Easy Money

Common sense tells us that tight money is bad for profits. The cost of money is an expense, and if money is hard to get, it limits the amount of capital available for expansion. But, life is a paradox were all blessings are mixed. In no area of human endeavor is this more true than investing in equities. As a money manager, we like to invest in stocks that are not popular and try to avoid, like the plague, all areas were stocks have become popular and money is flowing freely. The best returns on capital investment come from investment at times or in places were money is hard to get. Easy money will always bring poor returns on capital investment.

 

At one of the first Berkshire Hathaway annual meetings I attended, Warren Buffett described his system for allocating capital. The managers of Berkshire's various wholly-owned businesses could get all the money that they wanted, but they had to pay. I forget the actual numbers, but as I recall the rates varied from company to company depending upon the industry and typical capital requirements within their sector. Interest rates were generally a couple hundred basis points above market rates. On the other hand if the CEO returned money from earnings to the parent, Berkshire paid a very nice return (2 to 3 percent above the respective interest charged). It seemed a strange system to me then, but as I have thought about it over the years it has started to make sense.

The point is to make money expensive. The business can have all the money it wants but in most cases they are going to be better off giving the money to Warren to manage. The real cost of money within the Berkshire system is not the interest rate (the amount that you paid Berkshire to use the money), but the opportunity cost (the profit you lost by not turning the money over to Buffett). This makes money at Berkshire very expensive all of the time.

The one unbroken rule on Wall Street is that easy equity and cheap leverage inevitably attract those species most dangerous to investment capital: mediocre talent with no comprehension of the limits of their talent, and intelligent people who are ethically impaired.

Why easy money is bad for the stock market, and why corporate CEO's think that if they are smart enough to get their hands on large piles of cash they must be smart enough to spend it!

"More about the evils of cheap capital and why tight money is good for investors. "There is no better way to make managers understand how valuable capital is, than to charge them for it." ...Warren Buffett

Easy money generates poor returns and high risk for investment capital. Hard money means good returns and low risk. You bring me a model that shows how money is flowing, and maybe we could use that to measure risk.

This is also a story about central banks. Central banks occasionally become enamored with easy money and every time the eventual result is disaster. Think about the United States in 1920's and 1970's, and about Japan in the 1980's. Periods of easy money have been very bad for the nation's economy. Not only does easy money breed inflation, it seems to encourage all sorts of bad behavior. There can be no better example of this phenomenon than the resent tech bubble. The same result appeared in both 1920's and the 1970's.

 

"The US economy can only be protected against the real dangers of a bubble breaking by the Fed and its Chairman being willing, at rare intervals, to take some substantial political risks. They must attempt to identify and moderate major stock bubbles and be prepared to bear some consequences. If they are not prepared to do this, then the risk level of the economy will rise substantially." "Feet of Clay" by Jeremy Grantham

(It is time to turn off the bubble machine). A comment on FED policy in the spring of 2000, and impact of its policy on the stock market and the nation's economy. Will a soft landing really work?

How higher interest rates and a slowing economy effect tech stocks. And why a little pain is good for the economy.

"What if" questions for the FED. What if there had been a recession in 1994? What if there had been no drop interest rates in October 1998?

The "Greenspan Put" kept the rain falling, and the water kept rising. All the ducks thought they were getting smarter and smarter. The gap between what the ducks thought and reality became so wide that it fostered acts of superhuman stupidity. One example is all that is necessary to understand enormity of this gap. Bernie Ebbers borrowed $400 million to buy stock in his company. That's 400 with six zero's, for an equity position that is probably worth about $45.00 in today's market. What the hell was running though his duck brain? Clearly the water in the pond was going to keep going up forever. Sadly I fear this duck will soon receive the world's largest margin call from a bankruptcy court.

With equity investments there is a direct relationship between popularity and risk. The more popular a stock or an industry sector has become, the higher the risk an investment in that area carries. Risk builds in any market as money pours into a particular vehicle. The more the money moves in a particular direction, the higher the risk. Risk is always a moving target, where as concepts such as Beta perceives it as static. In the 1950's it was accepted wisdom that bonds where a low-risk investment, but the 1970's proved this was basically nonsense.

 

The perception of risk and real risk are entirely different things. Market psychology and mechanics make it that way. As people run from the risk that they see in the rear view mirror they tend to rush toward the risks they can not see. The best way to insulate your investments from risk is to avoid the crowd. Recent history is a great example, for years money poured into large cap tech stocks and out of small cap value. By March 2000 this had created a situation where the risk in tech was astronomical, whereas risk in small cap had decreased to point where there were margins of safety were readily available.