Do You Believe In Magic
Like so many things, magic can have different meanings. Many times, it is regarded as something special that defies easy explanation. Sometimes it also includes elements of nostalgia as in the Lovin’ Spoonful’s “It makes you feel happy like an old-time movie.” Positive, serendipitous experiences are often described as mystical, remarkable, or “magical”.
But magic can also have negative connotations. Common phrases such as “sleight of hand” and “smoke and mirrors” emphasize the misdirection of our attention, often for the purpose of gaining advantage. Increasingly, these types of “magic” infest investment analyses and financial statements and in doing so, belie underlying fundamentals. Just as hope is not a strategy, belief is not an investment plan.
One of the great lessons of history is that it is not so much periodic downturns that can cause problems for long term investment plans so much as it is specious beliefs about supporting fundamentals that can really wreak havoc. Often, we have decent information in front of us but we get distracted and focus on, and believe, something else.
In the tech bust of 2000, for example, investors learned that some companies inflated revenues through vendor financing. Some backdated options to retain high levels of compensation for key staff. Many used alternative metrics such as growth in “eyeballs” to embellish visions of growth while de-emphasizing real progress and costs.
Similar phenomena existed in the financial crisis of 2008. Exceptionally low interest rates boosted mortgage originations above sustainable levels. “No income, no assets” (NINA) mortgages allowed a large number of people to take out mortgages who were wholly unqualified to do so. Structured credit products boosted growth by creating a perception of manageable risk.
In both cases, there was a period of time during which people thought they were wealthier than they actually were, because they had not yet learned of the deceptions. Renown economist John Kenneth Galbraith thought enough of this phenomenon to develop a theory about it. John Kay describes it [here]: “Embezzlement, Galbraith observed, has the property that ‘weeks, months, or years elapse between the commission of the crime and its discovery. This is the period, incidentally, when the embezzler has his gain and the man who has been embezzled feels no loss. There is a net increase in psychic wealth.’ Galbraith described that increase in wealth as ‘the bezzle’.”
Charlie Munger went on to expand and generalize the theory: “This psychic wealth can be created without illegality: mistake or self-delusion is enough.” Kay notes that “Munger coined the term ‘febezzle,’ or ‘functionally equivalent bezzle,’ to describe the wealth that exists in the interval between the creation and the destruction of the illusion.”
As any magician knows, there are lots of ways to create illusions. For better and worse, the current investment landscape is riddled with them. One of the most common is to create a story about a stock or an industry. Investment “stories” are nothing new. In the late 1990s and early 2000s the story was that the internet was going to transform our lives and create enormous growth. In the financial crisis of 2008 the story was that low rates and low inflation created a “goldilocks” environment for global growth. Both stories, shall we say, overlooked some relevant factors.
New stories are popping up almost as reliably as weeds after summer rains. Zerohedge highlighted [here], “Back in December 2017 it was ‘blockchain.’ Now, the shortcut to market cap riches, and a flurry of speculative buying, is simply mentioning one word: ‘cannabis’.” If you are curious what a story stock looks like, take a look at the price action of cannabis company TLRY over the last month. After you do, try formulating an argument that the market prices reflect only fundamental information and no illusion.
Daniel Davies, author of Lying for Money, points out one overlooked, but highly relevant aspect of the cannabis story [here]: “Despite the “bright future of legalized pot”, he says, “The US Securities and Exchange Commission has already prosecuted several companies which appeared to be less interested in selling weed to the public and more interested in selling stock owned by the founders for cash.” As is often the case, the whole story is often more complicated and less alluring.
Stories are conjured about more than just exciting new stocks and industries, however. Sometimes they define a narrative about the economy or the market as a whole. One such story describes the economy as finally getting back on track and resuming its historical growth trajectory of 3 – 4%. It’s a nice, appealing story with significant tones of nostalgia.
It is also a story that is less than entirely realistic, however. The FT cites JPMorgan analysis [here]: “Jacked up on tax cuts, a $1.3tn spending bill, easy monetary policy and a weakening dollar, Wall Street and the US economy have enjoyed their own version of a ‘sugar high’.”
John Hussman describes how the discrepancy between real growth and perceived growth arises [here]: “The reason investors imagine that growth is running so much higher than 2-3% annually is that Wall Street and financial news gurgles about quarterly figures and year-over-year comparisons without placing them into a longer-term perspective.” He explains, “The way to ‘reconcile’ the likely 1.4% structural growth rate of GDP with the 4% second quarter growth rate of real GDP is to observe that one is an expected multi-year average and the other is the annualized figure for a single quarter, where a good portion of that figure was driven by soybean exports in anticipation of tariffs.”
Further, he reveals that fundamental drivers have actually languished during the huge run-up in the market: “[W]hen we measure peak-to-peak across economic cycles, annual S&P 500 earnings growth has averaged less than 3% annually since 2007, while S&P 500 revenue growth has averaged less than 2% annually.”
Tax cuts provide an especially interesting component of the investment landscape. Not only did the cuts in corporate tax rates quickly and substantially increase earnings estimates in financial models, they also provided a powerful signal to many investors that finally there is a business-friendly administration in the White House.
The reality, again, is more complicated and less sanguine, however. For one, the tax cuts came along with higher fiscal deficits, the cost of which will be borne in the future. Secondly, and importantly, the tax cuts did not come as a singular benefit but rather as part of a “package” of public policy.
The FT reported [here]: “At a meeting in Beijing late last year, US business executives tried to explain their concerns about imposing tariffs on Chinese exports to a group of visiting Trump administration officials.” It continued, “The meeting was held after President Donald Trump’s state visit to Beijing and the congressional passage of a large tax cut for corporate America. The executives, who had expected a polite exchange of views, were shocked by the officials’ robust response. One of the attendees reported that they were told, “your companies just got a big tax cut and things are going to get a lot tougher with China — fall in line”.
The attendee summarized, “The message we are getting from DC is ‘you’re just going to have to buck up and deal with it’.” Lest this be perceived as a one-off misunderstanding, it is completely consistent with Steve Bannon’s analysis of the situation reported [here], “Donald Trump may be flexible on so much stuff, but the hill he’s willing to die on is China.”
While “story stocks” and “tax cuts” and record growth” tend to steal headlines, they aren’t the only things that can engender perceptions that differ from reality. Sometimes the most powerful sources of misunderstanding are also the most mundane — because they garner so little attention.
While accounting in general is often overlooked because the subject is dry and technical, it also provides the measures and rules of the game by which financial endeavors are evaluated. But those rules, their enforcement, and the economic landscape have changed considerably over the years.
One big issue is the increasing use of non-GAAP metrics in earnings presentations. As I discussed in a blog post [here], the vast majority of S&P 500 firms present non-GAAP metrics in their earnings releases. Further, as the FT reported, “Most of those non-GAAP numbers make the company look better. Last year a FactSet study found that the average difference between non-GAAP and GAAP profits reported by companies in the Dow Jones Industrial Average was 31 per cent, up from 12 per cent in 2014.” A key takeaway, I noted, is that “non-GAAP financial presentations can play a significant role in cleaving perception from underlying investment reality.”
Another issue is that intellectual capital presents special accounting challenges and is far more important to the economy today than it used to be. The Economist reports [here]: “Total goodwill for all listed firms world-wide is $8tn, according to Bloomberg. That compares to $14tn of physical assets. Dry? Yes. Irrelevant? Far from it.” Further, one-half of the top 500 European and top 500 American firms by market value “have a third or more of their book equity tied up in goodwill.”
The Economist also reports, “Just as the stock of goodwill sitting on balance-sheets has become vast, so have the write-downs. For the top 500 European and top 500 American firms by market value, cumulative goodwill write-offs over the past ten years amount to $690bn. There is a clear pattern of bosses blowing the bank at the top of the business cycle and then admitting their sins later.” Because “the process of impairment is horrendously subjective,” the numbers for reported assets have become less defensible.
In addition, investors need to be on the watch for even more than clever numbers games and accounting obfuscation. The reliability of corporate audits has also been declining for a variety of reasons — which should reduce investors’ confidence in them.
As the FT reports [here], the original purpose of audited numbers was “to assure investors that companies’ capital was not being abused by overoptimistic or fraudulent managers.” However, Sharon Bowles, former chair of the European Parliament’s economic and monetary affairs committee, assesses, “But the un-anchoring of auditing from verifiable fact has become endemic.”
An important part of the “un-anchoring” process involves the increasing acceptance of fair value accounting, which was implemented (ostensibly) to provide more useful information to investors: “From the 1990s, fair values started to supplant historical cost numbers in the balance sheet, first in the US and then, with the advent of IFRS accounting standards in 2005, across the EU. Banking assets held for trading started to be reassessed regularly at market valuations. Contracts were increasingly valued as discounted streams of income, stretching seamlessly into the future.” “The problem with fair value accounting,” according to one audit professional, “is that it’s very hard to differentiate between mark-to-market, mark-to-model and mark-to-myth.” Yet another case of diminished verifiability.
At the same time as the reliability of audited numbers was decreasing, so too was the accountability for the audits. “[A]uditing firms have used their lobbying power to erase ever more of the discretion and judgment involved in what they do. Hence the explosion of ‘tick box’ rules designed to achieve mechanistic ‘neutral’ outcomes.” Professor Karthik Ramanna calls it a process “that is tantamount to a stealthy ‘socialisation or collectivisation of the risks of audit’.” In other words, don’t expect auditing firms to pay when their work fails, expect investors to pay.
To make matters worse, “There is also the perception that the dominant Big Four, which are now profit-hungry professional services conglomerates, are not that worried about audit quality anyway.” Erik Gordon, a professor at the University of Michigan Ross School of Business, highlights, “They have been able to do better with low quality than with high quality work.”
Jean-Marie Eveillaird, who accumulated an impressive record as an investment professional, summarized the effects of accounting changes in a RealVisionTV interview [here]: “[M]ost accounting numbers are estimates. And indeed, what happened in the ’90s, where there are a number … of chief financial officers decided that- with the help of some shop lawyers- decided that you could observe the letter of the regulations, and at the same time betray the spirit of the regulations, and you wouldn’t go to jail for that.”
In sum, there are a lot of different ways in which illusions about financial performance can be created and many have been getting progressively worse. Notably, they don’t even include the examples of intentional wrongdoing such as the Enron or Madoff frauds. Munger is right, “psychic wealth can be created without illegality: mistake or self-delusion is enough.”
The one thing all these examples have in common is that they are all essentially category errors. As Ben Hunt tells us [here]: “What’s a category error? It’s calling something by the wrong name.” In particular, a Type 1 category error is also called a false positive.
One opportunity for investors is pretty straightforward: Just don’t carelessly and uncritically accept a story as real fundamental information. Don’t call a narrative a fact. Don’t assign 100% value to numbers enshrouded with uncertainty. As Davies highlighted in regard to cannabis investors, “What they are not doing is asking the basic questions of securities analysts.” So ask the basic questions.
Davies also provides some useful clues as to when investors should be on special alert: “The way to identify a story-stock craze — overblown enthusiasm for a sector where there is a good tale to tell about its future — is if the justification for buying into the new hot venture is big on vision and short on detail.” For example, is the earnings presentation dominated by bullet points describing qualitative achievements or by revenue and earnings numbers accompanied by substantive explanations? If you are going to get involved with a story, a useful rule of thumb is: “the time to buy is either when very few people have heard the story, or when everyone has heard it and everyone hates it.”
In addition, the concept of the febezzle presents a fairly useful model for thinking about investment risk. Asset valuations can be thought of as being comprised of two separate components: One is based on fundamentals and reflects intrinsic value while the other is based on the febezzle and reflects illusory, or psychic, wealth. An important consequence of this is that when the illusion is shattered, the febezzle element vanishes and there is virtually nothing to prevent a quick adjustment to intrinsic value. In other words, the febezzle is much more of a binary (either/or) function than a linear one.
This matters for long term investors who are most concerned about creating a very high probability of achieving their long-term investment goals. Not only does the febezzle component subject their portfolios to sudden, substantial, and effectively permanent drawdowns, but it also defies conventional investment analysis. It is exceptionally hard to confirm that a popular illusion is being shattered, especially before everyone else does.
One signal of change, however, is volatility. Using language that closely parallels “destruction of the illusion,” Chris Cole, from Artemis Capital Management, explains [here], “Volatility is always the failure of medium… the crumpling of a reality we thought we knew to a new truth.” In this context, the absurdly low volatility of 2017 was ripe breeding ground for illusions. Investors believed. Higher volatility in 2018, however, suggests that some of those beliefs are becoming increasingly fragile.
Perhaps the greatest illusion of all is the belief that continued market strength confirms strongly improving fundamentals. While recent economic performance has been good, Cole rejects this view and offers an alternative explanation: “When the market is dominated by passive players prices are driven by flows rather than fundamentals.” In other words, strong market performance mainly means that more people are piling into passive funds. By doing so, they have the dangerously intoxicating effect of propagating the illusion of commensurate fundamental strength.
None of this is to suggest that stock fundamentals are strong or weak, per se. Rather, it is to suggest that, for several reasons, stock prices do not comport well with the reality of underlying fundamentals; there is less than meets the eye. As Ben Hunt warns, “It’s the Type 1 [false positive] errors that are most likely to kill you. Both in life and in investing.” If calling something real when it is not can kill you, it is hard to understand why so many people are so tolerant of mistakes and self-delusion when it comes to their investments. The question is simple: Can you handle the truth, or do you believe in magic?