From the Archive: Small-C February 2009 Letter

The portfolio returned a measly 1%, bringing year-to-date performance to +3.2%.  Most every trade was down, so the only thing helping us out is our net short on S&P.  We took a pasting on our investments in sterling corporate bonds, which leaves us totally perplexed since sterling bonds are supposed to have outperformed over the month.  Some commentators have even been speaking about a bubble in corporate bonds.  It may have something to do with marks and NAV on the two funds we are invested in.  We bought an individual bond for the first time ever: Citigroup senior unsecured 5.1% notes of Sep-2011, at a 10% yield, which seems like a pretty good return for government risk.  Once again, we were reminded how astoundingly difficult it is for retail investors to buy corporate bonds.

Bonds are a simple investment.  You lend some money to a company, it promises to pay you back with some interest on top.  The bonds lasts a determined number of years, at the end of which you either get your money or you don’t.  You can be sure the company will try pretty hard to pay you back since if it doesn’t that more or less means going out of business.  Contrast that with an equity investment, where there is no representation or promise at all, only a share in the fortunes of the company after everyone else with an interest is paid first.  To appraise the value of that investment, you have to make assumptions that stretch indefinitely into the future - out to infinity.  I would think bonds would be extremely popular, and that the regulatory framework would push retail investors towards bonds.  But that’s just not the case.  You can’t trade bonds on the Internet, only via old-school telephone brokers who give a market 5-10 points wide and won’t take a limit order to work.  The regulators won’t even allow ordinary investors buy those which are at the riskier end of the spectrum, while the issuers make it as difficult as possible as well, by often issuing bonds at high minimum sizes.  There are endless books, newspaper columns, even TV channels about speculating on the stock markets.  Bonds get the rare mention. 

In his annual note, Warren Buffett opined on the Government bailouts:

"This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone 'all in.' Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.  Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly."

We felt inspired to look at some data to see if, empirically, government bailouts should be expected to work.

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A Naïve View on Government Stimulus Packages

Many market participants accept that a government stimulus package to financial industry, housing markets, consumers, and/or general industry is necessary to restart the world economy and get us through the current rough spot.   My simple mind thinks these two graphs ought to inform the debate.  They present per Capita GDP, on the first graph, and GDP growth since 1980 on the second, versus a measure of government spending as a percentage of GDP (so higher number = more government involvement).  The size of the bubble relates to the size of the economy. (Data sourced from CIA Factbook, The Economic Freedom Institute, and the IMF)  If government intervention works, you would expect to see these graphs slope up to the right, indicating more government involvement in the economy leads to higher per capita GDP and higher long-term growth.

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This chart is inconclusive.  The broad shape of the graph indicates government involvement may indeed work.  But it also contains some counter-intuitive points - for example that China has low government involvement.  There may be problems with the measure, government budget as a percentage of GDP.  Other forms of economic involvement, like direct control and government-sponsored enterprise, aren’t captured.  On broader measures of economic freedom, China scores much worse.  The chart can also be divided into two groupings.  For developing nations, a higher government budget has a positive effect.  Across developed nations, government involvement has a negative effect on per capita GDP.

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This chart shows a more pronounced trend - over the last 27 years, countries with less government involvement in the economy grew more.  China is literally off the chart at 1289%.  But again, we have to contend with problematic data points like China’s low apparent government involvement.

There may be better ways to looks at this data; I certainly appreciate suggestions.  There may also be better data to use - some will suggest that GDP is a purely material measure of a nation’s wellbeing and other, less tangible matters such as cultural output, level of education, and sense of happiness should be included.  But those people probably aren’t concerned about whether the stock market goes up or down.  

The conclusion I am inclined to draw is that government involvement in the economy is bad in the long term.  The market won’t stop going down until investors are convinced that governments have stopped trying to stimulate the economy by meddling with the efficient allocation of capital and damaging prospects for future growth.

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Mr. Buffett also noted "Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down."  Can it be a coincidence that just days before this letter came out we followed a colleague’s tip and bought 14 pairs of socks for £15?  Our current positioning sees us covering most of our S&P short at 700 (going from slightly short to +25% AUM in stocks), then up to +50% AUM in stocks at 600.  No particular reason for the levels, really, just that many valuation measures will be suggesting that stocks are on the cheapish side, though not extremely cheap.  We are convinced that holding on to "safe" investments, like cash and treasuries, will eventually prove to be a disastrous mistake.

We had a look at a buy-to-let property on our street this month.  There are many observations, but simplistically, to earn a decent return on our equity investment, the price would have to fall about 40% from the offer (which isn’t far from peak 2007 valuations).  Otherwise, there are far more rewarding, more liquid, less-troublesome places to put our cash.  The estate agent was entirely uncomprehending; it appears that property "investors" have no concept of comparing returns across investment classes.  This is great news: they will help make us rich.

Also, we won £100 off Rajat this month.