Client Letter November 2000

1929 The newly created FED spent most of the twenties expanding the money supply, and the NYSE was poring gasoline on the fire in the form of 10% margin requirements

1973-74 Lyndon "Guns and Butter" Johnson spent the 1960s fighting both the war on poverty and the Vietnam War. "No problem we will just get the fed to pump up the money supply."

1989 Japan’s Central bank decides in the 1980 that they have discovered the Holy Grail of universal prosperity. "We will keep our interest rates at 2% until we liquefy the world"

Cheap Money Means Poor Returns

This is one those fundamentals of market behavior that Charlie Munger, would label as perfectly obvious but very little understood. It is something that Berkshire Hathaway’s Management understands very well, but seems to go over the heads of most corporate chief executives

Let me give you an example, last week the wall street Journal carried a story about a capacity glut in fiber network. It contains these figures on the capital spending by one of the smaller more obscure players in fiber optics.

"360 networks, based in Vancouver, British Columbia, is spending some $5.7 billion- and has taken on more than $2 billion of debt-to develop its fiber network. Those are hefty figures for a newly public company that had just $234 million of revenue in the first half of this year and is expected to produce negative cash flow and losses for at least another year... There are now 14 big-capacity national networks operating or under construction in the U.S. and the companies are ‘all burning cash at a pretty sharp rate,’ says Paul Sagawa, a Sanford C. Bernstein analyst who recently became bearish on the sector."

Greg Maffei CEO of 360networks justified his business plan with the following rational "I'm very optimistic about the long-term demand" for bandwidth, "Just as lower mobile phone charges have greatly multiplied the number of customers, lower bandwidth prices will lead to many more bandwidth-hungry applications, he predicts. And 360 networks says only a few networks can match its relatively low building costs and global scale."

The Build it And They Will Come Rule

In other words build it and they will come. This is the number one rule of executive behavior, and it is the main reason that cheap money always leads to poor returns. It is the same basic rule that has relied on by Iridium when they put up their satellites, Now their investors can experience the ecstasy of watching their $7 Billion burn up on reentry.

You give the typical CEO $5.7 billion and he will find something to spend it on. Will a good deal of this spending is well intentioned, cheap money invites abuse ("We need to buy a Gulfstream IV because the Boca office will need close supervision this winter"). The Typical CEO figures that he is smart enough to get hands on $5.7 billion, then he is smart enough to spend it. (Ya, right!) The easier money is to get the more they spend. The further you get along in a positive economic cycle the better this rule works. It is the easy money that creates the over capacity. CEOs do not know any better; they are just doing what comes naturally.

The interesting thing is that the easy money does not have to come from a central bank, in our present circumstance most of it came from Wall Street, but the source does not matter. The money will get spent. And the eventual result will be capacity is built that is not needed.

The Easier the Money the Bigger the Correction

So what happens now? How far down does the market have to go, to discount the consequences of Wall Street’s manic excesses? We are not all the way to low tide yet. So it is too soon for a comprehensive bathing suit check, but if I had to, I would guess that the size of the crash would be roughly proportional to the expansion. In other words the easier the money the bigger the correction

But, On the subject of the future consequences of this wild spending binge Barton Biggs was quoted in Barons as saying, "the excesses" (he) explains with a touch of regret, "have not been completely purged, not by a long shot".

In the fiercely damaged Internet section, for example, there remain, he notes, "loads of companies whose stocks, bloody but unbowed, still sport market caps of well over a billion dollars with nothing but dreams, mounting losses and fancy business plans."

In the monster bear market of the early 'Seventies, he reminds the graybeards among us, the speculative junk, no matter how inflated it got, "all ended up selling for three bucks." (Personally, The way I remember it, it was more like a buck and half.)

But if it really is easy money that is responsible for the eventual carnage, logic would suggest that the damage might be very lumpy. The worst damage will be limited to those areas that received the most easy money. The manic dimensions of our recent tech bubble has produced prodigious sums for chief executives to piss away, But beneficiaries were limited to certain select market sectors, so the worst of the carnage may be similarly limited.

There is a real possibility that a sharp cut back in tech capital spending will drag the rest of the economy into the ditch. The sharp drop in growth of GDP in the fourth quarter raises the chances of recession to something above 50% in my opinion. But a lot of old economy stocks have already discounted a moderate recession. Retail and consumer stocks started correcting some time ago.

As far as our major holding of Berkshire Hathaway is concerned, insurance stocks, as everyone here already knows, started correcting two years ago and may have already seen their lows. The insurance industry received little if any benefit from the flow of funds into tech stocks. Retail and consumer stocks received the benefit of increased consumer spending, but have already corrected for a lot of problems.

Money has been getting more expensive for insurance companies (Combined ratios increasing) for quite a while. With no cheap money it may now be possible expect better returns from insurance stocks than from tech stocks in the next few years. That is a prediction that you probably have not seen before.

This is wildly counterintuitive. Logic and math would suggest that cheap money would make corporations more profitable. The problem is that it does not work out that way, or least only for the short periods. Over the coarse of a long economic cycles cheap money destroys discipline in capital allocation, while expensive money demands it.

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Last modified: March 16, 2008