Finance in Europe: 5 Takeaways

For those of you that didn’t know, I spent the last three days in London taking my only class of the semester (and my final class of my undergraduate career). FNCE396: Finance in Europe was a 3-day seminar in London where we heard from three professors and a number of industry professionals (hedge fund managers, bankers, private equity associates, investors, and even Margaret Thatcher’s former economic advisor). The class was a great way to close out my time at Penn. Being able to spend it in Europe, where my passion for studying political economies and global macro began, truly made it a memorable experience. Here are my 5 key takeaways from the seminar:

1. The European Union is more about politics than economics

This was by far the most important takeaway from the seminar. In order to understand the European Union, you need to understand European history. You need to understand that it has been the bloodiest continent for the last century. It has been torn apart by two world wars and was the epicenter of one of the most calculated genocides in human history. The European Union started as the European Coal and Steel Commission (ECSC) primarily between France and Germany as a means of preventing another world war. The previous prevention strategy, completely suffocating and humiliating the loser,  had miserably failed. Over the last 50 years, the EU has evolved to be an economic common market where free trade agreements and the promotion of labor mobility has helped to bolster the European economy. However, this process was accomplished not primarily for economic reasons, but rather for political ones. The last 50 years has been process of European harmonization: an attempt to bring Europe together, to understand one another, and to prevent another world war.

The Euro has been the messiest policy implementation thus far. To further economic development (and thus political harmonization), the Euro was introduced as a common currency in 2002. While some may not have truly understood the ramifications of creating a monetary union in the absence of a fiscal union, economists certainly did. In the end however, the politicians had the final say.

Germany, with its competitive export industry artificially held down by a weaker currency boomed throughout the 2000s. They reorganized many of the outdated continental labor systems and have, by and large, been the center of Europe (something that they failed to achieve just half-a-century earlier). The problems started to arise when the South (Italy, Greece, Portugal), who had historically weak currencies (high inflation, high interest rates) started to have the stability of a Germany currency (low inflation, low interest rates). What did they do? They borrowed, borrowed, and borrowed some more. They ran up  their debt levels.

Then in 2008, the US credit market blew up. Sending shockwaves throughout the world, the global economy stagnated, and suddenly debt-to-GDP levels started skyrocketing. These problems were very noticeable in Greece, Portugal, and Italy.

Spain, believe it or not, had some of the most manageable debt levels in Europe, at 40% of GDP. But because of their rigid labor markets, the crisis not only decimated government tax revenue, but expenditures skyrocketed as a result of unemployment compensation. 25% unemployment today is a result of both economic stagnation and an incentive structure that prevents labor force participation. Spain pays its people to stay unemployed. Why work when you can get money from the government every week?

And here we are today with Germany attempting to reform the EU. Normally, poor countries would devalue their currency. On the Euro, they can’t. The two possibilities are both problematic economically, but even more so politically. Natural devaluation involves wage cuts. Economically, this can suffocate consumer demand. Politically, it leads to social unrest and rioting. The other mechanism is inflation. Economically, it destroys the currency’s stability. Politically, it transfers money from Germany to Greece and Italy. At an even deeper political level, German hyperinflation throughout the 1920s led to a political vacuum giving rise to Hitler’s Nazi party. Here again, we see economic history influencing today’s politics.

So now we have an awkward case of Southern countries unwilling to reform, an unwillingness of Northern countries to help, and a troubled currency and economic union. Many economists and many on Wall Street thought the Euro was doomed and it was only a matter of time before certain countries would splinter off and the EU project would fall apart. But these economists (trained in a one-dimensional discipline) have ignored the political nature of the EU. The EU is meant to bring all of these countries to the table to discuss their issues and work through them. Clearly this current crisis is a bump in the road, but might it lead to more political communication, an enhanced international understanding, and eventual political harmonization throughout continental Europe. Only time will tell.

2. The EU will never be the US; there are too many cultural barriers

Once the Americans had defeated the British in the American Revolution, it became time to decide on the union. One of the most influential American revolutionaries was not a President, but a Treasury Secretary. An avid Federalist, Alexander Hamilton, saw America in a far more prophetic way than some of the more famous Americans (e.g. Thomas Jefferson). Where Jefferson believed in an agrarian lifestyle centered around state-held power, Hamilton understood that a strong political union would lead to better coordination and, in time, generate economic prosperity. Had Jefferson gotten his way, the US might look like the EU.

The political institutions for economic harmonization (a common currency, a federal system of transfer payments, a common language, and flexible labor mobility) have been in place since 1789. Europe achieved the first in 2002 and still doesn’t have the following two. While labor mobility was supposed to be in place years ago through the European common market, it has failed. Why? Without a common language, it is nearly impossible for a Spaniard to work in Germany. Cultural differences have also created racial tensions that persist to this day. Moreover, social welfare states make countries less likely to accept foreigners (there is no better example of this than in Denmark).

Does this mean that Europe is necessarily worse than the States? Yes and no. Economically, it is less flexible, less suited to compete in a global economy. Politically, it is much more fragmented. But these differences also have their hidden strengths. The European Union will continue to develop and because of its unique history, it will develop in a slightly different manner than the US. European culture is nothing like American culture, and in my opinion, these cultural differences make Europe a unique place unlike any other. If Europe can leverage its differences and synergize them creatively, it will surely rebound in a robust way.

3. The UK will probably leave

This may be a more politically-charged observation but definitely one with some merit. The UK has always had reservations about joining the EU. It was a reluctant member from the very beginning. When the Euro was proposed, the UK said “No, thanks. We’re good.”

The UK, while obviously European, has never thought of itself as distinctly European, at least not in the continental sense. We all remember the US’s hesitancy in its WWII engagement, but England’s aversion was even worse. Chamberlain appeased Hitler, allowed him to take much of central Europe, and never really intended to back up France until its own island was subjected to Germany’s blitzkrieg attacks. While economically weakened from unproductive colonies and WWI, its reluctance to fight the Nazis speaks volumes about its political position within Europe.

Sir Norman Blackwell, chief economic advisor to Margaret Thatcher, spoke to our class on Monday. Politically charged, he stood to the far right of the stage. But more importantly, he stood firm and answered all of our questions in stride. He believed the Euro project to be a mess and was very clear that the UK should have no further role in its development. And truthfully, he had some very fair points.

The Euro crisis is far from over. Since Greece started asking for bailout money nearly 5 years ago, the fundamental problem has been unresolved. It will be years before countries agree on fiscal unity. It will be years before labor markets are reformed. The South needs to adapt to global economic conditions. France needs to as well. And something that could only be written in a Hollywood movie script, Germany, after failing  to conquer Europe in two major wars, will reluctantly lead the continent in its quest for political unity. The question for the UK is: Can they wait?

While not tethered to the Euro, England is still subject to many of the leftist policies pushed through Brussels. Recent banker compensation caps are just an example, but trading restrictions and other financial disincentives truly hurt the UK. London is Europe’s center of finance. A friend asked me why. I didn’t know off the top of my head, but it took me all of 10 seconds to figure it out. It is the only European country to speak English as its first language. Tokyo, Singapore, and New York all do business in English, not German, not French, not Swiss, and certainly not Italian. How could Europe’s financial capital be anywhere else? And if Brussels wants to experiment with market distorting policies like they are currently doing, it is best for England to go in a different direction.

Blackwell also made the point of focusing on a global economy. He expressly mentioned England’s important relationships with other capitalist democracies, namely the United States and India. England is distant from Europe because for centuries before WWII, the sun never set on its global empire. From India to South Africa to Canada, its island has been a global force, not a continental one. In visiting London, you don’t get the sense of being in Europe; it’s quite different. It’s not necessarily the language, but its also the melting pot of cultures, the variety of languages, and eclectic collection of its people. London is an international epicenter, a pioneer in free trade, and a stalwart in liberalized markets. The UK needs to continue in that direction. Instead of cleaning up continental Europe, maybe it is in the UK’s best interest to part ways and focus its political economy on the rest of the world.

4. Demographic changes will be increasingly important

Much of the developed world will suffer from stagnating populations. In short, a woman needs to give birth to 2.1 children in order to keep populations at a constant level. Anything below will create population decline. For the last 30 years, birthrates across many developed countries have fallen and are continuing on a disturbingly linear trend line.This phenomenon is a problem in many developed countries for a number of different reasons.

The US is in a precarious situation. Japan is too. Europe, especially continental Europe, is in dangerous territory. Germany and Austria have reproduction rates between 1.1-1.4, well below the 2.1 rate of population sustainability. Why is this a problem? Social welfare systems, for one, will demand higher payments from a contracting tax base. The US has a problem with entitlement spending but it palls in comparison to Europe’s social programs.

Even if you eliminate these programs entirely, population decline continues to pose problems. A contracting labor force might appear to demand less jobs which could solve the unemployement problem, right? Wrong. Less jobs means less income which means less consumer demand. The economy shrinks. The whole idea of the European common market was to expand Europe’s economy, to foster a greater and less inhibited exchange of goods, services, and ideas. Even if the Euro succeeds, population declines will reverse many of these developments. Less labor means fewer innovators and fewer entrepreneurs. What is most tragic is that this problem is seemingly solution-less. How do you convince an entire population to have more kids? Deciding to have children is such a uniquely personal decision, and one that does not respond to any form of external incentives. Maybe, trends will change. Maybe this is just a cycle…

5. Don’t confuse cyclicality with trends

Not uniquely European in nature, but an important point nonetheless. Europe is struggling and it looks problematic. But once you take a step back and realize that Europe has been in a process of integration for 50 years, this current debt-to-GDP debate doesn’t look so bad. Take a further step back and compare this crisis to WWII, WWI, the Black Plague, or the collapse of the Roman Empire. This is not even a comparative blip on Europe’s radar.

China was a world superpower in the years before the Mongolian invasion. All sorts of inventions from gunpowder to clocks to paper to money came from the Orient. And then for nearly a millennium, China shut down. I’m not a Chinese historian, but it is worth noting that one of the most influential regions of the world stagnated for a very long time. Napoleon once said, “Let China sleep, for when she awakes, the world will tremble.” China, today, is growing at a clip nearly 5x faster than any developed economy. It is doing so in a uniquely Chinese way and is reversing its fortunes after years of stagnation.

The point is simple. The world isn’t fixed. Cyclicality is a natural part of life. Things go up, then they come down, then they go back up. Europe may look lost today, and maybe they are. But Europe’s history and unique culture makes it unique. Its roots are spread deeply throughout the entire world.

Remember, Greece and Rome dominated for nearly a millennium. When Rome finally collapsed in the 600s, Europe declined. It took one of the world’s worst disasters, the black plague, to ignite the Renaissance which sparked the Industrial Revolution. For 500 years, Europe was the center of the world. Today, it is clearly in remission. But history tends to repeat itself, and it is inevitable that Europe, with its global reach, its historical roots, and its geographic centrality, will make it an important place to do business for many years to come.

Currency Wars: Monetary Policy as a Zero-Sum Game

For every action there is an equal and opposite reaction -Sir Isaac Newton

I have always thought that Isaac Newton would have been a great investor and/or economist. Not because of his rigorous dedication to his craft. Not because of his mathematical ingenuity. But because of his ability to step outside of conventional thinking and to see the bigger picture. Isaac Newton advanced the field of physics, but he could have equally advanced the field of economic theory. He understood that forces don’t exist in a vacuum and came to realize that every action has its consequences. In fact, forces between people and governments are strikingly similar to forces in nature.

John Makin, a resident scholar at the American Enterprise Institute (AEI), recently published an informative piece on Japan’s two-decade period of stagnation and provided a few takeaways for current U.S. policy. You can read it here.

After the Japanese real estate bubble burst in 1990, the Japanese economy has more than just struggled to regain its footing. Makin points to deflation as the primary cause in the prolonged stagnant economy. Because the Yen hasn’t appreciated in twenty years, debt levels have soared. Governments must pay down their debts in nominal terms, and unlike a country that experiences a reasonable inflation rate of 2% per year, the tax base has also remained stagnant. His proposed solution is to print money, ramp up inflation, increase the tax base, force investors into riskier assets, devalue the Yen, and boost export competitiveness.

So far, so good. This is very sound economic advice and advice that the Japanese government is starting to reflect in their own policy changes. Yesterday, Japanese prime minister, Shinzo Abe, chose Haruhiko Kuroda to stabilize Japan’s money supply. However, Abe has made a very, clear mandate for the new central bank governor: print money. Following up on that dovish promise, Abe has chosen someone who is willing to devalue the currency, avoid deflation at all costs, and set an inflation target to help out Japanese industrial competitiveness. So much for central bank independence.

I agree that in an insular world, this policy makes the most economic sense. It may be a Keynesian way of thinking, but it is a policy that should stimulate an economy that has been stagnant for way too long.

Unfortunately for Japan (and for the rest of the world), monetary policy doesn’t exist in a vacuum. As one country devalues, every other country revalues. Like physics, it is an inherent law that any currency devaluation is followed by a currency revaluation on the other end.

The Federal Reserve, the ECB, and the BOE have all pursued aggressive monetary policies as of late. In September when Bernanke proposed yet another round of quantitative easing, Brazilian finance chief, Guido Mantega, expressed his disapproval. While Bernanke may have been focused on easing credit markets, this action weakened the US dollar and strengthened other currencies around the world, including the Brazilian Real.

In Europe, the ECB has long been expanding its balance sheet (more out of political necessity than economic self-interest). The BOE continues to pursue aggressive monetary policy and has even spoken of negative nominal interest rates, which would entail charging banks a fee for keeping money with the central bank.

So is Japan just playing catch up. Yes, they are. But what happens when the end goal is currency competitiveness and everyone is acting towards the same goal. Like any prisoners’ dilemma game, no one wins. But even worse, everyone loses.

Why does everyone lose? Because the transmission mechanism for expansionary monetary policy (aka printing money) is lowering interest rates. And when short-term rates are at 0%, you lower long-term rates. And suddenly, no one is better off and the economy looks a lot more fragile, with interest rates that are not in line with economic fundamentals.

Many of the fundamental economic problems in the US are large and quickly expanding entitlement programs, like Social Security and Medicare. If the American taxpayer believes he will need to pay more taxes in the future, he will demand a higher return for lending his money to the Federal government. The way to push long-term rates down and incentivize risk-taking is to reform these medium-run obstacles in Congress, not by printing more money at the Fed. Again, structural problems need to be solved structurally. Any monetary remedies are just band-aids.

It is worth noting that many central bankers do believe that lower interest rates (rather than a competitive currency) is key to economic growth. Others, however, tend to disagree. Jeremy Stein, a  member of the Federal Reserve Board of Governors, has alluded to the problem of pushing interest rates far beyond their fundamental range. In this speech, he discusses some of the problems with low interest rates, most notably excessive risk-taking. While the Fed is actively encouraging investors to take risks, too much easing can incentivize excessive risk-taking, much like we saw in the run up to the 2008 financial crisis. A summary of his talking points can be found here.

The global economy is stagnating, not because monetary policy is too tight, but because of political uncertainty. The Yen fell after Kuroda’s appointment, but jumped right back up earlier today when the Italian election results added more uncertainty to the Eurozone mess. Meanwhile in Washington, Bernanke testified before the Senate Banking Committee, reaffirming his bond-purchasing mandate.

How do we get rid of political uncertainty? A currency war will certainly not help. There needs to be more coordinated action at the national level with regards to both fiscal and monetary policy. While monetary policy is supposed to be independent of politics, that independence has unfortunately been compromised. Open communication between central bank governors would help move the global economy in the right direction. Much like meetings between G20 finance ministers, central bank governors should meet more often and make their monetary goals more transparent. The Fed, ECB, BOE, and BOJ need to lead the way; presumably, other countries would follow. However, if the banks continue to fight for a competitive currency, no one wins, and we all lose.

Breakout Nations: Country Report Cards

I have recently finished a book by Ruchir Sharma entitled “Breakout Nations: In Pursuit of the Next Economic Miracle”. It is a fantastic book, and I highly recommend it to anyone with an interest in emerging markets, emerging economies, political economies, or public policy. This book attempts to uncover the next economic miracle: the country that will successfully produce economic growth for its people and financial returns for its investors. Sharma, the current head of emerging markets equities at Morgan Stanley, dives into a number of different countries, examines their economies, details their governments’ involvement, and ultimately comments on whether that country will be a “breakout nation”.

He is quick and persistent in noting that there is no simple formula for analyzing a country. It takes an appreciation for the country’s history, its political economy, and the value of its economic activity. He provides numerous rules of the road, which serve as broad indicators to a country’s ultimate success. One of my favorites: “Rich countries make rich things”.

There is a lot of information in this book, but thankfully, I took some notes. (I actually take notes for most of the books I read. You can view them here). After reviewing my notes, I have given each country a letter grade based on my interpretations of Sharma’s research. This letter grade roughly corresponds to prospects for economic growth, not necessarily for investor returns moving forward (be careful: there is a difference). For each country, I have also listed a few highlights that led me to decide on that country’s grade. These grades are in alphabetical order. And without further ado, my report card:

Brazil: C-
+ Wealth of natural resources
– Dutch disease has made the Brazilian Real one of the most expensive currencies in the world
– Spikes in growth are almost always a result of commodity exports
– One of the most closed economies in the emerging world
– Failure to invest in roads and factories raises costs and creates operational bottlenecks

China: C+
+ Centrally-planned economy behind an economically-focused government
+ Not a single billionaire in China has a net worth of over $10 billion
– Over-investment in roads, railways, and commercial real estate has led to the proliferation of ghost cities
– High levels of debt despite having the appearance as a creditor nation
– Exponentially more difficult to sustain 8% per year growth rates year in and year out
– Growth in consumer spending is already at its peak at 9% per year
– Wage-driven inflation

Czech Republic: A-
+ Has continuously worked towards EU integration
+ Only Eastern European nation to preserve their own auto brand

Hungary: B-
– Government’s inability to control the budget
– Uncompetitive currency, high interest rates, and high unemployment
– Smaller workforce than the Czech Republic despite similar size

India: B-
*India needs to be thought of as an amalgamation of states, rather than one unified country
+ High population growth leads to a larger workforce
+ Entrepreneurial energy
– Its “high-context” society and culture has led to cronyism and nepotism
– Top-heavy with billionaires distorts an essential balance

Indonesia: B
+ Large population with an underdeveloped consumer market
+ Wealth of natural resources
+ “Efficient corruption”
– Highly vulnerable to swings in commodity prices

Japan: B-
– Expensive currency
– Astronomical debt levels
– Stagnant growth
– No sense of urgency to innovate and grow economically

Malaysia: C-
– Move away from manufacturing exports to commodity exports
– Poor execution of grand schemes

Mexico: C
*Most of its exports are to the US, so as America goes, so goes Mexico
+ Cheap currency
– The top-ten business families control almost every industry
– Strong stock market returns are mostly a result of monopolies taking advantage of high margins
– Not a modern capitalist democracy, but rather a premodern political economy
– Poor bank lending

Nigeria: C-
+ Booming film industry “Nollywood”
– Severe lack of investment in roads and energy grids
– Corrupt government

Philippines: C+
+ Wealth of natural resources
+ Large and young workforce
– Weak tourism despite beautiful tourist attractions
– Inefficient government that invests too little

Poland: A
+ Has continuously worked towards EU integration
+ Only economy that didn’t contract in 2008 and 2009
+ Vibrant labor market which has successfully created jobs at a rapid pace
+ Only nation in Eastern Europe large enough to generate economic growth

Russia: D+
+ Entrepreneurs can thrive in such sectors as retail, Internet, media, and other consumer areas
– Little government investment (half the level of China)
– Strong state control over strategic sectors such as oil and gas
– Excellent comeback story until the GFC exposed its inability to implement serious reforms
– Too few small and medium-sized businesses to support innovative growth
– Nonexistent mortgage market
– Criminalization of politics

Saudi Arabia: D
+ Low tax base
+ Does not suffer from the Dutch Disease
– Does not produce anything; merely an oil exporter
– Very little progress in putting citizens to work
– No competitive advantages and has to import nearly everything
– Strict, autocratic government

South Africa: C
+ Low debt levels
+ Low levels of inflation
– Severe unemployment with too little investment in education
– One of the largest income gaps in the world
– State-ownership has led to a lack of competitiveness
– Dutch Disease
– High levels of street crime

South Korea: A-
+ Ability to stay at the cutting edge of fast-changing industries
+ Conformist, yet highly adaptable society
+ History of efficient, autocratic leaders
+ Healthy investment in education
+ Strong, global brands
– Weak service sector
– Weak consumer market

Sri Lanka: B+
+ End of a long civil war usually leads to a “peace dividend”
+ Strategic investments in roads, expressways, and tourist attractions
– Located in an area of the world with underdeveloped trade

Thailand: C
– Overly concentrated capital city of Bangkok
– Running battle between the poor, rural “red shirts” and the richer, urban “yellow shirts”

Turkey: A
+ Low levels of personal debt
+ Un-penetrated consumer market
+ Shift in markets from the West to the East, which is more aligned with its cultural identity

Vietnam: C
+ Recent investment in education at the elementary and high school levels
– Politicians don’t understand economic reform and have no power of eminent domain
– Inefficient port cities
– A central bank that lacks independency has led to runaway inflation

Bernanke-Targeting: Breaking Down the Fed’s New Policy Objectives

Forgive the late timing of this post, but it is winter break. I wanted to briefly discuss Bernanke’s most recent Fed announcement and discuss some of the contradictions he might “appear” to be making. Despite the announcement’s “appearance”, it is in reality the same old Bernanke strategy we’ve been accustomed to since the onset of the current crisis. 

On December 12th, Bernanke did two things: one of which was expected while the second was unexpected.

The mundane first action was inaction–to leave the Federal Funds rate at its current level of 25 basis points. With the economy continuing to stall, this was not a surprise. And while unemployment rates “appear” to be falling, these numbers have been proven to be very untrustworthy and are subject to revisions weeks and months after the fact.

The second action was not just unexpected, but historic. Bernanke announced that rates would be raised IF unemployment reaches 6.5% or IF inflation exceeds 2.5%. For the first time ever, the U.S. Federal Reserve System decided to make interest rate decisions contingent on clearly defined macroeconomic targets. Previously, the Fed has used discretionary decision-making to implement monetary policy. Furthermore, monetary policy-making has been the most discretionary it has ever been in the last five years: bailouts, bank liquidity programs, quantitative easing, credit easing, and MBS purchases, just to name a few.

It “appears” that this stricter, more rule-based decision-making policy would be a complete 180 for Bernanke & Co. John Taylor, a Stanford economist, is a strong supporter of a rule-based monetary decision-making process. He has even developed a formula, commonly known as the Taylor Rule, to implement his policy. His formula has been adapted in many different forms by many of the world’s central banks as a rule (as he would propose) or as an academic guideline (a means of evaluating a discretionary decision). Many iterations of the Taylor Rule use forecasted rates, inflation measures without energy prices, and other normalizing factors. In any case, it “appears” that a decision to make interest rate decisions conditional on inflation and unemployment is a divergence from discretionary policy and towards a stricter, rule-based monetary policy.

While this explanation holds some weight, it is not sufficient enough to understand the current situation. Ever since the departure of former Chairman Alan Greenspan, Bernanke has sought to make the Fed more transparent. He has argued, and many agree, that a more transparent central bank will, in and of itself, instill confidence in market participants and foster economic growth. In that light, this announcement, much like his January decision to leave rates unchanged through 2014, “appears” to be more of a market signal, a sign of transparency, than a strict rule.

Rather than following a prescribed policy rule, Bernanke has chosen to select two “round” and “appealing” numbers to represent both economic robustness (unemployment) and unsustainable inflation (inflation). By openly and numerically conveying this to the markets, Bernanke is hoping to instill more confidence and certainty to market participants as to monetary policy decisions. This, in turn, should better price in Fed decisions, decreasing speculation, increasing confidence, encouraging healthy risk-taking, and thus, spurring economic growth.

I wouldn’t be surprised if Bernanke deviates from this announcement, similar to my wariness of his January announcement of unchanged rates through 2014. After all, these announcements aren’t set in stone, they are just words. Words meant to alleviate current fears for future economic performance. If a tragic event occurs, it is customary to hear “Everything is going to be OK”, even when everyone knows its not. Maybe, that’s a stretch, but you get the point.

“Appearances” can be deceiving. While a historic announcement, nothing has changed. We’re still at an economic standstill and despite his best efforts, there is nothing Bernanke can do about it.

The Folly of Shareholder Value Maximization

Shareholder value maximization implies that the CEO or the upper management of any publicly-traded company has one goal: to increase the value of outstanding shares (i.e. make the company more profitable).  Many interpret this to be long-term value, whereby CEOs should make decisions to benefit the company in the long-run. However, with benefits such as stock options and the inability of market participants to see years into the future, many managers implement policies that help the company in the short-run.

I’m going to ask a question that many people would take exception to, especially anyone who subscribes to the theory of shareholder value maximization. Should the ultimate goal of a company be to make the most money?

In a Western, democratic society, the answer is a resounding yes. This country was founded on principles of individual freedom, manifest destiny, and entrepreneurial spirit. It is counter-cultural to think about anything beyond the individual, or in this case, the company. As a CEO, you are the head of a business and it is your job to better the business. This encourages innovation and competition (both positive). However, it also encourages short-term strategies, unfair business practices, and can lead to some disastrous consequences.

Let’s take the largest company in the world, Apple. Apple currently has a market cap of just under $500billion. Just a few weeks ago, it was close to $600billion. Last quarter, Apple managed to collect $8billion in profit. That $8billion is accounted for as retained earnings and is either re-invested in the company (again, to make the company better) or given to shareholders (shareholder maximization).

In 2011, there were two separate incidents of aluminum dust explosions at iPad manufacturing centers, which ended up killing factory workers. Although these are not Apple facilities, Apple has a history of forcing its contractors to accept very low margins. These contractors therefore look to cut costs by forcing longer hours, giving less pay, and in some instances, neglecting workplace safety. Why couldn’t Apple just give these contractors better margins? Maybe make $7billion in profit instead of $8billion. Some might argue that smart CEOs would take these risk factors into consideration when choosing an operational strategy and maybe Tim Cook will take a deeper look into this. My point is that shareholder value maximization doesn’t have to be the be-all, end-all. There are other ways to run a company.

Some countries are not democratic. China, for example, relies heavily on government intervention for economic policy. For all of its faults, the Chinese government has done exceptionally well (maybe even too well) in building infrastructure systems for the entire country. It protects its companies’ export strengths by holding its currency down and is second-to-none in providing key jobs for a labor force looking to grow. In China, the focus is not on the individual companies and their market capitalizations. The focus is on a government-directed economic strategy not based on the Western ideals of laissez-faire.

Clyde Prestowitz is the founder and President of the Economic Strategy Institute. In a 2010 speech, he likened many of China’s current policies to American policies throughout the 19th century and first half of the 20th century. He discusses a “catch-up” strategy in which the forefathers wanted to beat the British. Government officials worked closely with some of the largest US companies to out-do the British. He gives the example of a joint venture between AT&T, GE, Westinghouse, United Fruit, and the US Navy designed to provide a better alternative to British Macaroni in radio telegraphy. That company became RCA, the Radio Corporation of America.

He goes on to discuss how China’s President Hu Jintao wakes up every morning looking at economic developments and statistics while President Obama gets briefed on foreign affairs in the Middle East. He says, “Obama’s strategy is not to have a strategy. It’s just to let the unfettered, free market run.” Furthermore, Prestowitz discusses the folly of shareholder value maximization:

This whole concept of fiduciary responsibility to the shareholders is a dominant doctrine that has taken hold in the business schools over the last 30 years, the doctrine of shareholder value, the notion that the only, or at least almost the only, mission of the CEO is to raise the price of the stock, to increase the value of the company, and, since that is measured in the short-term, pretty much to raise it in the short-term.

His point is that these CEOs are so focused on their individual companies and their individual earnings for the next few quarters that they lose sight of the bigger picture. The bigger picture being American economic competitiveness moving forward. The picture that our government thought about prior to 1950. The picture China and other developing nations are thinking about today.

How can we make the United States a better place to invest? The answer to this question will “raise shareholder value” for every company in this country, but believe it or not, no one is paying attention to it. No one is incentivized to.

Because the United States has no central economic strategy, its largest corporations are left to a free market where they are free to pursue shareholder value maximization. Any emerging market like China, India, or any other country needs a centrally-directed economic strategy to survive. Without it, its corporations would have no direction. They would compete against each other for short-term gains, eventually losing sight of the bigger picture.

Norway has always been one of my favorite countries to think about. They have under 4million citizens  and are fairly well off because of a surplus of oil reserves. Moreover, it is a very socialist and democratic society. Yet, they centrally plan their economy and coordinate their policies unlike any other democratic government today. Maybe it is because they are so small and homogeneous, but there are lessons to be learned from a country which controls its oil reserves according to global supply and demand, collects high taxes, and redistributes them to profitable investments (infrastructure projects, education, etc).

The United States can keep on doing what it’s doing: focusing on external threats, spending money in the Middle East, allowing its economy to keep on its laissez-faire path. But as we saw in 2008, without proper safeguards in place, it is bound to blow up. And with the way our current account deficit and our national debt is growing, it is only a matter a time before the economically-oblivious United States finds itself in real trouble.

On Jordan Zimmermann

The Nationals arguably have (or had) the best starting pitching in all of baseball. Their complete pitching staff boasted a 3.33 ERA throughout the regular season (best in the NL) and is anchored by Cy Young candidate, Gio Gonzalez, and the 2009 first overall pick, Stephen Strasburg. These two pitchers have been the face of the Nats turnaround, but there’s a third starting pitcher who has gone slightly unnoticed. In fact, he is not even the most well known “Zimmerman(n)” on the team.

Jordan Zimmermann has quietly put up a fantastic season, and one that in my opinion, rivals both Strasburg’s and Gonzalez’s. Sure, his numbers may not be as flashy. But nevertheless, take a deeper look at the statistics, and you will see a remarkably consistent and efficient 2012 regular season.

Let’s start with wins. #1 Gio (21), #2 Strasburg (15), #3 Zimmermann (12). But we all know wins are not particularly good indicators of pitching performance. Too many other variables most notably run support and reliever performance can skew these numbers. Zimmerman’s 12-8 record looks fairly average, especially on the winningest team in baseball.

Another populat stat is Earned Run Average. 2012 regular season ERA among starters: #1 Gio (2.89 ERA), #2 Zimmerman (2.94 ERA), and then #3 Stephen Strasburg (3.16 ERA). However, ERA has been an historically inefficient metric to compare pitching performance. Year-to-year fluctuations based purely on chance distort this figure. Zimmermann’s ERA is even better than Strasburg’s and not too far off from Gio’s.

Let’s take a look at some other numbers. Strikeouts are a flashy number that actually means something. The ability to get someone out without incurring the risk of a live ball is critical to the sport. Zimmerman’s 153 Ks trails Strasburg’s 197 and Gio’s 207. Opposing Batting Average (the average hitters against pitchers) is above .250 for Zimmerman, .230 for Strasburg, and a mere .206 for Gio.

What Zimmemann lacks in flash, he makes up for in consistency. We saw last night that despite a wildly erratic performance from Gio, he still managed to throw 5innings with 2ER and just 2 hits. Maybe his worst performance of the year and he escaped with a somewhat respectable statline.

Walks are worse than hits. It has been statistically proven that walks lead to more plated runs than do singles. Although they have the same end result, momentum factors make walks much worse than singles. Zimmermann walked just 43 all season. Strasburg walked 5 more batters, but also pitched 35 less innings. Gonzalez who pitched about 4 more innings than Zimmermann walked 76 batters, 176% more than Zimmermann. In terms of BB/9, only reliever Sean Burnett boasted a better ratio.

As mentioned previously, innings pitched is also a significant metric. Although Strasburg pitched with an innings limit, the ability to post nearly 200 innings for a ball club has important ramifications for the bullpen’s health and efficiency. Both Gio and Zim threw between 195 and 200 innings this season. Another note: this is just Zim’s second year back from reconstructive elbow surgey.

We want pitchers to eat up innings to save the bullpen, but at the same time, we want pitchers to pitch less to save themselves. Zimmermann’s pitches/IP was lower than both Gio’s and Strasburg’s. Not only does he pitch efficiently, but he gets the defense off the field in a timely manner. The 43 total walks doesn’t hurt either.

Finally, Zimmerman gets hitters to hit the ball on the ground and subsequently into double plays. As we saw with Mattheus’ 2-pitch inning yesterday, the ability to turn a double play (especially in the playoffs) can be huge and reverse momentum. 18 times this season Zimmermann induced double plays. Detwiler and Strasburg each induced 14, and Gio induced just 9, half of Zimmermann’s total.

He might not be flashy, but Jordan Zimmermann anchors the National’s rotation better than any of the three playoff starters. His consistency will be key if the Nationals expect to advance further into the playoffs.

First pitch of Game 2 of the NLCS  is at 4:37pm on TBS. Follow @jasonrkeene for live tweets starting around 5:00pm.

Baseball in October

It’s been a long time since a DC baseball team has played a postseason game. Scratch that. It’s been a few generations. To put things in perspective, it was 1933. My grandfather was just 5 years old.

Aside from baseball mediocrity, the city of Washington has struggled with the postseason. The Washington Capitals have not managed to make it past the second round since 1999. The Redskins won a SuperBowl before I could say “Redskins” and have since made just 4 postseason appearances, again never making it past the second round. And the Wizards, well, do we even need to go there.

The Nationals came to DC in 2005, and I obviously didn’t grow up a Montreal Expos fan. Rather, I grew up as an Orioles fan. For the first 14 years of my life (the first two-thirds), I made the 35-mile trek up Interstate-95 to Camden Yards to watch the Orioles. The team was actually pretty good in its early years. My first, and only memory of playoff baseball happened at age 5 (my grandfather’s same age at the time of the last Washington postseason appearance).

October 9th, 1996. It was a cold night in the Bronx and the Yankees were hosting the Orioles in Game 1 of the ALCS. Trailing 4-3 in the bottom of the eighth, a rookie by the name of Derek Jeter came to the plate. He hit a long fly ball to right field that should’ve landed in Tony Tarasco’s glove on the warning track. Instead a 12-year old Jeffrey Maier reached his glove over the right field fence and snatched the ball. The call was a HR. Bernie Williams would end up homering in extras to give the Yankees the win. New York would win the series 4-1. The Orioles would make it to the ALCS the following year, falling to the Indians in 6. And that’s been it. They haven’t been back since.

October 7th, 2012. Both the Baltimore Orioles and Washington Nationals are back to October baseball. One team hasn’t been here in 15 years. The other hasn’t ever been here (the Expos franchise last trip was 38 years ago, in 1984).

And it is only fitting that the Orioles will face the New York Yankees. In a bizarre playoff jumble, divisional opponents will face each other in the first round for the first time ever. As for the Nationals, they will fly to St. Louis to face the defending World Champions, a team that snuck into the playoffs last year, won it all, and had to sneak in again. Even then, they needed a newly created “outfield fly rule” and three Atlanta errors to get here.

I recently posted an article about the decision to sit Stephen Strasburg for the postseason. If my deeper reasoning wasn’t clear then, I will try to clarify it now. For most teams and for most fans, winning the World Series is everything. Especially in cities like New York and Boston, anything less is a failure. The ability to call yourself a World Champion supersedes everything and for most outsiders, it should supersede a pre-emptive sitting of one of the game’s most dangerous pitchers.

However, my thinking is different than most. A World Series would be nice, for sure. But with today’s current playoff system and the uncertainty surrounding the postseason, there isn’t a clear-cut favorite to win  it all. Really, any team could make a strong case for going all the way.

I have never been to a baseball game in October. I only have one memory of postseason baseball, and it involves a 12-year old kid. I guess it makes sense that my only memory would not be of some heroic feat by a grown man getting paid thousands of dollars to play the sport as a career. No, my memory is of a 12-year old baseball fan who decided to bring his glove to a baseball game in hopes of catching a fly ball.

And that’s the way it should be. A championship would be nice, but I’m just happy to see my two favorite teams playing meaningful baseball in October.

On Stephen Strasburg

Stephen Strasburg will be shut down within the next four or five starts. Since Day 1, Nats GM Mike Rizzo has made it clear that Strasburg would be working this season on an innings cap, much like Jordan Zimmermann the year before. Although rare, it’s not unprecedented to shut down a pitcher like Zimmermann after 160 innings. However, it is unprecedented to shut down a pitcher like Strasburg, a #1 draft pick and the ace of the rotation, in the midst of a pennant race. Let alone the first pennant race in Washington since the 1930s.

It seems like everyone has an opinion on the matter. And everyone has the same opinion: the Nationals are crazy to shut him down. He’s the ace of the rotation. He boasts a 98mph fastball, a 90mph change, and an 82mph curve. All deadly pitches on their own and when combined together, it’s nearly unbeatable. This season, Strasburg is 15-5 with a 2.85 ERA and leads the NL with 183 strikeouts. His team has a 7 game division lead in the NL and owns the best record in baseball at 77-46. Through 123 games last year, the Nationals were 60-63. The year before that, they stood at 53-70.

But we need to take a look at how the Nationals came to be the best team in baseball. A lot of people, who have not been following the team since they moved to Washington in ’05 view this season as somewhat of a fluke. Who knows whether they’ll be this good again? How do we know the Nationals will be healthy in future years? Will they ever be in a good enough position as they are today?

This team isn’t a fluke. It is the result of years of mediocrity coupled with an unbelievable front office job. Mike Rizzo and his team have put together the strongest rotation and one of the best bullpens in all of baseball. Their lineup is solid and their bench is deep. They’ve drafted, developed, and acquired. In addition to notable draft names like Strasburg, Zimmermann, and Harper, they managed to unload other draft choices and prospects for an asset on par with Strasburg, Gio Gonzalez. They have developed players like All-Star shortstop Ian Desmond, Danny Espinosa, and Steve Lombardozzi. They found a 30-year old journeyman in Michael Morse that they have turned into one of the best pure power hitters in the game. Sean Burnett, Craig Stammen, Tyler Clippard, and Drew Storen have combined to produce a formidable bullpen for any team that manages to get past the Nats’ starters. Mike Rizzo even managed to lure Jayson Werth away from a first-place team to a last-place team, without even leaving the division. And Adam LaRoche should be the comeback player of the year. No doubt.

The Nationals aren’t going anywhere. They’re good. Really good. And as good of a season as they’re having, they have been riddled with injuries. Ryan Zimmerman, Ian Desmond, Michael Morse, Drew Storen, and Jayson Werth have all spent time on the disabled list. The Nats also lost Wilson Ramos for the season to an ACL tear. The only part of the team that has stayed off the disabled list has been their starters.

And that is exactly why Stephen Strasburg is going to stop pitching mid-way through September in the midst of a playoff race, for a city that hasn’t seen the postseason in nearly 80 years. Although Strasburg has been spectacular, I would go as far as to say that he has been the third best starter this season. The Nationals traded for All-Star left-hander Gio Gonzalez in the off-season. His stat line: 16-6 with a 3.23 ERA and 161 K’s. But the most consistent starter has been Jordan Zimmerman. Although his 9-7 record might not scream “ACE”, he has a 2.54 ERA (lower than Strasburg’s and Gonzalez’s) and has walked less than 30 batters in over 150 innings of work.

And this is the model. This is their blueprint. Zimmermann underwent Tommy John surgery a year before Strasburg. They capped his innings. And he’s even better this year. They want to do the same thing with Strasburg. A 24-year old kid underwent major reconstructive elbow surgery two years ago. They literally take tendons from your leg and put them back in your arm! And the Nationals plan is to proceed with caution, rest his arm, continue to refine his mechanics, and hopefully enter next season with a better pitcher than the All-Star that he’s been this year.

Side note: One thing that bothers me is Strasburg’s pitching motion. He has an unconventional delivery which places too much stress on the arm. When pitchers come back from Tommy John, they have a tendency to overwork their shoulder to take some of the pressure off the elbow. There have been a number of Tommy John patients who have had shoulder problems a few years down the road. With Strasburg’s motion the way it is, prudence is the best strategy.

June 8th, 2010. On this date, I watched Strasburg’s MLB debut from the Nationals pressbox. I had the rare opportunity to sit next to one the most knowledgeable men in baseball and a good friend, ESPN’s Tim Kurkjian. He was in shock. He had never seen a debut performance like it in all of his year’s of covering baseball. His enthusiasm and awe for the kid’s 14 strikeout performance was contagious. There was energy and electricity at Nationals Park that night unlike anything I’ve ever felt watching a baseball game. Even Opening Day 2005 didn’t have the same feeling that Strasburg’s debut did. A packed house came to watch their #1 draft pick, their phenom, their future. This is when I knew that the Nationals were going to be good. Maybe not next year, maybe not the year after, but sometime in the future.

And now I have to listen to people talk about how shutting him down is a bad idea. And none of these people are Nationals fans. None of these people have followed this team since ’05. None of these people have lived their whole lives in DC. None of these people understand that this is a good team that got a little too good, a little too fast. All of these people, however, think they know what’s best. Their opinions are somehow more valuable than those closest to the situation. “The GM who has constructed the best team in baseball is wrong. The entire front office is wrong. The doctors are wrong. Scott Boras, Strasburg’s agent, is wrong. The Nationals fan base is wrong.”

There’s no debate here. There has never been a debate. The Nationals are doing what’s best for Stephen, what’s best for the Nationals, and what’s best for Washington.

As I see it, there are 12-14 teams that are capable of winning a World Series. With those odds, it would be foolish to think the Nationals are going to win it all. As Oakland GM Billy Beane likes to say, “the postseason is all luck”. At the end of the 2012 season, a team will be crowned World Champions, that team will probably not be the Nationals, and everyone will raise their arms and say, “I was right. They lost because they shut down Stephen Strasburg”.

Next Post

Curly W Live

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Just about every night, I remind myself, be careful what you wish for.

For years now, we watched with silent envy as teams played meaningful games late into the season. We were thrilled to play a role — any role — in the season’s outcomes, to affect the standings from the outside.

Some call it playing the “spoiler.” Whatever they called us, it fit at the time.

But when everyone went home at night, all we could do was picture and dream what a pennant race was like from the inside.

Well no longer. Friends, we are in the midst of a real pennant race. And, bonus, this one appears to have started a bit earlier than most.

Honestly, my early impression is that it is equal parts pleasure and agony.

As if the late innings of a tight game…

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The Death of Equities: Was the Last Century a Statistical Anomaly?

Bill Gross, the king of bonds, and the CIO of the trillion dollar bond fund, PIMCO, has recently come out as bearish on the stock market. Very, very bearish.

“The 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes — a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?”

Here, Gross is referring to our 100-year historical trend. Since 1912, the stock market has returned 6.6% annually to investors, while GDP is only at 3.5%. He argues that there is a significant gap between GDP gains and stock market gains, in which a correction is in order to return stocks to their historical, or fundamental, average.

Throughout the last week and a half, a rather ruthless debate has ensued between Gross and Wharton professor, Jeremy Siegel, author of Stocks For The Long Run. Siegel argues that Gross failed to consider the impact of dividend-paying stocks, in which those 6.6% returns are overestimated. He also states that Gross predicted a Dow 2,000 in 2002, where we stand at 13,000 now (after a financial crisis and a half).

So who’s right, who’s wrong, and more importantly why?

I believe that both men, although arguably two of the smartest, and most accomplished in their respective fields, fall victim to a common saying. A saying that every single investment manager, stock or bond, must spell out in writing to their investors.

“Past performance is not indicative of future results”

The point is that we can’t look at historical data to dictate what the future might hold. Looking at a 100-year trend and trying to discern any meaningful trend as to predict the future would get any first-year statistics student a failing grade. In the same vain, Jeremy Siegel, should know better than to criticize the bond king on one past prediction, and use it to prove his own point.

I’ve read Jeremy Siegel’s book (well, at least a third of it–it gets pretty boring to be completely honest). He uses a lot of data and past examples to explain why the buy-and-hold stock strategy will pay off over the long run, but his premise is relatively straight-forward and has nothing to do with stocks. Really, risk drives return. Because stocks are riskier assets and inherently have more volatility than do bonds, they will drive returns. Put simply, if investors can cope with ups and downs, the safest strategy is the riskiest one. Siegel’s strategy has since evolved. The once famed “60-40, stock-bond” allocation is a thing of the past. In the last few decades, investors have adapted their portfolios across multiple asset classes, including real estate, private equity, commodities, and even venture capital. I once learned that asset allocation drives almost 94% of returns. This idea assumes an efficient market (a theory I have zero faith in), but nonetheless, it illustrates an important point. The riskier and more diversified your portfolio, the higher your returns over the long run.

Let’s go back to Gross and Siegel’s debate about the death of equities. I’m going to step out of the financial models and statistical inferences for a second and try to explain why Gross is right, yet why his arguments fall short. To say that GDP=stock market growth is absurd. The two are definitely correlated, but no one has ever said they need to be in lockstep with one another. Stock market growth is not indicative of GDP growth, but is rather a function of both consumer confidence and public company growth.

I would argue that since 1912, the relative importance of public equities has far eclipsed what it was prior to 1912. Starting with the industrial revolution in the 1700s, then the garment factories in the 1800s, and the assembly line production studios in the early 1900s, our economy has relied more and more heavily on mass production, and it has also benefited more and more from economies of scale. Thus, stocks, or publicly traded companies, have prospered. As our reliance on mass production has increased, those companies that mass produced  (publicly traded equities) have outperformed the market (GDP).

Now I know that my math needs some work, but the idea is simple. Public equities have outpaced GDP over the last 100 years, because as an economy, public equities have outperformed the rest of the economy over the last 100 years. The question we must now ask ourselves is this: Does this trend continue?

I don’t think it does. We have reached an age in which mass production is in its decline. The influence of large companies is starting to wane. More and more start-ups are shaping our economy and are producing goods and services in vastly different ways. The Internet, and technology in general, has made it easier for the individual and small groups to provide economic value. Really, this point should be straight-forward. I would suspect that very few people would doubt this.

I apologize for the length of this post, but I wanted to make sure my point got across clearly. It is a mistake to look at past performance as indicative of future results. Although statistics may help us understand the past, there is no substitute for foresight. If asset allocation really drives 94% of returns, then we must look at it very carefully and diligently. Stocks were big throughout the early and middle of the 20th century. Bonds made a flashy appearance in the early 1980s, especially with high, floating interest rates. Private equity became popular throughout the 1990s, real estate flourished in the early 2000s (although a massive bubble), and now venture capital seems to be the hot ticket.

Asset classes will evolve and change. We must understand what truly drives economic growth, and capitalize on it. I think public equities are not dead, but will slowly die until our future economy looks nothing like the past economy. However, there is no substitute for risk. Assuming humans don’t suddenly develop an aggressive risk appetite, risk will always be undervalued over the long run and thus, will always provide significant returns.