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GP27Oct04: Where Angels Fear to Tread The Generals’ Retreat. In the early 1970s, the stock market went into a terrible swoon that is well burnt into the memories of investment professionals from that time. Early on in that bear market, small company stocks plunged to new lows every day. At that point the generals in charge of investments at Bankers Trust Company decided that anointed big company securities (“The Favorite 50”) were the place to be. They commanded a small cap portfolio manager of our acquaintance to disband his fund which was focused on small, growth companies. He did so, and soon left the Bank. Not long thereafter, big company stocks took an even bigger dive, and the very small caps that had been thrown in the trash looked awfully good. The leaders, it turns out, did not have much of a nose for safety. The Bigger They Are, the Harder They Fall. In tough times or even boom times, the people on top do not have a good eye for risk or for reward. Perilous markets, which we had in the Internet nineties and which continue in the current decade, make our leaders very near sighted. This myopia is not a trivial matter. In our own estimate, only one of the major powers—China’s PRC—has a clear view of its problems and its opportunities. The leaders are trying to face up to an unstable banking system, huge unproductive state owned companies, a rural peasantry that is badly ruled and inordinately poor, health and environmental deterioration that sustains serious viral outbreaks and very thick air, etc. Seizing opportunity, they are fast building an internal market stretching well into the interior that will avoid the structural flaw of Japan—weak consumer demand. But the other major powers are paralyzed by blindness, not understanding their predicaments and over-reacting to the wrong events. Red Swans and Copperheads. Leaders with spiritual cataracts can be relied upon to look for safety in all the wrong places. Off limits for them are the very havens that offer safety and even some upside possibilities. We have already written about such risks extensively in both our Letter and Dictum entitled “Don’t Worry about the Copperheads; The Big Bear Will Get You First.” In “Irishmen Who Married Up,” we talk about “Red Swans,” the big opportunities missed by excitable participants who get caught up in events too near at hand. In these volatile times, we’re missing a fair number of real dangers and real opportunities, largely because we fail to stray where others fear to tread. Distressed Securities. With oil prices tilting upwards and the Fed forced to push interest rates upwards, equity investments are troublesome these days. But distressed securities (i.e., the stocks and bonds of bankrupt companies) offer opportunity through thick and thin. It’s the irony of a disturbed world that safety arises in the midst of collapse—in bankruptcy. Forbes (September 30, 2004) just wrote about the substantial track record of Mellon’s Mickey Harley in an article entitled “A Penny Stock for Your Thoughts.” There are a handful of players like him in the distressed securities area, and a smart one can patch together a surprisingly consistent performance with much less volatility than one will experience in conventional investments. The trick here is to separate the good merchandise (securities) from the bad, but there’s enough good stuff out there to get decent returns. Should you want to get started in this sector, you might subscribe to the free publication offered by our friends at www.bankruptcydata.com. When you get deeper into it, you should then subscribe to their premium information services which sell for a modest $500 per year. Incidentally, we have lots of yeasty bankruptcies coming up—in the airline industry, for instance. Deadly Drugs? Nathaniel Hawthorne, warning of the dangers of modern (nineteenth-century) science, wrote a short story about a mildly mad scientist who cultivated a garden of absolutely beautiful flowers and other natural bounty. They suffered from just one flaw. They were all poisonous, due to his sinful science. Our old friend James Duke (see Stitch in Time #4), who studied the medicinal use of the plants at the Department of Agriculture for much of his career and still maintains a database there, has lent us a speech that suggests that the world of prescription drugs is full of poisonous flowers. Of course, most recently, he calls to mind Vioxx. He advocates systematic testing of medicinal plants by the FDA alongside drug company trials, believing that this would put safer offerings in our medicine kit. The Chinese, incidentally, are now exporting more and more of their herbal medicines, and it will not be many years before America seizes on the efficacy and cost efficiency of medicinal plants. Real inroads by alternate medicine are still a few years, but not decades, away. Right now, health is still thought to come out of a bottle and not from the vine. That will change. Shutting out Ideas. William Baumol of New York University (see Big Ideas #122 and #172) was among the first to see where homeland security might give us trouble. Early on, he said that the economic costs of a risk averse attitude in the nation might be more devastating to America than the plots of foreign conspirators. As we have said in this year’s Annual Report on Annual Reports 2004, this uncertain, anxious atmosphere is causing businessmen to postpone a host of investment decisions. Apparently, too, as he and others note, we are scaring off a host of bright foreign students who either cannot get through our immigration barriers or who think the red tape not worth all the bother. Is it possible that our barricades are making us more insecure by undermining our creativity? That is, we have always had waves of foreign visitors who have not only done our low-paid work but have also been inventive enough to build up our intellectual arsenal. In the 20th century, foreign tuitions have also put a safety net under many of our academic institutions. Will they no longer be beating a path to our door? Today Microsoft and Intel, amongst others, are locating research hubs in India and China. Some of our own colleagues have arranged global research consortia in order to batch out certain discovery tasks to scientists in Europe and other parts of the world. If the scientists no longer come to us, we will have to go to them. Investment Opinion. Soon enough we will do a new Investment Opinion. We published our last on March 24, 2004, and advocated there that investors should look for gain in the areas that many regard as dangerous. Our next update, of course, will reflect our changing view of where safety and opportunity lie. Clearly, it will steer us away from insurers such as Marsh & McLennan and American International Group, which have used their scale to prop up prices. One should fear the goliaths in any industry that have obtained disproportionate pricing or purchasing power in flat or declining markets. Particularly in our financial markets, there are all sorts of bubbles yet to be pricked, making it less than obvious where you can find less risk and more reward. It is for this reason, as much as for its systematic irregularities, that one might cast a skeptical eye on mighty Citibank. Once the giants have fallen far enough out of favor, they will present an opportunity. Meanwhile, it may be time to search abroad for investments in many out-of-the-way places. P.S. We have recently added a new section to our SpiceLines newsletter. You will find a Spice Shop, which is really not a shop but a useful compendium on where to buy the finest the spice world has to offer. For the moment you will find here peppercorn establishments and a rundown on the best peppermills.
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