Is a tomato a fruit, or is a tomato a vegetable? Botanically, tomatoes are a fruit. But in 1894 the U.S. Supreme Court (Nix v. Hedden) ruled that tomatoes were a vegetable. The reason for this U.S. Supreme Court ruling provoked transformation was the Tariff Act of 1883 which protected domestic vegetable farmers; vegetables were subject to a tariff but fruits were not. (The tariff was removed in 1994 with the passage of NAFTA.) Perhaps the kindest remark I can make apropos our elected and appointed officials is they have elevated deception, falsehoods, fabrications, and obfuscation to an art form. (The financial services industry runs a very close second.)
In an unfettered market the prices of goods and services transmit, summarize, and create a feedback mechanism that will influence supply and demand. If the amount of a product is in short supply there is a strong tendency for prices to get bid up, attracting existing producers and opportunists to create more. Notice that this supply and demand interaction is dynamic, relentlessly seeking equilibrium: sellers satisfying buyers’ willingness to consume at various price points, and buyers satisfying sellers’ desire to provide a product or service at a profit. Market price adjustments occur for all goods and services as a natural consequence of the Complex Adaptive System in which it functions – assuming the market is not manipulated.
Prices Inform and Influence
At its core, investing is about deferring consumption today with the expectation (hope) that one will be able to consume more (or not) at a future time. How much more will depend on one’s rate of return, inflation rate, tax rate, etc.
The ultimate value of a financial asset is determined by the present value of its future cash flows. For a bond the cash flows are a contractual obligation: the bond’s indenture (its governing legal document) details the contract between the bond issuer and the bond purchaser specifying the interest rate, the dates when the interest will be paid, maturity date(s), etc. Equities also derive their value from future cash flows but there is no contractual obligation. Theoretically, the price at which a stock sells represents the weighted average of all investors reflecting their collective expectations of future cash flows. When a market is described as efficient it is inferring that the stock price reflects all available information about a company and its prospects – that is, an efficient market denotes that the value of a stock is indistinguishable from its price.
There is at least one material, although subtle, difference between the marketplace for goods and services and the marketplace for financial instruments: within financial markets prices not only inform and influence, but influence in a way that tends to be a more persistent self-reinforcing feedback loop. Impostor investors rely on a current price, or a price trend, to portend the future: higher prices stimulate increasing optimism of a bright future (think of dot.com stocks throughout the 1990s) while lower prices stimulate increasing pessimism of a less robust future (think financial institutions of recent vintage). This is one reason stock prices have a tendency to over-shoot and under-shoot enterprise value. The superior investment manager is capable of making a critical distinction: a distinction that reveals investment merits derived from an understanding of the fundamental factors of a company vs. the market price and what the market price implies about the future.
NIRP Replaces ZIRP
In July of 2012 the German government issued $5.13 billion of 2-year notes with an average yield of -0.16%. This is remarkable. At auction, investors willingly accepted a guaranteed loss on their investments. Welcome to a world in which Negative Interest Rate Policy (NIRP) has replaced a Zero Interest Rate Policy (ZIRP). Subsequent to the German offering, similar negative interest rate notes were issued by the Netherlands, Switzerland and France.
There are apparently two reasons for this self-defeating behavior. First, investors are saying they would rather invest money in a note that is guaranteed to lose a minuscule amount than invest in countries (e.g. Portugal, Italy, Ireland, Greece, Spain) offering more robust positive yields but where the prospect of default is high. The second reason is the conjecture that some investors believe these German, Dutch, Swiss, and French notes are effectively “options” on the break-up of the Eurozone. That is, if the EU currency union collapses, these euro denominated notes may be paid back in re-issued deutschmarks, gilders or francs which are expected to be more valuable than the price paid for the euro notes.
A prolonged experience of negative interest rates is potentially devastating because in a negative interest rate environment many financial institutions, like pension funds and insurance companies, cannot earn enough “spread” to function properly.
Float and Spread
Within a financial context, the term “float” usually refers to cash held in custody for a customer by a financial institution that is also available for investment by the financial institution. Float is an important source of profitability for many types of financial companies. In retail banking, for example, the bank can invest the cash its customers have on deposit in their checking and savings accounts into higher yielding investments such as mortgages. The bank then earns the difference between the interest paid to customers and the interest paid to the bank from its mortgages (the mortgagors).
“Spread” is the difference between what a financial institution pays (for a bank, the interest it pays its’depositors) and what it can earn on its investments. Similarly, retail brokerage firms make money by investing the cash left in client trading accounts. “Negative spread” is created if a financial company – e.g. an insurance company – experiences a difference where the guaranteed interest rate paid to policy holders is higher than what the insurance company investments yield.
The Insurance Industry
Insurance companies are an interesting sub-set of institutions that employ float to augment profitability. Let’s begin by defining the term “combined ratio.” The combined ratio represents total insurance costs (losses incurred plus operating expenses), in comparison with revenue from premiums. The insurance industry, by calculating the combined ratio, is able to isolate the profits that the insurance company generates from its underwriting activities. A ratio of 100 would indicate break-even, below 100 would yield underwriting profits and above 100 would indicate an underwriting loss.
The potential profits from underwriting are only one component of an insurance company’s total potential profitability. Life insurance companies, for example, are able to routinely make long term investments with collected insurance premiums because life insurance companies recognize that most claims will not require payment for many years. While these premium dollars do not actually belong to the institution (as explained above, they are held in custody for a client), in the interim they are available to the insurance company to invest.
Life insurance companies have the ability to generate profits in each of these ways:
- “Interest gains” are the difference between the guaranteed interest offered to customers and the actual interest earned from fixed income investments, mortgages, etc.
- “Investment gains” are gains exclusive of interest gains.
- “Float” represents a very low cost of capital available for investment; the insurance company may deploy their float at effectively zero cost.
- “Mortality gains” are the difference between the projected mortality rate and the actual mortality rate.
- “Expense savings” are the difference between the assumed expenses in operating the business and the actual expenses.
With the continuing record-low interest rates all interest rate sensitive financial enterprises have been experiencing a challenging business environment. Institutional investors, like pension plans and life insurance companies, cannot earn sufficient spread in a low interest rate environment to function properly.
A negative interest rate environment is mathematically unsustainable. Further exacerbating the problem, many of these institutional investors are required to only invest in the most credit worthy entities – positive yield, or not. Many believe this negative spread is a short term phenomena and confined to Europe… but is it? Recently, the 2-year US Treasury Note was yielding an insignificant 0.35%. Imagine if something unexpected was to happen in Europe and there was a stampede into US Treasuries. It is not a great leap to imagine the Treasury notes to be bid down to negative yields, as occurred briefly during the 2008-2009 financial crisis. If nothing else NIRP is implying the relationship between governments, banks and investors is at least malfunctioning, if not broken.
Low and negative interest rates clearly punish retirees who live on their fixed income investments; worse still, many of these naïve retirees believe fixed income is safe. What they do not understand is in a rising interest rate market, the value of their fixed income investments (e.g. bonds) will decline; furthermore, after the effects of taxes and inflation they are actually consuming their capital.
There are an endless number of reasons investors could, or should, be concerned about the future. Some concerns are more obvious than others. The possibility of the unforeseen – the Black Swan – is potentially the most disruptive. As investors it behooves us to be cognizant of the less apparent macro issues – it is the macro where we express our “worrying” concerns – but never lose sight that our investment decisions are rarely governed by macro considerations. Our investment commitments are based on the unique attributes of individual companies that are selling for prices reflecting compelling discounts to their appraised value.
The impostor investor wants to know if the market is headed higher or lower. This is like asking a politician if a tomato is a fruit or vegetable. Call it what you like, it will not change its botanical composition nor will the perceptions of the impostor investor alter market behavior – behaviors which are entirely unpredictable. On the other hand, understanding individual companies, their strengths and weaknesses, is not beyond estimation.
Read or watch almost any media broadcast of the news for a dose of the ridiculous, where pundits offer their sound bite predictions as they underscore the world’s obvious political and economic uncertainties. Impostor investors, as a result, are spending their time trying to assess likely outcomes of what is unpredictable in an attempt to avoid losing money rather than doing the research necessary to identify those businesses on which they can make money.
Irrespective of what the future may have in store we are supremely confident of at least one thing: until the excesses are purged from the global economic system, our profligate ways of the past 25+ years will likely result in the world becoming a less hospitable place for most investors – but the world will not end. If our investment results are anywhere close to our experience over the past 15 years, we expect we will be able to meet the challenge of the rising cost of tuition, cars, clothing, food, energy, health care, housing, etc.
One last thought. While money is a medium of exchange it is not, as is commonly described, a store of value. If you think otherwise you are not factoring in the ravaging effects of inflation and taxes. The engines of economic growth are the companies that create the goods and services coveted by their customers. Such companies are better than a store of value; they are wealth creators.
To learn more about Marshall Serwitz view his Paladin Registry profile.
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