WEBVTT NOTE Austrian Economics and Investing 1 00:00:00.000 --> 00:00:05.500 So our next speaker is Joe Colandro. 2 00:00:05.500 --> 00:00:12.200 He's an enterprise risk manager of a global financial services firm. 3 00:00:12.200 --> 00:00:16.100 And he's a faculty member at the University of Connecticut, 4 00:00:16.100 --> 00:00:22.700 where he designs and teaches MBA courses in value investing and risk management. 5 00:00:22.700 --> 00:00:27.600 He has a new book coming out called Applied Value Investing. 6 00:00:27.600 --> 00:00:29.600 And I'm holding it up right here. 7 00:00:29.600 --> 00:00:39.360 Applied Value Investing, so we're going to fill this in later with the magic of media. 8 00:00:39.360 --> 00:00:44.600 Joe, please join us. We're running about 10 minutes late, but we'll be sure and get you all. 9 00:00:44.600 --> 00:00:59.560 Thank you all. Before I start, I would like to thank the Mises Institute as well as the sponsors of this great event for inviting me to speak today. 10 00:00:59.560 --> 00:01:04.880 When I got here this morning, I was speaking with a friend of mine, Robert Blumen, who's 11 00:01:04.880 --> 00:01:11.440 a pioneer in Austrian financial economics, and he asked me, you know, when are you speaking? 12 00:01:11.440 --> 00:01:15.120 So I told him what my slot was, and I was somewhat complaining a little bit because 13 00:01:15.120 --> 00:01:16.800 the speaker after me is Lew Rockwell. 14 00:01:16.800 --> 00:01:21.320 It's like, I don't want comparisons with Lew Rockwell. 15 00:01:21.320 --> 00:01:26.160 And Robert said to me in the insightful way that only he could say it, he goes, Joe, it 16 00:01:26.160 --> 00:01:27.160 could be worse. 17 00:01:27.160 --> 00:01:28.160 It could be a lot worse. 18 00:01:28.160 --> 00:01:40.360 So by way of background, I traded currencies and commodities in the 1990s, and I did exceptionally 19 00:01:40.360 --> 00:01:42.200 well for about four years. 20 00:01:42.200 --> 00:01:49.600 At year five, I was caught in the Asian contagion, and my fortunes were reversed, if you will. 21 00:01:49.600 --> 00:01:54.740 So examining the mistakes I made, and I made quite a few, led me to the study of Austrian 22 00:01:54.740 --> 00:01:59.020 and Economics and Value Investing, which was fortunate in a sense, timing-wise. 23 00:01:59.020 --> 00:02:03.620 Now I say it was fortunate because there were parallels with what I was seeing in the 1990s 24 00:02:03.620 --> 00:02:09.060 in the new economy and what I was reading about from the new era in the 1920s. 25 00:02:09.060 --> 00:02:13.900 And significantly, from an investment point of view, Austrian business cycle theory predicted 26 00:02:13.900 --> 00:02:18.740 both the boom and bust waves of both business cycles, which is important from an investment 27 00:02:18.740 --> 00:02:19.740 perspective. 28 00:02:19.740 --> 00:02:23.100 So I started out writing memos for select friends of mine. 29 00:02:23.100 --> 00:02:27.180 Those memos turned into working papers, some of which I actually presented at earlier Austrian 30 00:02:27.180 --> 00:02:29.140 Scholars Conferences. 31 00:02:29.140 --> 00:02:33.440 Working papers turned into journal articles, including in the Quarterly Journal of Austrian 32 00:02:33.440 --> 00:02:38.540 Economics and some of those ended up in my book which was recently published. 33 00:02:38.540 --> 00:02:45.220 Now the thesis of my talk today is that good economics facilitates good investing. 34 00:02:45.220 --> 00:02:48.980 And I'd like to begin with something that Warren Buffett said about investment. 35 00:02:48.980 --> 00:02:53.500 He indicated that investment students need only two well-taught courses. 36 00:02:53.500 --> 00:02:57.940 The first is how to value a business and the second is how to think about market prices. 37 00:02:57.940 --> 00:03:01.900 Now if I was coming up with courses, I would add two more of those, one of which is how 38 00:03:01.900 --> 00:03:05.240 to think about money, but that's for another time. 39 00:03:05.240 --> 00:03:10.700 Now with respect to the linkage between business valuation and market prices, I note that Mises 40 00:03:10.700 --> 00:03:16.120 stated in his seminal 1920 article that quote, where there is no free market, there is no 41 00:03:16.120 --> 00:03:22.240 No Pricing Mechanism, and Without a Pricing Mechanism, There is No Economic Calculation." 42 00:03:22.240 --> 00:03:27.400 So there's a direct correlation between valuing a business and market pricing. So in other 43 00:03:27.400 --> 00:03:32.480 words, good economics facilitates good investing. And by economics, for purposes of this talk, 44 00:03:32.480 --> 00:03:37.240 I mean the science which studies human behavior as a relationship between ends and scarce 45 00:03:37.240 --> 00:03:43.920 means which have alternative uses. And that of course is Lionel Robbins' famous definition. 46 00:03:43.920 --> 00:03:48.360 Now what do I mean by investment? What's the definition for investment? And as Rothbard 47 00:03:48.360 --> 00:03:54.240 indicated, quote, the capitalist entrepreneur buys factors or factor services in the present, 48 00:03:54.240 --> 00:03:58.520 his product must be sold in the future. He's always on the lookout then for discrepancies 49 00:03:58.520 --> 00:04:03.200 for areas where he can earn more than the market rate of interest, close quotes. So 50 00:04:03.200 --> 00:04:08.500 price discrepancies. Well, how do investors do that? And according to Mises, open quotes, 51 00:04:08.500 --> 00:04:13.360 the books in the balance sheets are the conscience of business. They are also the businessman's 52 00:04:13.360 --> 00:04:19.240 Compass, close quotes. The books and the balance sheets, not just the books. And the 53 00:04:19.240 --> 00:04:24.660 method that I found that facilitates the analysis of both the books and the balance sheets the 54 00:04:24.660 --> 00:04:30.960 best is the modern gram and dot approach. And it proceeds over a unique value continuum 55 00:04:30.960 --> 00:04:35.360 analytically. It begins with the balance sheet and net asset value, proceeds to the books 56 00:04:35.360 --> 00:04:41.280 and earnings power value, and then potentially proceeds to franchise value competitive advantage 57 00:04:41.280 --> 00:04:45.680 Research Analysis and then potentially Growth Value, which is the final and least tangible 58 00:04:45.680 --> 00:04:48.080 aspect on the continuum. 59 00:04:48.080 --> 00:04:52.720 Now value investing was founded by Benjamin Graham, the late great Benjamin Graham, in 60 00:04:52.720 --> 00:04:55.060 the 1920s and 1930s. 61 00:04:55.060 --> 00:05:00.120 He was heavily influenced by the New Era boom of the 1920s and the subsequent Buster or 62 00:05:00.120 --> 00:05:01.120 Great Depression. 63 00:05:01.120 --> 00:05:06.640 Now significantly, especially for purposes of this talk, he founded a price discrepancy 64 00:05:06.640 --> 00:05:07.640 Based Strategy. 65 00:05:07.640 --> 00:05:13.040 In its original formulation, it involved buying assets less than the liquidation value, which 66 00:05:13.040 --> 00:05:17.860 resulted in a significant price discrepancy or what we call the margin of safety. 67 00:05:17.860 --> 00:05:22.120 Now this concept of a margin of safety is the cornerstone of the approach and remains 68 00:05:22.120 --> 00:05:27.280 so to this day, and it is what differentiates an investment from a speculation to Graham 69 00:05:27.280 --> 00:05:28.560 and his students. 70 00:05:28.560 --> 00:05:32.680 Now Graham's most famous student obviously is Warren Buffett, but there have been others 71 00:05:32.680 --> 00:05:39.680 The difference between bottom-up analysis and top-down analysis is somewhat analogous to the difference between mindset analysis and top-down analysis. 72 00:06:02.680 --> 00:06:05.680 Microeconomics and Macroeconomics 73 00:06:05.680 --> 00:06:09.680 Microeconomics pertains to individual action, supply, demand, pricing 74 00:06:09.680 --> 00:06:12.680 things we can all get our arms around 75 00:06:12.680 --> 00:06:15.680 whereas macroeconomics involves aggregate analysis 76 00:06:15.680 --> 00:06:18.680 gets very murky, there's definitional problems and the like 77 00:06:18.680 --> 00:06:21.680 Similarly, the difference between fundamental analysis 78 00:06:21.680 --> 00:06:24.680 and portfolio analysis is somewhat similar 79 00:06:24.680 --> 00:06:27.680 meaning fundamental analysis is concentrated on price discrepancies 80 00:06:27.680 --> 00:06:30.680 looking for areas where there's a difference between 81 00:06:30.680 --> 00:07:00.680 between Value and What You Can Buy the Assets for Today and Portfolio Analysis which is more concerned with top-down efficient frontiers and asset allocation strategies and significantly for the purposes of this talk portfolio analysis in many ways forms the basis of some of the risk models that did not perform very well in the credit crisis and to understand why I included a quote from Murray Rothbard which indicates quote it is certainly 82 00:07:00.680 --> 00:07:05.560 It is not legitimate and necessary for economics and working out an analysis of reality to 83 00:07:05.560 --> 00:07:10.520 isolate different segments for concentration as the analysis proceeds, but it is not legitimate 84 00:07:10.520 --> 00:07:15.960 to falsify reality in this separation so that the final analysis does not present a correct 85 00:07:15.960 --> 00:07:21.000 picture of the individual parts and their interrelations." 86 00:07:21.000 --> 00:07:26.920 And I would indicate that one of the reasons why some of the quantitative models have collapsed 87 00:07:26.920 --> 00:07:30.640 is because they did not present a correct picture of either the individual parts, meaning 88 00:07:30.640 --> 00:07:37.640 and Individual Securities, or their interrelations, especially under conditions of stress. 89 00:07:37.640 --> 00:07:42.120 Value investing begins with three core principles, and while these principles are associated 90 00:07:42.120 --> 00:07:47.200 with the school, they don't necessarily need to be unique to the school, meaning they could 91 00:07:47.200 --> 00:07:52.000 apply to any form of investment, and the first one is knowledge-based. 92 00:07:52.000 --> 00:07:57.320 To begin my discussion, I'd like to paraphrase something that Frederic Hayek said in his 93 00:07:57.320 --> 00:08:12.320 The recognition of the insupportable limits to his knowledge ought indeed to teach the student of investment a lesson of humility which should guard him against becoming an accomplice in men's failed striving to achieve quick and easy returns. 94 00:08:12.320 --> 00:08:18.320 In other words, human knowledge is inherently limited, and in many cases, it's severely limited. 95 00:08:18.320 --> 00:08:25.320 And as a result, from an investment perspective, you greatly increase the probability of success if you focus on what you know. 96 00:08:25.320 --> 00:08:29.920 Benjamin Graham referred to this as the circle of competence and with respect to 97 00:08:29.920 --> 00:08:33.680 the circle of competence Warren Buffett indicated that the size of that circle 98 00:08:33.680 --> 00:08:39.120 is not important but knowing its boundaries is vital and that's important 99 00:08:39.120 --> 00:08:42.480 because when you're doing a bottom-up evaluation you have to know which 100 00:08:42.480 --> 00:08:46.320 adjustments you have the expertise to make yourself and which require the 101 00:08:46.320 --> 00:08:50.120 services of an expert and I'll give you two examples of what I mean by that 102 00:08:50.120 --> 00:09:00.120 There's a show on cable television called Pawn Stars, and it's a family-run pawn shop in Las Vegas run by a family of entrepreneurs who are very, very savvy. 103 00:09:00.120 --> 00:09:09.120 But every now and then someone will come in the store with an item that's very specialized and they can't either assess its originality, if it's real, or price it, so they call in an expert. 104 00:09:09.120 --> 00:09:13.120 And many value investors do the same type of thing. 105 00:09:43.120 --> 00:09:47.960 I have an insurance background, so I wrote about Warren Buffett's Geico acquisition, 106 00:09:47.960 --> 00:09:50.600 Jennery acquisition, and Pepsi Play for a billion sweepstakes. 107 00:09:50.600 --> 00:09:53.920 So one of my students said, hey, you know, all right, you're real good when it comes 108 00:09:53.920 --> 00:09:56.920 to that type of stuff, but could you do like retail? 109 00:09:56.920 --> 00:09:59.160 Way, way out of my circle of competence. 110 00:09:59.160 --> 00:10:03.240 So I took a crack at it and I followed the framework level by level. 111 00:10:03.240 --> 00:10:04.800 I do not know Mr. Lampert. 112 00:10:04.800 --> 00:10:10.500 I don't know how he values investments, but using this approach and using it conservatively, 113 00:10:10.500 --> 00:10:14.980 I was able to come up with a value relatively close to what he paid for Sears. 114 00:10:14.980 --> 00:10:19.260 So again, you may not have as an individual investor the means to go out and hire a professional 115 00:10:19.260 --> 00:10:23.300 yourself, but you do know people and you do have resources you could tap as you conduct 116 00:10:23.300 --> 00:10:26.280 your investment analysis. 117 00:10:26.280 --> 00:10:31.100 Even if you're operating within a circle of competence, you could still be wrong. 118 00:10:31.100 --> 00:10:36.140 As Mises indicates, quote, man does not always act correctly from the objective point of 119 00:10:36.140 --> 00:10:37.140 view. 120 00:10:37.140 --> 00:10:48.060 Either from ignorance of causal relations or because of an erroneous judgment of the given situation, in order to realize his ends, he acts differently from the way in which he would act if he had correct information." 121 00:10:48.060 --> 00:10:53.860 In other words, as an investor, you could be wrong for any number of reasons, quantitative, qualitative, or behavioral. 122 00:10:53.860 --> 00:11:00.540 And as a result, you should approach each adjustment very, very conservatively or each valuation very, very conservatively. 123 00:11:00.540 --> 00:11:04.060 However, even if you do so, you could still be wrong. 124 00:11:04.060 --> 00:11:06.620 As Rothbard has indicated, quote, 125 00:11:06.620 --> 00:11:08.660 this world is a world of uncertainty. 126 00:11:08.660 --> 00:11:10.900 We shall never be able to forecast the future course 127 00:11:10.900 --> 00:11:12.900 of the world with precision. 128 00:11:12.900 --> 00:11:14.980 Every action therefore involves risk. 129 00:11:14.980 --> 00:11:17.340 This risk cannot be eliminated. 130 00:11:17.340 --> 00:11:20.020 The man who keeps his cash balances suffers the risk 131 00:11:20.020 --> 00:11:21.980 that his purchasing power may dwindle. 132 00:11:21.980 --> 00:11:23.980 The man who invests suffers the risk of loss 133 00:11:23.980 --> 00:11:25.940 and so forth, close quotes. 134 00:11:25.940 --> 00:11:29.620 So how do successful investors manage or mitigate this risk? 135 00:11:29.620 --> 00:11:32.860 Well, they discover discrepancies between present prices 136 00:11:32.860 --> 00:11:37.740 and the anticipated prices of products lest the market rates of interest and are interested 137 00:11:37.740 --> 00:11:40.660 and are eager to profit from them. 138 00:11:40.660 --> 00:11:45.420 Value investors in general have operationalized this by the margin of safety concept and the 139 00:11:45.420 --> 00:11:50.300 rule of thumb basis holds that the price you pay for an asset should be at least 30% less 140 00:11:50.300 --> 00:11:53.900 than conservatively estimated value. 141 00:11:53.900 --> 00:11:59.780 When you apply those principles in evaluation, absent of firm experiencing performance issues, 142 00:11:59.780 --> 00:12:04.500 What you're going to see most of the time is the net asset value relatively reconciling 143 00:12:04.500 --> 00:12:09.620 with the earnings power value and the reason for that is because most firms earn the rate 144 00:12:09.620 --> 00:12:15.100 required by capital providers and as a result are valued at an amount consistent with the 145 00:12:15.100 --> 00:12:18.920 reproduction value of their assets, no more, no less. 146 00:12:18.920 --> 00:12:23.700 But every now and then you're going to come across a firm with earnings power significantly 147 00:12:23.700 --> 00:12:29.460 greater than the net asset value and that will tip you off of the existence of a potential 148 00:12:29.460 --> 00:12:32.880 Sustainable Competitive Advantage. 149 00:12:32.880 --> 00:12:37.140 Value investors refer to that type of firm as a franchise and a number of my students 150 00:12:37.140 --> 00:12:41.860 ask me, what is it, how do you start one, what are some of the characteristics of one? 151 00:12:41.860 --> 00:12:47.540 And effectively, franchise begins with the entrepreneur and as Mises noted, quote, the 152 00:12:47.540 --> 00:12:52.140 business of the entrepreneur is to select from the multitude of technologically feasible 153 00:12:52.140 --> 00:12:56.620 methods those which are best fit to supply the public in the cheapest way with the things 154 00:12:56.620 --> 00:13:03.340 is there asking for most urgently." Now, for the most part, entrepreneurs can't do that 155 00:13:03.340 --> 00:13:10.820 themselves, so they start a firm or an enterprise. And as Mises also noted, open quotes, a profit-seeking 156 00:13:10.820 --> 00:13:16.260 enterprise is supported by the voluntary patronage of the public. It cannot subsist if customers 157 00:13:16.260 --> 00:13:23.340 do not pour in. Now, this concept of customers pouring in is very important because if a 158 00:13:23.340 --> 00:13:28.460 The firm is able to do that, meaning voluntarily now, produce goods and services people want 159 00:13:28.460 --> 00:13:31.900 to buy to the extent that they pour in to buy them. 160 00:13:31.900 --> 00:13:37.260 They effectively evolve from what I call a base case firm or a firm showing a value profile 161 00:13:37.260 --> 00:13:41.500 with assets equaling earnings to a franchise. 162 00:13:41.500 --> 00:13:47.900 And Murray Rothbard describes how this evolution occurs, quote, the elemental physical nature 163 00:13:47.900 --> 00:13:53.820 The structure of a good may be only one of its properties, in some cases a brand name. 164 00:13:53.820 --> 00:13:57.600 The goodwill of a particular company or a more pleasant atmosphere in the store will 165 00:13:57.600 --> 00:14:02.660 differentiate the product from its rivals in the view of many of its customers." 166 00:14:02.660 --> 00:14:07.180 So let's kind of see what one of those looks like. 167 00:14:07.180 --> 00:14:13.820 On the overhead is my valuation of Warren Buffett's 1995 acquisition of Geico. 168 00:14:13.820 --> 00:14:15.180 Now I don't know Mr. Buffett. 169 00:14:15.180 --> 00:14:19.820 I did work for one of his subsidiaries at one time, but I don't know how he values assets. 170 00:14:19.820 --> 00:14:24.060 I don't know what valuation methodology he used, but I do know he was a student of Benjamin 171 00:14:24.060 --> 00:14:26.860 Graham and he's a long-time proponent of the system. 172 00:14:26.860 --> 00:14:33.540 And when he purchased Geico, he paid approximately $70 a share for it, which was about 26% price 173 00:14:33.540 --> 00:14:38.020 premium over the stock price at the time, and it surprised many people. 174 00:14:38.020 --> 00:14:44.100 So when I valued, when I valued Geico, I came to, my earnings power value came to $69 a 175 00:15:14.100 --> 00:15:18.800 And with the benefit of hindsight, he made many multiples of that given the level of 176 00:15:18.800 --> 00:15:21.900 profitability Geico has generated over the years. 177 00:15:21.900 --> 00:15:23.660 It was a master stroke. 178 00:15:23.660 --> 00:15:28.340 So the question you may ask now is, all right, well, he did it with Geico, what's the next 179 00:15:28.340 --> 00:15:29.340 Geico? 180 00:15:29.340 --> 00:15:32.980 I mean, what's the key driver of franchise value? 181 00:15:32.980 --> 00:15:36.100 And in short, it's management. 182 00:15:36.100 --> 00:15:41.500 And as Mises noted, quote, the profit motive is precisely the factor that forces the businessman 183 00:15:41.500 --> 00:15:47.340 and to provide in the most efficient way those commodities the consumers most want to use." 184 00:15:47.340 --> 00:15:53.100 So again, there's a very customer focus to a franchise, but as I indicated, entrepreneurs 185 00:15:53.100 --> 00:15:57.780 and firms really can't do this themselves, so they have to have other people voluntarily 186 00:15:57.780 --> 00:15:59.060 help them. 187 00:15:59.060 --> 00:16:03.580 And as a result, one of the qualifications required for any higher position is precisely 188 00:16:03.580 --> 00:16:05.980 the ability to judge people correctly. 189 00:16:05.980 --> 00:16:11.100 He who fails in this regard jeopardizes his chances of success, and he's exactly right. 190 00:16:11.100 --> 00:16:15.560 And as a result, the fourth course I would teach to investment students today, in addition 191 00:16:15.560 --> 00:16:19.780 to how to think about market prices, how to value a business and how to think about money, 192 00:16:19.780 --> 00:16:21.620 would be management, how to manage people. 193 00:16:21.620 --> 00:16:26.500 There's been a lot written on this and some of it's better than others, but anecdotally 194 00:16:26.500 --> 00:16:31.220 and in my opinion, successful managers have four core things in common. 195 00:16:31.220 --> 00:16:35.100 The first is they have to have entrepreneurial insight and discipline. 196 00:16:35.100 --> 00:16:39.780 Now they don't necessarily have to be entrepreneurs themselves, but they do have to have insight 197 00:16:39.780 --> 00:16:56.540 Second, they have to know how to select, incentivize, develop and retain talent, third, they have 198 00:16:56.540 --> 00:17:05.100 to effectively assign decision rights, and fourth, they have to be fanatical about profit 199 00:17:05.100 --> 00:17:06.100 Profit and Loss 200 00:17:06.100 --> 00:17:10.060 Now notice I said fanatical about profit and loss, I did not say fanatical about the stock 201 00:17:10.060 --> 00:17:11.060 price. 202 00:17:11.060 --> 00:17:20.060 If you can find somebody who can do this consistently over time, and they're very, very rare, you 203 00:17:20.060 --> 00:17:22.860 will generate significant abnormal returns over time. 204 00:17:22.860 --> 00:17:27.380 There's another way to generate significant abnormal returns over time and that has to 205 00:17:27.380 --> 00:17:32.380 do not with a firm approach but with more of a kind of a macro approach. 206 00:17:32.380 --> 00:17:36.580 Now I know what I said at the beginning of the talk that value investors in general are 207 00:17:36.580 --> 00:17:42.420 bottom-up, not top-down focused, and that's true, but I note that even Ben Graham himself 208 00:17:42.420 --> 00:17:47.680 once said that, quote, you should buy during periods of pessimism and low prices and sell 209 00:17:47.680 --> 00:17:51.140 during periods of optimism and high prices. 210 00:17:51.140 --> 00:17:56.460 I think it would be easier to do that if you understood the macroeconomic reasons driving 211 00:17:56.460 --> 00:17:59.500 the pessimism and optimism, and I took it a step further. 212 00:17:59.500 --> 00:18:03.900 I think you could use macro-based insights to screen for potential business opportunities 213 00:18:03.900 --> 00:18:08.540 and one way of doing that is through the efficient use of Austrian business cycle theory. 214 00:18:08.540 --> 00:18:12.940 Now there were a number of other speakers today who spoke about this so I'm not going 215 00:18:12.940 --> 00:18:13.940 to define it. 216 00:18:13.940 --> 00:18:16.740 I'm going to move right into my example. 217 00:18:16.740 --> 00:18:23.820 Now the left chart on the overhead was created by George Soros, who's a favorite speculator 218 00:18:23.820 --> 00:18:27.420 and one of my two favorite investors, Warren Buffett being the other. 219 00:18:27.420 --> 00:18:32.940 And as I said, I have a trading background, someone with a trading background. The first 220 00:18:32.940 --> 00:18:38.340 time I saw that chart, it just had the right kind of feel to it. And again, I rode the 221 00:18:38.340 --> 00:18:44.620 Asian Contagion, I rode the good wave and I got clubbed in the bus, right? So from experience 222 00:18:44.620 --> 00:18:51.220 too, it mirrored what I saw. But he didn't provide, you know, definite criteria for each 223 00:18:51.220 --> 00:18:55.860 of the eight stages that are listed on the x-axis. So what I did is I used Austrian business 224 00:18:55.860 --> 00:19:05.860 I used his technical model, as well as behavioral economics and Soros' reflexive theory, and I came up with criteria for each of the eight stages of the business cycle. 225 00:19:05.860 --> 00:19:11.860 And I applied them to the new economy business cycle, and you see my application on the chart on the right. 226 00:19:11.860 --> 00:19:20.860 Now, this isn't completely a retrospective analysis. I actually started this in stage five, and I was making calls. 227 00:19:20.860 --> 00:19:28.860 I wasn't timing this market. That's impossible to do. George Soros can't do it. There's no reason why I would think I could do it. 228 00:19:28.860 --> 00:19:34.860 And we can't do it. So I didn't even try. But you did say, okay, this is where we are now. This is what's going to happen. 229 00:19:34.860 --> 00:19:37.860 Not quite sure when, but here's kind of how you should protect yourself. 230 00:19:37.860 --> 00:19:43.860 And it started off with just verbal consultation with friends, started off to a memo, then a paper, and then another paper. 231 00:19:43.860 --> 00:19:49.860 And I can't, due to time constraints here, go through each of the criteria, but I will go through one. 232 00:19:49.860 --> 00:19:59.860 And I want you to focus on the left-hand side chart, stage three, the significant short-term top is what I call it. 233 00:19:59.860 --> 00:20:06.860 And that's a very important technical indicator because it means if you follow that over the life cycle of the boom and bust waves, 234 00:20:06.860 --> 00:20:14.860 once the bust prices blow through that level of support, it effectively creates a speculative bubble. 235 00:20:14.860 --> 00:20:19.540 So, specular bubbles don't pop. It's basically just a price structure that forms over the 236 00:20:19.540 --> 00:20:24.140 boom and bust waves of a business cycle. So, what does that mean? Earlier this morning 237 00:20:24.140 --> 00:20:30.000 Doug French quoted a famous economist from Chicago who said, I don't even know, I don't 238 00:20:30.000 --> 00:20:33.860 know what bubbles are, I don't know what they mean. And I think what he meant by that is, 239 00:20:33.860 --> 00:20:39.560 he's a mathematical economist. Mathematically, this is very difficult to do. I spent a year 240 00:20:39.560 --> 00:20:45.320 You're trying to do it after I traded. Again, I had a lot of bad habits to unlearn. My numbing 241 00:20:45.320 --> 00:20:51.200 math didn't make any sense, was completely wrong, and it was the wrong approach. And it's 242 00:20:51.200 --> 00:20:56.960 the wrong approach because, as the Austrians tell us, economics is not a quantitative science, 243 00:20:56.960 --> 00:21:01.360 it's a qualitative science. And you could make qualitative predictions and they're intellectually 244 00:21:01.360 --> 00:21:05.480 valid but more importantly for those of us in this room, they're actionable. You can 245 00:21:05.480 --> 00:21:17.800 Let me sum up my thoughts. Pricing and valuation, as I hope I've been able to convey, is predominantly 246 00:21:17.800 --> 00:21:23.000 about people voluntarily buying and selling, and the resources allocated to produce goods 247 00:21:23.000 --> 00:21:29.000 and services they want to buy and sell. Therefore, buying a security is like buying anything else. 248 00:21:29.000 --> 00:21:33.920 You likely would not buy a compact disc based on a cross-section of different musical genres 249 00:21:33.920 --> 00:21:44.120 As investors, we must know what we're buying, why, what we expect to get out of it, and 250 00:21:44.120 --> 00:21:46.840 when, on every deal we make. 251 00:21:46.840 --> 00:21:52.720 Value investing is a proven method of doing that over time. 252 00:21:52.720 --> 00:21:57.440 There's also potential, value potential, buying into a privilege early, and I gave you an 253 00:21:57.440 --> 00:22:00.240 example of business cycles, there's potentially a way to do that. 254 00:22:00.240 --> 00:22:02.800 But you can also do it on a firm by firm basis. 255 00:22:02.800 --> 00:22:07.380 I'm doing a paper right now on Warren Buffett's Burlington Northern Deal, and no, railroads 256 00:22:07.380 --> 00:22:11.960 are not in my circle of competence, so I'm being very careful as to how I put this together. 257 00:22:11.960 --> 00:22:18.240 Doug French reviewed an early draft of that paper for me, and you know, railroads have 258 00:22:18.240 --> 00:22:21.680 a long history in the United States of governmental privileges, and one of the things that came 259 00:22:21.680 --> 00:22:26.800 out of the research was they're very well positioned to benefit again under the Obama 260 00:22:26.800 --> 00:22:31.520 administration, and if that does happen, it could greatly increase the value of this acquisition 261 00:22:31.520 --> 00:22:32.520 over time. 262 00:22:32.520 --> 00:22:38.040 Now, one cautionary note, if you're going to do this, I mean, if you're going to try to play a government privilege, 263 00:22:38.040 --> 00:22:43.720 you should be very, very conservative and very, very careful, because it's very much a dual-edged sword, 264 00:22:43.720 --> 00:22:47.480 as one very prominent investment bank is finding out right now. 265 00:22:47.480 --> 00:22:55.800 It's just like a boom bust, if you ride it on the boom wave up, you could really be the beneficiary of significant abnormal returns, 266 00:22:55.800 --> 00:22:59.560 but get out before it tops out and protect yourself, especially during a bust. 267 00:22:59.560 --> 00:23:05.000 Now that said, as Murray Rothbard indicates, especially over the last 100 or so years, 268 00:23:05.000 --> 00:23:09.480 there's a very long history of investors and businessmen seeking privileges, quote, 269 00:23:09.480 --> 00:23:14.440 the steel manufacturer seeking a tariff, the bankers seeking taxes to repay their government 270 00:23:14.440 --> 00:23:20.040 bonds, the rulers seeking a strong state from which to obtain subsidies, the bureaucrats wishing to 271 00:23:20.040 --> 00:23:25.160 expand their empire are all professionals in statism. They are constantly at work trying to 272 00:23:25.160 --> 00:23:28.680 to Preserve and Expand their Privileges. 273 00:23:28.680 --> 00:23:32.780 One last word on playing a boom bust or playing a privilege. 274 00:23:32.780 --> 00:23:37.280 Whenever you hear the word new, used to describe market phenomena, especially by a government 275 00:23:37.280 --> 00:23:39.360 official, get ready for a bust. 276 00:23:39.360 --> 00:23:41.760 And I mean directionally, not timing-wise. 277 00:23:41.760 --> 00:23:47.160 We saw that in a new era boom of the 1920s, the new economy, the 1990s, and the recent 278 00:23:47.160 --> 00:23:51.640 new paradigm credit boom that ended in such a disaster. 279 00:23:51.640 --> 00:23:59.400 So, Austrian economics facilitates good investing. However, the converse is not necessarily true. 280 00:23:59.400 --> 00:24:04.280 Good investing does not equate to good economics. An example of this will be after the recent 281 00:24:04.280 --> 00:24:10.080 credit crisis. There were a number of very, very successful investors, many of whom clearly 282 00:24:10.080 --> 00:24:13.960 should have known better, who were clamoring for more state intervention as a result of 283 00:24:13.960 --> 00:24:43.960 and I spoke to a few of them and rather than getting in a shouting match or a debate all I reminded them of was what F.A. Hayek once said that the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design and usually when I say that many of them said well who's Hayek so I explained who he was and what's Austrian economics and as a former educator that gave me the opening I needed to talk about for the reading. 284 00:24:43.960 --> 00:24:47.880 Mises Institute offers a book called The Mystery of Banking by Murray Rothbard. 285 00:24:47.880 --> 00:24:51.400 I strongly recommend it to every investment professional. 286 00:24:51.400 --> 00:24:58.480 We live in a time right now where you're no longer able not to really understand banking 287 00:24:58.480 --> 00:25:02.440 and what's going on in the banking community, and that book is a great primer on it. 288 00:25:02.440 --> 00:25:07.600 I just bought my second copy because my first copy has notes written all over it. 289 00:25:07.600 --> 00:25:10.040 I also recommend His America's Great Depression. 290 00:25:10.040 --> 00:25:14.680 For those of you interested in value investing, there's two books in particular I want to 291 00:25:14.680 --> 00:25:16.120 call your attention to. 292 00:25:16.120 --> 00:25:19.760 The sixth edition of Security Analysis just came out last year. 293 00:25:19.760 --> 00:25:24.840 Seth Klarman, who's probably the leading value investor today, served as the lead editor. 294 00:25:24.840 --> 00:25:30.800 In my opinion, if you serve as the lead editor of Security Analysis, you lead the school. 295 00:25:30.800 --> 00:25:34.080 But Seth also wrote a book in 1991 called Margin of Safety. 296 00:25:34.080 --> 00:25:38.180 It's very, very difficult to find, especially priced reasonably. 297 00:25:38.180 --> 00:25:43.260 But it set the stage for all modern work in the field and all authors, including me, that 298 00:25:43.260 --> 00:25:45.100 came after him, worked to that book. 299 00:25:45.100 --> 00:25:48.820 I want to say one more thing because I know there are young students in this room and 300 00:25:48.820 --> 00:25:51.500 I know there are young analysts and young investors. 301 00:25:51.500 --> 00:25:57.080 The field of Austrian finance and Austrian financial economics is really in its infancy 302 00:25:57.080 --> 00:26:03.020 and you have a great opportunity to develop the field both intellectually and from a practical 303 00:26:03.020 --> 00:26:04.020 perspective. 304 00:26:04.020 --> 00:26:08.980 And over the coming years, I'm looking forward to celebrating your success, to reading your 305 00:26:08.980 --> 00:26:12.460 papers and to moving or to advancing the school even further.