer: would you pay me $200 for a one in six change of winning $1,000? I’ll roll a die, if it comes up 1 I’ll pay you $1,000, if it comes up 2-6, I keep the $200 you pay me to play. Sound like a good offer?

No, it’s not. You have a 1 in 6 chance of getting $1,000, so you have a 16.67% chance of winning. Multiply the probability, 16.67% times the payout, $1,000, and you come up with the expected value: $166.67. Because you have to pay $200 to play and the expected value is less, you shouldn’t play.

Let’s suppose you haven’t done the math above, and you decide to play. Suppose you win. Winning will be psychologically exhilarating, releasing all kinds of feel-good endorphins in your brain. This “high” feeling will encourage you to play again. But, the more you play, the more likely you are to lose. The odds and payout are against you.

The good result, winning luckily the first time, may encourage you to continue using a bad process, playing a game with a negative expected value.

Let’s suppose I tell you it costs $100, instead of $200, to play the game. Would you play now? Because the expected value is more than the price to play, you should play.

Let’s suppose you decide to play, but you lose the first time. Let’s suppose you play again, and lose again. The more you play and lose, the more you feel like you should quit the game. The price of playing over and over again and losing takes it’s toll on you, you begin to get angry, frustrated, and want to quit. Should you?

No. The odds and payout are in your favor, so you should keep playing. Just because the outcomes look bad over the short term, doesn’t mean they are bad over the long run. In the long run, you’ll win if you keep playing, but that takes a lot of discipline.

I think about process and results all the time. Sometimes I make a good process investment and it doesn’t do well. I beat myself up for being so stupid, but that doesn’t mean my process is bad or that my long run results will be poor. If the odds and payout are in my favor, I’ll win if I keep implementing the right process. Sometimes I make a bad process investment and it does well. This encourages me to repeat the process, especially if I don’t examine whether I was lucky or good. But, implementing the bad process will eventually catch up with me, the odds always do, and I’ll lose in the long run.

Focusing on process is vitally important in any situation where randomness plays a part. If you focus too much on short term results instead of the process, you’ll make costly and repeated mistakes.

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.