Baseball, Brass Knuckles and Wild Weekends

It is going to be an interesting weekend. The Inauguration of Donald Trump as the 45th President of the United States is going to touch of arguments, paid discussions, rallies, counter demonstrations and at least a moderate chance of full on riots in some of our major cities. It will be loud, it will be constant, and it will be on the major news networks all weekend. I will watch some of it since I am a news junkie but is going to be painful at times. It seems everybody has an opinion about Mr. Trump and also feels a need to express it loudly and apparently sometimes with a baseball bat and Molotov cocktail.

There will be another much more important argument this weekend as well. Did the Hall of Fame get it right? I think they did, for the most part, this time around for the most part. I confess that Curt Schilling losing votes because of his political opinions leads me to fear that politically correct thinking is invading baseball writers as well as the mainstream press and I find that as bothersome as not allowing whiskey in the Press Box. If we use PC as a standard that a bunch of folks like Ty Cobb, Tris Speaker, Eddie Murray and a host of others. The guy won 10 of 12 postseason games he pitched in with a postseason ERA of 2.82. He was a World Series MVP. He should get in.

Of course, the biggest argument is Barry Bonds and Roger Clemons. Should they be in the hall? We are pretty sure they used steroids to enhance their performance. We do not have enough evidence to convict them of it in a court of law however and they were the most dominant players of their time. They were great before they were thought to be using the juice. I think Pete Rose should be in Cooperstown. I don’t care if he bet on baseball as long as he never bet against his team. In fact, I think making players and managers bet on their team every single game might bring an extra level of suspense to the game!

What does all this have to do with markets and stocks? Nothing, but then again neither does much of the stuff you here discussed with great passion and conviction on the major financial news networks. We have a tendency to over thin all of this and look for clues where they do not exist. Former Chairman of the Yale Endowment and author of several fantastic investment books Charley Ellis did a recent interview with the Financial Times and told reporter John Authers ““We all learned in school that if you studied harder you could get better grades, then we learn in our jobs if we do more work for the employer we get more promotions. Trying harder works in many, many places. It doesn’t work in straight jackets, Chinese finger puzzles, and it doesn’t work in investment management.”

When asked, to sum up his investment approach legendary investor Walter Schloss put it very simply saying “We buy cheap stocks.” I am constantly looking for new ways to find and evaluate potential cheap stocks, but the secret sauce is simply “We buy cheap stocks.” Talking about all the macro stuff is fun, and there are some observers like Henry McVey at KKKR that I think to get things right a lot more than they get things wrong but focusing on cheap stocks will tell you all you need to know about macro investing conditions. When markets are out of favor, and it is a very good time to buy, and there are lots of cheap stocks. When markets are high, and sentiment favors stocks there ae very few cheap stocks, and it is a pretty good time to consider selling or hedging your portfolio.

Charlie Munger said back at the 2008 Wesco Annual meeting that “”One of the greatest ways to avoid trouble is to keep it simple. When you make it vastly complicated, and only a few high priests in each department can pretend to understand it what you’re going to find all too often is that those high priests don’t really understand it at all. The system often goes out of control.” Some years later in an interview wth the Wall Street Journal that “It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.”

The concept of a magical key that provides instant stock market riches and if we just work hard enough, read enough trading books and draw enough lines of a chart is one of the biggest reasons most individual investors underperform not just the stock market buy cash and inflation as well over time. Our greatest advantages as individual investors are size and time and we give them away every day. We can buy exciting companies with solid prospects at bargain prices and wait for them to grow up. We can invest in a portfolio if liquid community bank stocks purchased below book value and just hold them until they either grow or sell. We do not have an investment or policy committee that will fire us if we build cash balance to buy in a severe market decline at the cost of short-term performance.

The advantages of individual investors are size and time. It is like having brass knuckles in a boxing match or loaded dice at the crap table. Roger Ibbotson did a study on stock market liquidity factors and found that small, less liquid value stock outperformed growth stock with higher valuations by a margin of more than 8 to 1 over time. There are a ridiculous number of studies that show that longer holding periods mean higher returns and a good deal of the performance comes via the natural upward drift of the market and keeping the broker and taxman’s hands off your stash.

These are powerful wealth building advantages and every day I see individuals throw them away, step into the ring and get their clock cleaned. They draw lines on charts and when they lose don’t understand what happened because they worked so hard reading these trading books and drawing lines all night. They unload the dice and buy the same popular stocks everyone else is buying expecting different results. It doesn’t work that way.

Work smart. Use your advantages. Buy cheap stocks. Hold them for a long time. Hoard cash for a crash. That seems too simple, but the truth works. Best of all it leaves lots of time for naps, baseball, family and a voracious reading habit.

As for the weekend I do think we will see some unrest around much of the nation but those on both sides to listen to the wisdom of Charlie who once advised during a speech at the USC Law School graduation ceremony that “”Another thing I think should be avoided is extremely intense ideology because it cabbages up one’s mind. When you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out, what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind.”

Have a great week everyone. Don’t forget the new Ed Thorp book is A Man for All Markets is due next week. Be sure to preorder your copy. You will want this one in print as it’s a keeper.
Have a great week

Ps. Buckle up. It just could be a

Greek Philosphy, Tough Guys and Rubbernecking

In his most recent memo, Howards Marks of Oaktree (OAK) talks about forecasting. At one point he cites Greek philosophy to make his point saying ““If you wish to improve,” Epictetus [first-century Greek philosopher] once said, “be content to appear clueless or stupid in extraneous matters.” One of the most powerful things we can do as a human being in our hyperconnected, 24/7 media world is say: “I don’t know.” Or more provocatively, “I don’t care.” Not about everything, of course – just most things. Because most things don’t matter, and most news stories aren’t worth tracking. “

The hardest thing for anyone connected with Wall Street to say is “I do not know.” The whole business of Wall Street is making a bet based on a guess of the eventual outcome. The S&P 500 will rise by 7.3% over the next 12 months. The interest rate of the ten year Treasury Bond will rise to 3.01% by the end of 2017. IBM (IBM) will earn $13.84 next year. Amazon (AMZN) will grow earnings by 36.08% annually for the next five years. These predictions are all very concise and delivered with a high degree of confidence. They are almost certain to be wrong.

As Mr. Marks points out in his memo “Developments in economies, interest rates, currencies, and markets aren’t the result of scientific processes. The involvement in them of people, with their emotions, foibles, and biases, renders them highly unpredictable. As physicist, Richard Feynman put it, “Imagine how much harder physics would be if electrons had feelings!” It is hard enough to predict what might happen. It is impossible to predict how people will react to what happens.

I read a lot of forecasts and outlook every year to see what folks think of the world. The very best of these is done by Henry McVey and his team in the Global Macro Department at KKR(KKR). While the do make some predictions they also focus on what looks good to them right now and they take great pains to lay out what might happen to derail their expectations. They also outline how to hedge so of the risks in case they are wrong. It is more of an in-depth explanation of current conditions than an accurate forecast, and I find it useful in understanding the world and markets.

Their expectations this year are for rates to rise slowly and equity markets to return in the low single digits. Real assets that produce income are also expected to do well, and they favor opportunistic real estate purchases, and KKR likes MLPs in the energy infrastructure space. Again their decision is based more on pricing right now than any expectations or guesses about what might happen in the economy or the world.

In what I think is the most relevant paragraph of the whole report Mr. McVey writes “Also, as we outlined earlier, many of our models suggest more limited upside to asset class returns than in the recent past. Accordingly, we continue to favor a strategy that takes advantage of idiosyncratic opportunities, particularly those that enjoy better pricing during periods of market dislocations as well as those that harness complexity to their benefit. On the other hand, we continue to shun simplicity and/or areas of the market where we believe recent inflows have been too exuberant, particularly around visibility of earning streams.’

That sounds somewhat Melvinesque in nature. Buy when prices have fallen sharply and avoid those areas of the market everyone loves. The whole report can be found at, and I highly recommend you take the time to read it.

Next week we will have a new President, and the real fun will begin. If you think the journalists, pundits, and whackos on both sides of the aisle have been ridiculous since the election wait until you see what happens when Mr. Trump is in the White House. The fur is going to fly, and I am going to be very interested to see how it all plays out. Melania needs to ground the Prez like I do my youngest but taking his social media accounts away, or he could lose the support of Congress early in this whole thing. While I like some of his ideas on the economy and jobs and am a huge fan of many of his cabinet appointments I fear that he will run into huge problems with the process of governing. This is not the Trump Corporation where his world is law. This is a pretty good chance to remake the regulatory environment and rewrite the mess we call a tax code, so I hope he doesn’t blow it in 140 characters or less.

Turning again to Epictetus in life and equally so in the markets, it’s not what happens to you, but how you react to it that matters. We cannot predict tor control what the markets will do, but we can put ourselves in a position to respond to what it does. We currently own some little banks, REITs, discounted closed-end funds and other companies that we purchased at bargain prices. If the market gets carried away and pushes the prices of these assets to silly levels, then we will monetize euphoria by selling them at fantastic prices. We also have a lot of cash, so if price should collapse in the cold gray aftermath of Inauguration Day or some other geopolitical even, then we will be in a position to monetize fear by purchasing quality assets at deep discounts to their underlying value.
In the recreational reading front, I am on the second of 6 of the novels by former Forbes and New York Times business writer Lawrence De Maria featuring tough guy detective Jake Scarne. The main character is a lot like Spenser in the Robert Parker novels with a touch of Travis McGee thrown in for good measure. It is clear that McGee is an influence as in one the scene in the second book a hit man is talking to a woman he met on a plane about the many virtues of reading John D. MacDonald and Travis McGee. So far both books have a financial or real estate backdrop and are easy fund reading. The Kindle versions are bargain price so that naturally appeals to me as well.
Have a great week everyone!
PS- When approaching the markets it pays to take the philosophy advice of the King-who would have turned 79 this week!

Talking Banks With Chris Marinac Of FIG Partners


Tim: Okay. We’re on today with Chris Marinac of FIG Partners, a community bank specialist, research, and investment firm. Chris, thanks for spending a little time with us, and as we all know, the community banks have been pretty exciting since the election. What do you see as we go into the new year in the community bank space?

Chris Marinac: Well, I think the companies are very healthy, Tim, from a fundamental perspective. The capital is strong. They do have loan growth. The deposit growth, for the most part, has been solid. We think the liquidity at these companies is very good in many respects. These companies have more money to lend, in that we can see the cash and securities balances coming down, and loan balances go up. That’s gonna be positive for revenue and positive for margins. So I think it’s a pretty healthy time. And as I mentioned, credit is in very good shape, and I think that is always important, because credit tends to be what hurts the banking industry the most, and right now, we’re in a pretty good spot.

Tim: Okay. Do you see that credit possibly worsening in 2017? Bankers keep telling me that credit can’t possibly get any better, and then quarter after quarter, it keeps getting better. What can happen, economically, to change that?

CM: So the banks are a mirror of the communities they serve, Tim. So, if local economies were to deteriorate, then credit will get worse. I think the attitude among businesses is stable to improved, and that actually is gonna, I think, increase spending. And as businesses increase spending, potentially, change hiring plans, even if it’s modest, it should actually spill over into more loan demand, which actually would spill over into better credit. I think, on a selective basis, you’re always gonna have flare-ups that happen. There were individual situations where companies or borrowers have one-off incidents that occur. Sometimes, those get extrapolated. I think we had that happen with Opus Bank, of the past quarter or two, where some credit issues were extrapolated into a much bigger issue than probably exists, and that company, most likely, creates stability in the next quarter or two and proves that out.

CM: I think, in other instances, we’ve seen a lot of energy-related issues that are now going to get cleaned up in terms of the initial recognition has already been done. The problems that exist and the write-downs that are needed will occur, Q4 and the first half of ’17, and we’ll move on to another issue. And as long as energy prices stay where they are now, I think a lot of that has sort of been identified and should work its way through the system. So, the ongoing, incremental problems just aren’t out there. The level of past dues, the level of substandard loans for those banks who report that information, are very low. The charge-offs, most importantly, are very low. I think it will take time for that to develop that. If it does become more of a credit cycle developing, it occurs more in ’18 and ’19 than I think it occurs in ’17.

Tim: Okay. And I take it, you’re not seeing any bankers make a come 2006 brand or stupid loans at this point in the cycle, are you?

CM: Well, “stupid” is always a relative term, and so, compared to what we see today, we see, if anything, more examples of banks taking undue risk in terms of interest rates, where they’re fixing loans for five to eight years. Sometimes, they’re properly hedging those loans, perhaps with a federal home loan bank instrument, or other long-term CD, but typically, they’re not. And so that would be the only example of sorta stupid that I feel is out there. I think, credit in terms… We’ve seen those terms and structures sort of weaken and lessen over the last couple of years. It will just take another probably two years to fully develop into issues. But again, the good thing is that banks have earnings, they have capital, they can handle those issues, and we’re seeing that. Again, I use the Opus incident. Opus can handle the issue and address it and move on, and that’s a sign of health, it’s a sign of strength. Even though it’s unfortunate those things happen, they can handle it and move on.

Tim: Okay. Now, of course, the big question on everybody’s mind, and really the driver of this rally since the election, how does the regulatory environment change next year? What are your thoughts on that? Because I’ve heard everything from probably not gonna really change much at all ’til they’re just gonna rip Dodd-Frank up and throw it away. Where do you come in on that one?

CM: Well, regulatory change took a long time to be implemented, and I think it’ll take a long time to be broken down. I think that this will be a year where the regulations are known, that there’s no new rules that are put on, with maybe a couple of exceptions, which I’ll talk about. I think it’s gonna sort of be steady as she goes. I think the big picture question which has engaged investors who do look out longer than the next six to 12 months is that the direction of regulatory is towards reform. It is towards reducing Dodd-Frank, it’s towards perhaps rethinking how we treat the regulatory process. And that’ll be changed in, I think, 2018, 2019, there’ll be a lot more subtle than it is direct. I think looking for Dodd-Frank to be repealed or Glass-Steagall to change, that’s really unlikely. I think it’s more of an attitude shift that occurs over the time, and I think we don’t see much change on that in the next year. I think bank examinations are gonna be pretty much the same that they are now.

CM: In fact we’ve seen a slight increase, what I would say I call regulatory incidents where there’re banks who have been cited for not having as strong of a BSA, bank secrecy, or the AML, anti-money laundering, standards are strong as the Fed and FDIC want. A couple of companies have to correct those. They should be able to handle it with no issue, but it’s just an example that the regulators are still watching. I think regulation is gonna be a much more of a modest and slow change. But attitudes investors really is what’s changed, and I think the attitude is that the regulatory environment is going to get better. Even if it’s a 2019 event, it is getting better, and therefore they have a better ability to make a commitment to invest dollars in the space.

Tim: Now, an interesting thought, and this just popped into my mind this morning because I saw an article that a group of guys are actually starting a bank in Austin, Texas. They had previously started one in San Antonio. Does the changed perception of the regulatory environment perhaps see the return of De Novo banks?

CM: So there’s a new De Novo in Texas, as you mention. There’s a new De Novo in Atlanta, that we’re aware of. I believe there’s one or two on the West Coast that may come eventually. The regulators had already been becoming more open towards a handful of De Novos. Even if the election didn’t change the attitude of regulation, I think that these De Novos were going to happen. I think if anything the regulatory bodies had wanted to demonstrate that they’re at least willing to do a couple. I still think a couple is the operative word. I don’t think it’s gonna be a land shift. I think that the attitude towards new De Novo banks is definitely much different than it was in 2003-2006, that era where we had hundreds of new banks. I just don’t see it coming back to that.

CM: The capital might be there, but I think the structure of what regulators want, and the straitjacket that they put new banks under is going to make it more conducive for existing banks to re-capitalize or reset their business plans, and that becomes the de facto De Novo.

Tim: Okay. Now, how about your outlook for M&A activities? M&A has been very strong in the last few years with regulatory costs with the smaller banks being often cited as a reason. Does M&A slow down if there is some sort of regulatory reform, or is this more of a secular trend that’s just gonna keep going?

CM: I think it’s definitely a secular trend. I think M&A is here to stay. I think if anything, M&A accelerates because of higher prices. Currencies really drive M&A. What happens over time is that stock prices tend to have wider dispersion in terms of their valuations. That is beginning to develop, and I think it will continue to occur as 2017 unfolds, and what that means is that there’s a bigger spread on the price-to-tangible-book, and as that happens, the buyers distinguish themselves from the sellers, and more transactions can happen.

CM: There are still many boards of directors who I would say are tired by the environment. They certainly were scared by what went on during the financial crisis years, and they remember what it felt like. And when they’re given an opportunity to come out at a reasonable price, and particularly when they can take strong currencies from the buyer, I think there’s enough banks who will say yes and take that on. I think the decision was made a long time ago that they would like to sell. It was just a question of when they could get a reasonable price. This is still an ego game, and the egos don’t like when they have to take a low price, and something that is seen to be less than a real market bid. Now, that pricing has come back, I think egos can very much be massaged into feeling good about a particular M&A transaction, and that the pricing is much better.

CM So I still think the number of M&A deals will be higher at ’17 versus ’16 and ’15, and I think that there are gonna be some banks who decide not to sell because they feel a little bit less pressure from the regulations. But honestly, I think there’s enough boards who want to get a transaction done because the pricing is better, and that they can get a price that they can be happy with and feel good about. That’s where I think the ego comment is important ’cause I think this is an exercise in human behavior as much as it is finance.

Tim: Okay. That’s an excellent point. And I’ve talked about tired board syndrome for some time, and I think especially those with older boards and officers, I think they’ve wanted out for a long time, and I think you’re quite correct about the pricing environment making it a lot easier for them to do so. Now, regulatory cost has been cited as one of the big issues in the industry, but more and more it looks to me like a lot of banks are facing some serious technology spending challenges. Can you comment on that?

CM: It’s a great point, Tim. It’s interesting. I meant to mention, and I’ll mention it here, the concept of cyber security in the regulatory framework is awfully important. In fact, I would say that cyber might drive certain companies out of the business, A, because the regulators are as serious as a heart attack about banks and boards of directors being all in on cyber. That’s in spending, and it’s also just an attitude commitment that you have to be vigilant 24/7 on cyber security, and you have to be on guard, and if you’re not, that’s gonna create regulatory decimation where there’s gonna be chiefs of companies who just can’t take it, and they have to move on.

CM: So I feel like the cyber and the tech spending is still a real topic, and that if anything, companies might be investing savings that they’re getting on taxes… If we get tax reform, or frankly better spreads, which I think are going to happen, you might see companies taking the revenue from a better margin, and perhaps stronger net income because of taxes, and reinvesting some of those profits back into technology spending to not only make sure that they’re in line with the rest of the Jones’, but also that they’re ahead, that they can anticipate the problems. The cyber issues, large and small are still out there.

CM: And I hate to say this, but I believe it’s gonna be proven true that it’s gonna take an incident of public knowledge knowing that banks had issues and that they had to respond. It’s always worried me that only BBT and JP Morgan are the two most vocal banks about cyber. We haven’t seen enough banks being vocal about what they spend and how they do it. And I think unfortunately an incident’s gonna have to change that. I hope it doesn’t happen, but history suggests that that’s the type of thing that creates change in the industry. But again, I think there are plenty of boards who recognize that the regulators are not gonna let go of cyber, nor should they. And I think the new president is just as committed to cyber as anybody else out there.

Tim: Yeah. And the thing is, when you talk to the bankers and you talk to the cyber security guys, the guys on the other side of the equation, this technology is not cheap and it’s ongoing. Because every time you block one sort of attack, well the bad guys come up with another one and you gotta spend some money to tackle that one. It’s not a one time thing. It’s an ongoing thing. And I think a lot of bankers are daunted by it.

CM: Unfortunately, you’re 100% correct. This is the time of the year, the holiday season, where the cyber criminals are very active. The fact that you had Christmas on the weekend may have helped, but by the same token, it will be interesting to see what comes out. Last year, there were several banks who got targeted with debit card scams galore. And it was an unfortunate nuisance but it’s all wrapped up into the whole cyber security arena of discussion.

Tim: Yeah. You talked about the banks needing to disclose it more and it’s interesting that you said that because at our conference in Dallas last year, I found out that at these conferences you learn an enormous amount sitting at the bar. [chuckle] One fellow who was on the board of a not big bank, like 500 million, said that they average 10,000 attempts a day. Whether it be phishing or trying to commit fraud or just crack through the firewalls, 10,000 attacks a day at this small little bank. And I think this is much more widespread than people realize.

CM: No, it is. And I think that the email fraud is rampant as well. There’s not a CEO or CFO who hasn’t told me that they get emails all the time requesting to wire funds. It’s almost becoming comical, that their internal people know that we have to follow up with a phone call in multiple ways to get money wired internally to pay vendors just doesn’t come because a CEO asks via email to wire some money, X dollars. That unfortunately continues to be a good example of incidents that are occurring in the industry.

Tim: Okay. Now, as long as we’re on technology, the FinTech threat, how real is it? Are they really gonna make banks obsolete?

CM: Oh, I don’t think so. I think we see banks who are continued to be focused on branches because it’s the center point of how to do business. A branch is not just a place to go in and get a cup of coffee and a donut and to make a deposit. It’s really a way that you know a bank is in your neighborhood. And I think we’re gonna see banks in 2017 on a select basis really use the branch for a very strong purpose, which is as a marketing tool in the area. Having it be a first class facility, in a first class street corner, but using that as the epicenter for their own calling effort. Where they’re going out and calling on people individually so that that personal relationship, one on one, still occurs. And it’s not necessarily at the branch but it originates from the branch. And that employee at the bank has a cubby hole or an office there that they use that as a springboard to go drive the community and have cups of coffee and lunches and meet with people in their office and close business and solve problems.

CM: That sort of door-to-door service is where we’re going. And I think that’s where the industry is gonna take a mixture of the really good tools that are available for mobile and check truncation and then deliver that with the face to face service so that customers can tell the bank what they need, what they’re looking for, and the bank can come back and respond. I think the branch is alive and well. I think that the number of branches certainly is changing, the focus of branches is changing. But it’s gonna be a blend of technology and physical infrastructure that gets it done. Every bank in the country is finding ways of doing more with less that will continue to play out in 2017. But to our earlier point in technology, companies are spending money, they have to. And recently a CFO tell me pretty directly that, “I’ll spend a dollar all day to make two or three dollars in revenue,” and I think that’s where we’re heading. Most investors and analysts are probably tired of hearing the term operating leverage, which is really getting revenues growing faster than expenses.

CM: But it’s true, operating leverage is real important that it happens in a positive way at banks. And I think that’s gonna become one of those terms we hear often, just like we hear ROA and price to book and return equity and margin. We’re also gonna hear about operating leverage and whether a bank does or doesn’t do that over time.

Tim: How likely is it that… ‘Cause I think the way the whole FinTech scenario plays out is I think the banks end up acquiring a lot of these technologies outright. Is that a realistic view?

CM: I think so, and if you think about it, the banks have more currency now. The fact they have stocks that they can use to do small equity deals, absolutely. And I think in many respects the marketplace would embrace that. It’s a way of getting thin comments aways and being sharper. I think you’re also gonna see alliances come. I encourage investors to take a look at what Fifth Third is doing. They announced a alliance in September where the company out of Atlanta called GreenSky that does home improvement lending and not only are they buying loans from GreenSky but they’re also licensing their technology and the technology is very sharp, it’s very regulatory friendly, but it allows Fifth Third to kinda rethink their own internal processes and that’s gonna help them not only save money but also create more revenue over time. That’s a real good example where FinTech and the banking industry overlap and I think it can actually be very helpful for each other.

Tim: Yeah. I think that the FinTech lenders in particular have to look to sell their license to the bank because the technology maybe wonderful, but at heart, they’re non-depository lender and first time there’s a liquidity crisis they’re in trouble.

CM: Absolutely, and I think I’ve talked about this before. Deposits are the life blood of the banking industry and the banking industry does extend into the FinTech and those lenders and most of those lenders do not have a good cost of funds. They have a high cost of funds and that’s where the banks win. The banks who have a cost of funds between 20 and 30 and 40 basis points, they can deliver a meaningful spread, and again that’s where the ticket is. We’ve seen companies try to go the securitization route. That certainly works. We’ve seen companies get partnerships with banks. We’ve seen success at GreenSky, as I mentioned, and SoFi is another good example. But at the end of the day banks and their low cost of funds is really what’s gonna win out and that’s where I think the partnership with the online lenders is going. I just that some of them had admitted it and some have not.

Tim: Okay, good point. Alright, now, let’s move to loan classifications and categories because the regulators earlier this year, they expressed some concerns about commercial real estate concentrations and there is a fear that it will go from a gentle suggestion to a regulation talking the 100, 300 rule. Can you comment a little bit on that?

CM: Sure. It’s a fair point and I think that it’s a fair expectation. Like a lot of things, the regulators can only hint at things so long and there comes a point where they have to make it more of an official rule. And while we may not necessarily get an official ruling, it’s gonna become more direct. The interesting thing to me is that the technical rule takes all four categories of real estate which are gonna be construction, multi-family, owner occupied and the non-owner occupied and lump them together for the concentration ratio. For the most part, the owner occupied real estate, Tim, has been excluded from the conversation, but in the Fed and FDIC guidelines, they really include it. They have the ability just like the traffic cop to create a letter of the law expectation that this is the letter of the law and we expect you to abide by it and if you’re above that level, we wanna know why. I think that there is going to be more, and they already have been, changes made as banks diversify away from commercial real estate and it’s both good and bad.

CM: It’s bad because there are some really good lenders in real estate who know how to make very good money from the concentration despite their concentration and they’ve had really good credit scores, but I think they’re gonna naturally back down. But it’s also positive and that it forces banks to find a way to be not only creative, but I think also focused on other categories. C&I lending is something that some banks are good at and other banks are not, but we could see that purchased. I think more banks are purchasing loans from each other to try to get themselves some diversity. I think you’re gonna see banks focus on the consumer area and not necessarily trying to match car loans or match the online lenders, but really trying to find where they can have niches. We’ve seen BBT be successful for years in the lending on recreation vehicles and they’ve done that quite well. They’ll take a higher loss rate, but they also have a really nice spread so that it works out in their favor net net. I think more banks are gonna adopt that model.

CM: We’ll probably see more banks buying paper in the consumer area to get some exposure there. All because they wanna at least send the signal to the regulators that they’re listening and making progress. The other point I’d make is that the concentration is not just a statistical exercise. It’s really more of a focus of the bank and are they paying attention. There are banks who have and will continue to have high concentration in real estate but it’s really how they manage it, they manage it well. If you look at an Eagle Bank, for example, EGBN, their concentration numbers may come down over time, but they’re still gonna have a concentration. It’s what they do. They manage it very well and I think that they have a good regulatory relationship and they’re able to work within the guidelines even though their statistic may look high, they have had a really good track record for a long long time. And in a lot of respects, they are model citizen and shows that it can be done. A lot of it is focus, but I do think your general point’s accurate that we are gonna see more banks having to limit their commercial real estate.

CM: There is a lot of companies that I think have to improve their internal processes in terms of how they track real estate and that’s really what the regulators want. They want to see banks getting deeper on their own book of business so they know where the issues are and they can respond when there are problems because that was the big lesson learned from the financial crisis, is that banks had too much real estate and too much construction and they didn’t know how to respond or what to do and that I think is… We’re definitely educating a better financial system and a better financial institutions industry as a result of this sort of regulatory guideline that continues to be talked about louder.

Tim: Are there any loan categories that you’re a little concerned about at this point where you’re seeing that, “Oh, that might be a problem down the road?”

CM: So multi-family has grown a lot. It’s been the biggest growth category. I think that multi-family is something to watch. At the end of the day, multi-family’s a function of supply and demand. If the supply and demand are in balance, multi-family will be fine. We think that there has been a lot of attention paid to multi-family the past six months, and that banks have already made changes and pulled back and changed behavior. That’s very positive already. It gets back to the job growth and the economic activity. If the economic activity is positive, it’s going to sop-up the supply. I feel like multi-family, while it is asterisk in terms of being something to watch, I don’t feel that the problems are gonna be that high. And I think there’s a lot of companies, perhaps in the New York area, who get cited for having a concentration of multi-family, but generally those loans are performing very well. We’re seeing some signs at the high-end. It’s slipping a little bit, but for the most part, a lot of your rent controlled buildings in the big urban areas like New York continue to perform really well.

Tim: Okay. It doesn’t really like it’s… Goin’ back to the commercial side of it, it doesn’t look like there’s any cracks in the market. It may not appreciate as much as it had over the last five years, but it doesn’t look like it’s going to go down a bunch, which basically means it’s an okay time to be a lender in that sector, doesn’t it?

CM: I think it does, and I think, to me the attitude is that companies have to build reserves. And so one of the things that could happen if the corporate tax rate gets cut is that you can see companies actually investing those dollars back into reserves. And that would be a really healthy thing. The reserve argument for years has always been that the SEC and the accounting firms do not wanna see banks using the reserves as a cookie jar where they set ’em aside without any rationality and they pull ’em out when they need it. But the reality is, reserves and equity go hand in hand, and it’s a really healthy thing. I think the regulators are mistaken sometimes for not having more reserves. I think banks are gonna get better at putting reserves aside and really documenting it. What we’re hearing companies do is getting more creative about how they document putting those loans and loan-loss reserves up.

CM: So the challenge for the industry is loan-loss rates, are very low. You have a lot of companies who have charge-off rates below 20 basis points, so if they have a 1% reserve, they effectively have five years of coverage. And five years of coverage is pretty doggone strong. But 20 basis points can easily become 40, and that’s the point that I think banks are gonna hang their hat on is that we may have a low loss rate in ’17 but we can’t guarantee that in the future. And I think forecasting higher loses, there’s nothing wrong with being conservative. So we do have a new, accounting standards that’s gonna go into place in 2020, called CECL, which is gonna be kind of expecting losses. Instead of going historical, it’s gonna be more forecasting, and I think you gonna see banks get creative to be pretty cautious and pretty conservative in expecting the future. It’s a way for them to justify high reserves.

Tim: Okay. Now when we talked last December, doing a little year-ahead look, you had suggested that bank book-values you thought in ’16 would grow probably right around 7%, and I think you came in pretty close to the actual number. How does that look for 2017?

CM: Okay. So fourth quarter’s gonna be a reset because fourth quarter gonna have to mark-to-market on having interest rates go up as much as they have. We’ve seen 70 basis points, approximately the 10-year increase from the end of September to where we are here in late December. That, unfortunately, is gonna create a negative mark-to-market for the available for sale securities. But I think most banks will probably only will probably only see book-value go down. I think net-net about 1%, maybe less. That’s because earnings will still be very good for the quarter. So for example, banks may take a 2% hit on the book-value from the mark-to-market, but they may make one-and-a-half or so back in terms of their profits for the quarter. So that’s really gonna be the net change, less than a percent. So I feel like we will see a little bit of that noise, quarter-to-quarter, in ’17, Tim, but I think a 6% growth rate is still a pretty good number to have, because I think the industry will have a good year, and even if interest rates go up and we have a little bit of mark-to-market negativity, it’ll still be a positive on net net.

Tim: Okay. Any final thoughts on the community bank space for investors as we go into 2017?

CM: So we’ve seen a lot of stocks go from 90% a book to now 120 and 130 a book and some that gone from 120 to 150. Historically, this group has more to run. That doesn’t mean we don’t see profit-taking because I think that would be healthy in the first part of the year, but I think there’s room for a price to book to expand. And again, as we just talked about, book-value should rise for the year. So, if we can see the price to book expand, and we could see the book-value itself per-share expand, it’s not a bad thing for the industry. The challenge is we’ve seen 25% plus returns in banks in the last two months, and that always is lovely while it lasts, but we have to be realistic that this an industry that probably… If we can get a 9% to 10%, or a 10% to 12% return each year, that’s pretty solid, and will be my expectation for this year after the big move we’ve had.

A Conversaation With Ed Thorp


Alright, let’s get started here. We’re on today with Edward Thorpe, who’s got a brand new book out, “A Man for All Markets.” That’ll be out in January. And as I went through the book, you’re really considered to be one of the fathers of quantitative investing, which brings up a certain picture of a guy with a bunch of computers trading wildly. But as I go through the book, you really have a tremendous Warren Buffet kind of Ben Graham influence on your approach to investing. Can you talk a little bit about that? Because that really surprised me.

ET: Sure. I came at the securities markets without basically any prior knowledge and I educated myself by sitting down and reading for all of two summers, anything I could lay my hands on and began to get oriented and then I discovered how to evaluate warrants, at least in an elementary way, and I decided that was a way that I could apply mathematics and logical thinking and maybe get an edge in the market. So then I focused on it and it turned out to be correct. I was able to use the analysis of warrants to get an edge on other people.

T: Okay, and then, so you weren’t trading like a mad man, like what we think of quants today. You were setting the trades and letting them run, right?

ET: Yes, initially it was slow trading, we’d put on warrant hedges and watch them and every so often, if there was a big move in the underlying stock, we’d change the ratio of warrants to stock. And then that evolved into revertible bond trading and we did pretty much the same thing there. We means my co-author, Sheen Kassouf and I, we wrote a book about it called, “Beat The Market” that came out in 1967, in fact. So, then we both went on to careers managing money. I started a hedge fund in 1969, after meeting and talking with Warren Buffet for a while in 1968. He’d been running a hedge fund for about a dozen years, and he was just shutting down. And turned out that stocks were at manic highs then. Which is why he was shutting down, and for me, it didn’t matter because I was putting on market neutral hedges. Something people hadn’t been doing before.

T: Yes, by the way, please do not ever authorize a re-issue of that book.

ET: Because?

T: I have supplemented my income for the last, I’m gonna say 15 years, by finding copies of that book and Seth Klarman’s book at book sales and used bookstores, buying them for a buck or two and selling them for 50 or 100 times what I paid for them. I’m usually able to pull that off once a year.

ET: I’ve seen prices as high as $2,000 or $3,000.

S1: Yeah, I just saw it on Amazon for like $1,900, which is remarkable. The only other one I’ve seen higher is Seth Klarman’s “Value Investing” book, which is now I think trading at around $4,000 for a copy.

ET: Oh, I probably got one around here, I’d better take good care of it.

T: I had a copy for years, saw what it was selling for, then about $1,200, downloaded a PDF and sold the book.

ET: That’s funny.

T: Speaking of PDFs, I’ve got one around here of the “Mathematics of Gambling.” And every time one of my friends, ’cause a lot of my friends are traders, and they have a propensity to gamble, every time they tell me about their new system I just run off a copy and give it to them.

ET: Oh, that’s nice.

T: I think I’ve saved them some money over the years.

ET: You probably saw in my new book there’s a section about the Blackjack Ball in Las Vegas?

T: Yes, yes.

ET: So the kind of people that you’re talking about gather there once a year and have a really grand time.

T: I can only imagine.

ET: There’s about a hundred people who come, and I think the average net worth in the room is about $10 million.

T: Wow. Every trader I’ve ever known has a thing for gambling, even the most statistically oriented guys will end up at the race track betting the long shot of the day at impossible odds. It’s the craziest thing I’ve ever seen.

ET: Well, that’s kind of how I got into the stock market, because I first got interested in gambling as you know, and there are a lot of things that are similar about the two. The way you manage money for example, and the way you sit down and if you find a system that you’re sure is right, you stick to it. People have trouble learning that, but if you have a training at the blackjack tables to start with, it’s an amazing education to get you ready for the markets.

T: Now, I had this question slated for later, but you brought it up, so I’m going to slip it in here. When you’re sizing trades and managing money, you talk a lot about using the Kelly criteria. Now, in the Kelly criteria, and this is something I’ve always wondered because I don’t have the deep math background of a lot of guys, but in the market, it’s really hard to define the percentage of the edge, but that’s a necessary component of calculating the proper size bet with the Kelly criteria.

ET: That’s correct.

T: How do you do that?

ET: What you have to do is, you have to make your assumptions more conservative to give yourself a margin of safety. And one of the things about the Kelly criteria, if you take the case where you can in fact calculate the odds exactly. In that case, if you were to back off and only bet half as much, you’d grow at about three quarters the rate you’d grow at if you had the full Kelly bet down. So you can give yourself a pretty good margin of safety, by just backing off to let’s say, half the Kelly bet. So, that kind of thinking, if you apply it to uncertain estimations of the odds, you can say to yourself, “Well, if I’m off in calculating the odds by a fair margin, if I back off in the amount that I bet under the Kelly system, one of two things will happen. If I were right in calculating the odds, I’d maybe grow at three quarters of the rate that I would if I put the full Kelly bet down. But if I were wrong, then I might end up having a full Kelly bet down, but the odds would only be half as good, let’s say, or two thirds as good as I thought they were.” So, by backing off to a half Kelly you give yourself a big range of protection, and of course, this isn’t an exact rule, if the uncertainty is very large you might want to back off even further. So you give yourself a margin of safety on top of everything else.

T: Okay, now I’m going to go back and try to recalculate using some of my bank stocks later where I can come within a range on the edge. I’ll shoot you an email, let you know how it comes out. Because that’s always been a huge question for me was, okay, I know I’ve got an edge, but in order to use Kelly to size it, how do I… It’s not a definable edge that much, but okay. In the book you talk a lot…

ET: As far as Kelly itself, for people who are really quantitatively oriented, I edited a book called “The Kelly Capital Growth Criterion” with two other people, Leonard McLean and William Ziemba. That came out in 2010. And it’s 700 pages of academic papers about the Kelly criterion and commentary and explanation that we put in the text. It’s put out by World Scientific, so anybody who really wants to dig, can go get that book.

T: You don’t have to dig, it’s available on Amazon right now.

ET: Yes.

S1: So no digging required.

ET: Do you have it?

S1: I do not have it, but I checked before we started this call to check prices of “Beat the Market” to see where it was today and I did happen to notice the book.

Now, in the book you talk a lot about statistical arbitrage, I know you stopped doing it in about 2002, according to an interview I read.

ET: Yes

T: But it’s a term that’s used a lot. I don’t think anybody really knows what it means that’s not in the business. Could you kind of describe that a little bit?

ET: Sure. As you actually will have seen by reading my new book, “A Man for all Markets”, the idea was discovered by us back at either December 1979 or January 1980. The reason why I’m not sure is because I was on vacation while it was being discovered, I’m not sure whether it was the end of the month or the beginning of the next month. But in any case, the root idea was a researcher discovered that if you took the stocks that had been the worst performers over the last two or three weeks and bet on them, they would tend to outperform over the next two or three weeks and the reverse was true too. The stocks that were the best performers over the last two or three week would underperform over the next two or three weeks. The stocks acted as though they had some unobservable true value that wandered along some unknown curve, and they set a range back and forth around this curve, and followed it. Sometimes demand would push them up too high, for a while. And sometimes supply would push them too low for a while.

ET: And so he ran a simulation where he bet on the 10% that were the most up for the last couple of weeks, and sold them short. And then bought the ones that were the most down for the last couple of weeks, and set up a hedge portfolio. Now you might say, “Where’s the hedge?” Well, if you have a diversified pool of stocks that are kind of randomly chosen, they’ll tend to track the market. So the ones that were up the most, we would short, and that group tended to track the opposite of the market. That is, it would tend to move as though you would short the market. On the other side, we had a pool that were long and they tended to track the market. So when you put them together, the long and the short sides, the market effect was pretty much cancelled out. Now, of course, there were a lot of other effects, all these stocks were traveling around their own random way around their market factor or market component. Well, we got rid of the market part. So we said, “Gee, this is an interesting new source of profit.” And it’s a statistical play, but it’s kind of… It’s really hedging. Arbitrage and hedging tended to become synonymous even though arbitrage originated for situations where you really have a locked-in profit. Whereas hedging describes situations where you had a pretty good expectation of getting rid of a large part of the risk, but it wasn’t certain that you were going to make a profit.

ET: So in any case, we looked at this and found out that it was somewhat riskier than the other things that we had in our portfolio. Even though it was making about 20% annual life. So we put it aside. And then as I tell in, “A Man for All Markets,” somebody at Morgan Stanley came across the same idea about two or three years later. And Morgan Stanley turned it into a very profitable product. And then that person was disaffected by his treatment at Morgan Stanley, he happened to answer an ad that we had put in the newspaper looking for people with good quantitative ideas. I interviewed him. I saw that what he had done was very much like what we had done, only he had improved it a notch because he used groups of stocks in a single industry separately, to set up these long short hedges. So the upshot was we went into business with him, it worked very well. And it did find… Through the crash of 1987, for example, made money during that terrible down day. Then it began to lose some of its power as Morgan Stanley and others spread the idea and also put more money into it. So, we devised a new method that got rid of not only the market factor, but lots of other things, oil factor, interest rate factor, that sort of thing. And that ran just fine.

ET: And then, as I describe in my book, Princeton-Newport partners shut down at the end of 1988, the beginning of 1989. And I took a time off. Then I heard that people who were continuing with the idea of statistical arbitrage, were doing quite well. So, I set up shop here with just two or three people helping me in 1992 and we had 10 good years running it. Then I decided I didn’t need to work that much anymore. So, I retired again. But anyhow, that’s the root idea and it had a huge impact on the markets, because it’s a natural seque into the idea of high frequency trading. The reason it’s a natural seque is because you have computer fees of the stock ticker. So, prices are pouring into the computer continuously, all day long for statistical arbitrage. Then the machines are recalculating what to bet on, and how to modify the portfolio. So, once you have a high speed data feed that you’re processing all day long. You begin to think, “Well, are there other ways to trade to this data feed, besides putting on trades that are on for an average of ten days or so. And you begin to look for patterns that are shorter. So there’s a natural segue then into high frequency trading, you’ve got all the equipment, all the background and so forth. And I think that’s probably how people got into high frequency trading.

T: That makes a lot of sense. Now, you did a lot, as you went past just the warrants. You found a lot of things that you found and revealed and beat the market also worked in the listed options market. Buying an undervalued stock and selling an overvalued option against it. Would that still work today?

ET: I would say yes, but probably the barriers to entry are very high. Probably the spreads are mostly very small, and so you got to have low cost, you’ve got to have computers, you got to have data feeds and so forth. So just seeing what I’m seeing at home looking at things isn’t going to be able to make much headway I don’t think. But somebody in a big hedge fund that could well be a profit center.

T: Now speaking of the guy sitting at home. Is it, and you addressed this in the book, but I think what you had to say was pretty important, so I’ll bring it out, is it worth the extra effort to try to beat the market today?

ET: That depends on the person. That’s an interesting question. I think to myself, “Gee, if I were 25 and I got interested in this, what would I do?” And I’m not sure, but for what I know now, I’d say the Warren Buffett way is a good way if you want to put your whole life into it. I’d probably decide not to want to put my whole life into it. Now Warren loves it so much, that’s all he’s ever done since he was a little kid. And it’s day in day out. So I would say if you wanted to get really rich and you wanted to spend your whole life, trade your whole life for getting really rich, a trade I don’t necessarily recommend, then I’d say that’s the way to go. But if you just want to make lesser amounts of money, I don’t know what to tell a person at this point because you can do so well knowing nothing in the market.

T: Just by indexing.

ET: Yes. Just sitting there passive index investing. Or like I’ve done, buy a big chunk of Berkshire Hathaway and sit and just watch it.

T: I tell people that. I have a column that I write, it’s daily on and I’ll often say, “I want you to buy this, put it in a drawer and don’t look at the quote again.” And people say, “You’re crazy.” I’m just say “No, I’m not. Reinvest the dividends. Come back in five years. Let’s talk.”

ET: And people say, “Gee, what if your Berkshire goes down?” I say, “Oh, that’s good because now I can buy more.” They say, “But what if it goes up?” I say, “Well, that’s good too because I feel good because I feel suddenly richer.”

ET: So let it go up or let it go down. I don’t care.

T: In the book, you talk about a way to beat the market that you used at Princeton-Newport and that I still use today and that’s buying deeply discounted closed-end funds and allowing the discount to narrow. Have you considered that much in recent years?

ET: I’ve thought about that and I think you can probably make,I don’t know if you’re doing it better than I, but my experience was long ago when there weren’t people tuned into this as much, you could maybe make 15 or 20% a year pretty safely. Well, later it got down to about 10% a year and then I kinda lost interest.

T: Our research shows that if you track an activist right in behind the first 13 day, let him do the activist work. You’re still up at 15% plus mark so. You say it’s widespread and while that’s true among those of us that follow the market more people know about it then back when you were doing it at Princeton, the average guy has no idea. Now, another one of my favorites and I know that as recently as 2014 you were still doing it, but are you still doing the thrift conversions?

ET: Yes. We’ll be doing one in a few days actually.

T: Now you actually do the deposits, don’t you?

ET: Yes.

T: We buy the aftermarket and you still you do a little bit better than us but…

ET: But you have less work. You just wait.

T: I just wait for like the third day trading. There’s still liquidity and I’m still buying it at 75% a book. And then again at the end of the three year period, which is the change of control period. We come back and revisit them again and we look at price to book and as with closed-end funds at that point, we want to know who else owns it.

ET: And what allows you to buy in the after-market and make an excess return are the flippers.

T: Yes.

ET: They sell too soon and they keep the price down for a while.

: I’ve never understood why a guy would go to all the trouble of depositing all that money all over the country and then flip it in three days for 25% when if you hold another three years you’re probably going to double your money.

T: Yes.

T: It’s always been a puzzle, but I love those guys. They make things so easy for me.

ET: That’s true.

T: Alright, just a couple of other things, and these are, by the way, not just market related questions they’re just,If we were having coffee together and had unlimited amount of time these are things that I would probably ask you.

ET: That’d be a lot of fun.

T: The part about, in the book, in the early part of the book, you were such an intellectually, inquisitive child and pulled remarkable stunts. I love the one with the flare in the balloon. That just cracked me up. But as a parent and as an educator over the years, is there a way to bring out that natural intellectual curiosity in a child?

ET: Well, I can tell you what we did with our kids and it seemed to work. We made dinner time a special time, when everybody got together, nobody had any devices, or other activity or distractions. We all sat down, we talked about whatever was on anybody’s mind. So the mean teacher at school, the bully, whether or not there’s a God, whatever came up. The logic behind climate change, or the arguments against it, and so the kids learned to think for themselves. And this power of thinking for yourself is really formidable because it enables you to do many things. Whereas people who don’t do their own thinking kind of have to key off other people to try to figure out what it is that they should be doing. They basically follow the crowd. So that was one thing. The second thing is that we try to give our kids opportunity, so they had choices, but we tried not to steer those choices. So just because I’m a science, math, gambling stock market type guy, doesn’t mean that I try to steer my kids that way. So one kid became a hedge fund manager eventually, one kid became an architect, and one became a district attorney. So they went their separate ways, they’re all smart. So they inherited that outlook, and they treated their kids that way. So their kids have turned out to be amazing. One girl has triplets, they’re all sophomores at MIT.

T: Okay, that’s impressive and also a very large bill.

ET: A very large bill, yes. Luckily, my activities could cover it.

T: Okay, I was kind of curious about that, because I know that, as a parent myself, that’s been one of the challenges, is to get them to be as intellectually active as you know they can be. So I just wanted to hear your thoughts on that.

ET: I was having an email correspondence about this with Paul Wilmott. Do you know who he is?

T: Yes, I do. I read his publications and understand about 25%

ET: Okay, great. Anyhow, he’s a very smart guy, he lives over in a priory in rural England, but he was a PhD in mathematics, and then started this magazine, Wilmott, a finance magazine, for which I occasionally write a piece. We were discussing raising up children because he raised the same question you did. He said, “Well, I and my wife Andrea were left on our own, and we turned out fine. We just explored and taught ourselves like you did. But our kids are pretty busy, and there’s various things that one can schedule them for and they can do them, so I’m wondering whether that is a good thing or a bad thing.” And so I told him, “It works either way.” I was like him, left on my own to explore and figure things out, just because my parents had no time. They were busy working in war industries then. They were sleeping all the time, or working and that was it.

ET: On the other hand, with our kids, we didn’t exactly schedule them, but we gave them opportunity and encouraged them. And then they had a lot more scheduled activities for their kids: Soccer, Chinese, music that sort of thing. So their kids were a lot busier. But it works either way. The important thing I think is not to try to live again through your children, not to try to make them be like you, but let them just be whatever they want to be, and do what they enjoy doing. My experience was if you do what you love and you just follow that, it will work out.

T: You talked about that several times in the book. In fact, I have passages underlined. You attribute a lot of your success as an investor because you did it not just for the money, but for the love of the mathematics behind it. And at one point, you say that you… Hold on, it’s right here. Your discoveries fit in with your life path as a mathematician had seemed much easier. Leaving me largely free to enjoy my family and pursue my career in the academic world. So you weren’t 18 hours a day bent over a screen. You were enjoying your life, because you enjoyed the work. Not because it was finance, because it was math.

ET: That’s exactly right.

T: I love that quote, because that’s something I tell people all the time, and again I get that crossed eye funny look. And I just tell them I say, “I’ll put my returns up against you every day, but I work a fraction of what you work.” And they don’t think that’s possible, and you are a living proof that it is in fact possible. Now 1948, you apparently spent the entire summer sitting on a beach reading 60 novels that you considered to be classics. Did that make a big impact on the way you thought, the way you approached the rest of your life, because it sounds really cool, it’d be a great thing to do .

ET: I would say yes. It gave me… I’d call it maybe more of a philosophical and humanitarian perspective on life. And it made me think about the big world of society, politics, history, geography and so on. And it gave me a framework for putting things in their place.

T: You talk a lot also about the importance of education, and your concerns about the future of education. Can you talk about that a little bit? Because that’s a huge area of concern of mine as well.

29:58 ET: Yes. I think of education as a lot like the seed corn for society. And if people are willing to pay for it, if they’re willing to be taxed and if they’re willing to build a good educational system, then I see that the minds that are generated out of that will apply tremendous leverage to society and society will grow and advance much more rapidly. And many good things will happen and get done. If you had a society that was devoid of education, it would just sit in place and do nothing. It would be the same thing decade after decade, perhaps century after century. It would be like the perhaps inaccurate image that we have of the dark ages where nothing much happens.

ET: So in a place like California, for example, they made a terrible mistake back in 1978. They passed something called Proposition 13, and I mentioned that briefly in my book. What that did was bust the state budget. So the biggest component of the state budget is education. So that of course was going to suffer. And so education has gotten squeezed ever after in California. At both the elementary, the secondary, and the college level. And tuition has gone up enormously. When I went to the University of California, my tuition was $35 a semester. Of course, that was back in 1949, 1950 and you might say, “Well, inflations changed the number quite a bit.” It has maybe 10, 12 times but just add a zero to $35, $350 a semester, but we’re looking at instead of $700 a year, we’re looking at maybe in today’s dollars, we’re looking at maybe $12,000 a year. Something like that for in state, maybe $30,000 for out of state. So what happens is people can’t afford to get as good an education.

ET: They go to school and even if they can pay the tuition, they have to work in large part to supplement to get the money to pay it because it just isn’t available in so many of the families. If you work while you’re going to school, which I did, you don’t do as well in school as you might. You don’t learn as much. I can think back at the courses I took because I was working, I didn’t learn the courses as well. And the rest of my life, I could feel the impact of that lack of knowledge, that I would have had if only I had been able to focus properly on the course I was taking. So anyhow, to make a long story longer, I’ve seen charts of how much is invested in science, engineering, and education in a society, as a fraction of their GMP versus the rate of change of GMP. And it’s quite dramatic. Societies that have a higher investment of education advance the growth in their GMP much more rapidly in societies that don’t. And the obvious example is something like Silicon Valley. If we didn’t have a Silicon Valley or the equivalent, or Redmond, Washington or the equivalent, we wouldn’t have all the computer advancement that we have. Apple would be a giant company in some other place, Japan, Russia, China, something of that sort as opposed to being a giant company in the United States. So anyhow to not spend money in education is a terrible mistake.

ET: And another consequence of that mistake is gambling. There are lottery systems all over, and one of the ways of getting people to accept them is we’re willing to fund education with lottery proceeds. But that’s actually been in California bait and switch. What happens is they have signed a certain fraction of the lottery profits to education, but then they take away money from education with the other hand. So education doesn’t end up getting any more money. California ends up getting more money in the general fund, and ends up with a major gambling problem on top of it.

T: I think that’s the case in every other state that has a lottery that I’ve run across. They all set the lottery intake by pulling back money.

T: If the money actually did go to school, that’d be a fantastic thing. But there’s, I don’t see any real evidence that that’s happening anywhere in the United States.

T: You do talk in the book and I’ve, this intrigued me, I was surprised to see that we agreed on this, but you think a flat tax might be the answer to solve some of the funding problems at all levels of government.

ET: Yes, I do and there’s an obstacle to getting it in, which is that the complicated tax system is one that’s been made that way by politicians who are busy paying off special interests who in return make campaign contributions to elect or re-elect the politicians. So that’s why the tax code degenerates into horrible complexity over and over. Now flat tax would eliminate most of the power of the politicians to extract benefits from the tax code. So they would oppose it. But, you could probably get support from large parts of society if you made the flat, the change to a flat tax neutral. So for instance, suppose you take away the carried interest benefit for hedge funds. Just to explain what that is, carried interest is a scheme which has been disguised by an obscure phrase, carried interest, a scheme to tax money made by hedge fund operators at the capital gains rate rather than at the ordinary income rate. And so they pay far less tax.

ET: They can also defer the payment of the tax for many years, 10 years or more. Let’s say you took that away. You might get another $20 billion in tax collections that way. What to do with it? Well, go to the politically unconnected rich, the ones who don’t have benefits built into the tax code from bribing politicians. Take the top tax rate down. Apply that $15 or $20 billion tax savings that you capture from the changing the carried interest toward their income, apply that to the top rate. So it comes down from 39.6% to maybe 39% or 38.5% or whatever that comes down to. My idea would be that you keep making changes that are revenue neutral and if you brought a flat tax in all at once, that would be a massive change that if were done in a revenue neutral way, would have as many winners as losers, so you’d have a lot of people rooting for it.

T: Yeah. I agree. I’ve always said to the first part of your statement, that taxes are not just about raising income. It’s also a very complex reward and punishment system. And that’s been the biggest reason it’s developed into the nightmare that it is. I was surprised to see you comment on it in bringing it out in the book, happily so, but we’re in complete agreement on that.

ET: Well, one of the reasons I have some, I’ll call them public policy commentary in the book, is that if you have a math and science background like I do and you believe yourself to be a rational thinker, you end up applying it to as many things as you can. And with a large part of my life spent in finance and economics, I naturally ended up applying a lot of this thinking to public policy and other things that I see in society that have a broad impact. That’s where a fair amount of this is coming from. I believe that if people just learned how to think instead of letting other people do the thinking for them, that we could work our way to a considerably better society.

T: Yes, you address a lot of that in the last part of the book, the chapter called “Thoughts” and it’s one of my favorite chapters in the book. Your comparison between the Roman Empire after they defeated Carthage and the United States today given the fall of the Soviet Union, I thought were absolutely spot on. And I love the way that you say one thing to the optimist and one thing to the pessimist. I think that’s fantastic.

T: Alright, I’ve got one last question for you and this is the big one. It’s one that I try to ask everybody I run across. What books are you reading now?

ET: Right now, I’m reading a book called “The Accidental Superpower” by a guy named Peter Zeihan. And the reason I’m reading it is because one of my friends who I mentioned in the book, Gary Basil, who was a professor of economics and finance over at UCI when I first met him, sent it to me thinking it was going to be interesting, good to read. We had been talking about the election of Donald Trump, what we thought that meant for the country. This book looks at things much differently than I do and I find that if I read things that may not agree with the way I look at the world, than I’m more likely to learn something than if I just read things that keep telling me, “Yes, you’re right” over and over and over. This is a for geopolitics type book, which basically thinks that geography is a major determinant, geography in demographics are major determinants of how things evolve for societies. It’s an interesting historical perspective and it has predictions of how the future’s going to go. I’m enjoying working my way through that and seeing where I agree and where I don’t agree with it and what I’ve learned from it or haven’t. That’s one interesting book that I’ve been reading.

T: Anything else in recent history that stands out as something that folks should consider reading?

ET: No. One I read not too long ago, parts of it, is “Thinking Fast, Thinking Slow” by Daniel Kahneman. But everybody’s “read” that but they really haven’t. They did a study of people who read books, I guess it’s on Kindle or iBooks I’m not sure which, and they can tell from feedback which pages people have been on and what they found was that only about 5% of his book was read by the typical buyer. So anyhow, I read about 20% or 30% of it because a lot of the rest of it I knew. And a lot of the rest of it I wasn’t fascinated by at the time, but the parts that I read, I really liked.

T: Yeah, I think that’s a lot like the book that was out a few years ago that was real popular, “Influence,” and everybody heard of it and knew a couple of quotes, but I don’t think anybody actually read it.

42:08 ET: Yeah. There’s another book like that I read a moderate part of, again, that nobody else read very much of or hardly anybody did. It’s “Capital in the 21st Century” by Thomas Piketty.

T: Oh, yeah. Again, everybody had cherry pick quotes, and I’m with you, I read about 10% and threw it aside. I thought it was a horrible book but…

ET: That, and, “Thinking Fast, Thinking Slow” were the two least read best sellers according to elaborate studies.

REIT, Reading and Rum

a_pirate__s_christmas_by_maiden13I spent some time today talking with Brad Case about the REIT and real estate markets going into the New Year. Brad is a Senior Vice President, Research & Industry Information at the National Association of Real Estate Investors and has become a valuable source of information when it comes to real estate investing. Brad is one of the few upbeat voices on REITs as we enter 2017 and we spent some time talking about his expectations.

First of all, he pointed out that REIT fundamentals are very strong. Occupancy rates and rents are rising right now. New construction is still well below historic lows, and the absorption rate for new properties is very high right now. There are signs that the economy is picking up and higher GDP growth is closely correlated with high returns for commercial real estate and the REUTs that invest in those assets.

Brad also shared with me the results of his recent research in yield spreads and REIT returns that is very bullish for long-term returns for real estate investment trusts. He found that there the relationship between the spread between REITs and the 10-year Treasury yields is highly predictive of how REITs perform over the next five years. The higher the spread better REITs performed. He told me that right now the spread is pretty high and is predicting a five-year average annual total return of over 14%.

To make sure he did not see accidental conclusions he tested the yield spread using other fixed income assets and found that it held true when using different maturities of Treasuries, corporates, and even high yield. All of them worked, and all of them are bullish with the high yield spread being at one of the highest most bullish levels ever.

He shared his data with me, and the relationship is pretty solid. The spread relationship showed that it was a fantastic time to be a buyer of REITS in 203 and 2008 when some of the highest reading ever were recorded. The yield spread went negative in the first six months of 2006 and as we all know that was a terrible time to be a buyer of anything. Spreads were also at very low levels in 1999 preceding a period of very low REIT returns and returned to bullish levels after the internet crash was delivered five years of outstanding average annual returns.

In a recent article on the NAREIT website Brad summarized the relations between Treasury and REIT yields writing “When Equity REIT yield spreads were negative, as they were in 1997 and again around 2006, forward-looking Equity REIT total returns tended to be disappointing: positive on average, but by only 2.68%. When yield spreads were higher, though, forward-looking total returns tended to be higher as well: in fact, when yield spreads averaged 2.0% or more, returns over the next four years averaged an amazing 21.13% per year.”

I am not as unabashedly bullish as Brad Case, but neither am I rushing to sell the majority of my REITs and real estate securities. Most of the bankers I have talked with in recent months are quite happy with the CRE and multifamily markets in their service areas and don’t see any imminent signs of collapse. Occupancy rates are decent, and in the vast majority of US markets, there are no signs of the dramatic overbuilding and excessive risk-taking that usually proceeds a serious setback. If we get a decent stock market pullback anytime soon, I will become a serious buyer of some of the REITs on my shopping list.

This is one of my favorite times of the year. The holiday is part of it(more on that in a moment) but the new release list from publishers is reaching peak levels and it my Kindle reflected the weight of the stuff I have downloaded in the past few days I would need a wheelbarrow to haul it around. Right after Christmas every year we always get new books from WEB Griffin and Jack Higgins, and they both have a new one due this year as well.

As for the Christmas holiday that starts Saturday when we head out to so the shipping for food wine and liquor for the Christmas Eve Open House. MY wife turns several shades of several different colors when she sees how much I spend on this bash every year, but it is a long running Melvin tradition. We open the doors to friends and neighbors and every year we meet some new neighbors that pop in for a few minutes or a long evening. At some point there will be singing, mainly Christmas carols but I have vague memories of my sons belting out a few badly off-key choruses of Sweet Child of Mine around midnight or so. It is a fantastic time and one of my favorite holiday traditions.

Now at last its time for

Banks, Cyber and Black Eyed Peas


As we head into New Year’s weekend, I find myself reading a lot of year in review and next year outlook material. I am a big fan of the overviews and outlooks but try to avoid those prognosticators making specific predictions they insist are actionable right now for the low, low cost of your retirement accounts. I find that by reading a bunch of the overviews, I can begin to develop a picture of potential developments and obstacles an industry or market my face in the New Year. I won’t act on them today but being aware of what might happen allows me to have a game plan ready if the events do unfold in the manner.

I probably spend more time on banking and real estate outlooks than anything else since that is where I focus much of my attention. Of course, I also believe that if you understand what is going on in the banking sector and real estate markets of a given city, town, nation or continent you know everything you need to know about the economy of that locale.

Deloitte, the global audit, consulting, financial advisory, risk management, and tax consulting firm released their Banking and Securities Outlook 2017 this month, and there are some key takeaways for us as investors. The company thinks that post-election may have brightened the outlook for banks and securities firms, but challenges still exist. Banks will face significant technology challenges in 2017 and will probably have to spend some money to build and protect a new model of banking in a Fintech world.

Deloitte is equally confidently caution about the overall economy saying “US gross domestic product (GDP) growth should be higher than in 2016, reflecting a tighter labor market. However, this almost-full employment is far from ideal; a serious skill divide exists alongside too many temporary and underemployed workers. The resulting low productivity growth could lead to a plateau as the year progresses.” I have been saying this for some time as the job creation I see outside the beltways and rivers is not of the kind we need to achieve higher growth rates and I still talk to a lot of people who are incredibly frustrated with their inability to find a meaningful and rewarding job. Better, not good. Perhaps now that a firm as renowned as Deloitte agrees with me, I will finally get the recognition as a brilliant economist that I clearly deserve!

The company also addresses one of my favorite topics, Bank M&A. The report notes that “M&A activity may slow considerably until greater clarity about the coming regulatory landscape emerges, possibly prompting a fundamental rethink of business strategy. Even so, large national banks will likely continue strategic divestitures to hone their business footprint, shedding ancillary businesses that aren’t core to the portfolio of client services and don’t generate sufficient ROI. Large regional banks with assets in excess of $50 billion may continue making strategic acquisitions to better tackle regulatory compliance overhead. Smaller regional banks approaching $50 billion in assets will try to get comfortably above that mark to attain operational and compliance heft that systemically important financial institutions require. However, most M&A activity will take place among banks with assets between $1 billion and $10 billion. “Since we primarily live in the under $10 billion world we are okay with this.

I spoke with Chris Marinac of FIG Partners also had some comments on M& in community banks when I talked with him earlier this week. When I asked him if M&A was coming to an end or was still a secular trend he told me “I think it’s definitely a secular trend. I think M&A is here to stay. I think if anything, M&A accelerates because of higher prices. Currencies really drive M&A. What happens over time is that stock prices tend to have wider dispersion regarding their evaluations. That is beginning to develop, and I think it will continue to occur as 2017 unfolds, and what that means is that there’s a bigger spread on the price-to-tangible-book, and as that happens, the buyers distinguish themselves from the sellers, and more transactions can happen.

“There are still many boards of directors who I would say are tired by the environment. They certainly were scared by what went on during the financial crisis years, and they remember what it felt like. And when they’re given an opportunity to come out at a reasonable price, and particularly when they can take strong currencies from the buyer, I think there are enough banks who will say yes and take that on. I think the decision was made a long time ago that they would like to sell. It was just a question of when they could get a reasonable price. This is still an ego game, and the egos don’t like when they have to take a low price, and something that is seen to be less than a real market bid. Now that pricing has come back, I think egos can very much be massaged into feeling good about a particular M&A transaction, and if the pricing is much better.”

“So I still think the number of M&A deals will be higher at ’17 versus ’16 and ’15, and I think that there are going to be some banks who decide not to sell because they feel a little bit less pressure from the regulations. But honestly, I think there are enough boards who want to get a transaction done because the pricing is better, and that they can get a price that they can be happy with and feel good about. That’s where I think the ego comment is important because I think this is an exercise in human behavior as much as it is finance.”

Both Deloitte and Chris had some comments on cyber security as well. The Deloitte report said that “While core cybersecurity threats remain the same, more sophisticated threat vectors are emerging resulting in greater impact. For example, in addition to distributed denial-of-service (DDoS) attacks, denial-of-system attacks that make enterprise-wide information systems completely inoperable are likely to increase. With cloud adoption accelerating, encryption, identity, and access management are likely to dominate the agenda. Also, regulatory pressure is likely to increase, forcing banks to focus more on regulatory compliance rather than risk mitigation.”

Chris Marinac was in agreement telling me that “the concept of cyber security in the regulatory framework is awfully important. In fact, I would say that cyber might drive certain companies out of business, because the regulators are as serious as a heart attack about banks and boards of directors being all in on cyber. That’s in spending, and it’s also just an attitude commitment that you have to be vigilant 24/7 on cyber security, and you have to be on guard, and if you’re not, that’s going to create regulatory decimation where there’s going to be some of the companies who just can’t take it, and they have to move on. So I feel like the cyber, and the tech spending is still a real topic, and that if anything, companies might be investing savings that they’re getting on taxes. If we get tax reform, or frankly better spreads, which I think are going to happen, you might see companies taking the revenue from a better margin, and perhaps stronger net income because of taxes, and reinvesting some of those profits back into technology spending to not only make sure that they’re in line with the rest of the Jones’ but also that they’re ahead, that they can anticipate the problems. The cyber issues, large and small are still out there. “

Write this down. If we did a remake of Mrs. Robinson today, Mr. McGuire’s one word would be “Cyber.” All the great new things that technologists and pundits see happening are heavily reliant on cyber security. FinTech, EdTech, robotics, driverless cars, virtual reality, the list goes on and on, and every single one of them is hackable and will require a constant and expensive vigilance on cyber security. You need to be aware of the best companies and emerging technologies in cyber security because lacking an EMP blast that takes us back to the stone ages Cyber Security is the going to happen 100 to 1 sector right now. Be patient, buy at a good price but be aware of what is going on in the sector and who is doing it.

Happy Year to you all and best wishes for a happy, safe and prosperous 2017. Will be kicking back at home this year as over the years I have had one too many drinks spilled on my suit, one too many overindulgers puking on my shoes and paid way too much money for high priced poorly prepared “special “ dinners that weren’t. We will break out the bourbon, some good wine and spend a nice, safe evening watching those foolish enough to flock to Times Squarer freeze their butts off and most likely pee their pants to welcome 2017. Of course for New Year’s day we will cook up the pork roast and black eyed peas to greet the year. I am not particularly superstitious, but I do like a tasty tradition.

Flawless Predictions

Originally published on Real Money December 23rd 2016 at Real Money


Originally published on Real December 23 2016

oday we kick the holiday into high gear around our house. We have a party for Christmas Eve every year, and of course, there is a huge dinner to cook for Sunday, so there is lots of shopping and prep work that begins today. There will be last-minute errands, packages I forgot to wrap and late additions to the bar I need to pick up. It will be a busy few days, but if history is any guide, it will be a good time for all.

The other thing that has kicked into high gear is the prediction machine. I am getting a flood of emails offering to tell me exactly what the market is going to do in 2017. Some are pie in the sky, and some are doom and gloom.

So far, the range is from up 30% to down 70% for the S&P 500 next year. We could have runaway inflation or a disastrous return to severe deflation according to the experts. Oil is either going to $100 a barrel or collapsing to $10 depending which expert you choose to believe. Real estate is probably going to collapse unless it soars as a result of inflation. Interest rates will spike unless they collapse.

The predictions range from very well considered and presented analysis of the possibilities in 2017 to just plain wild-eyed rants. The former are generally from the big Wall Street and mutual fund firms, and the major goal of these pieces seems to be to keep investors in the fold with their cash continuing to earn fees for the company. The general outlook is for decent gains with positive economic activity and the possibility of some increase in what they call volatility. They are as much marketing pieces as anything else.

The latter are marketing ploys. If you make a prediction of epic proportions and it comes anywhere close to coming true, you will be a temporary legend. In spite of all the evidence that such predictions are nothing more than lucky guesses, the suddenly wise prognosticator will be showered with attention and cash from the investing public. It begins to taper off in a year or so when the role of luck becomes more apparent as subsequent forecasts fail to hit the mark, but the lucky fortune teller does not need to return the cash. More than one decent fortune has been made using this technique, so as long as you have little to no conscience, it’s a sensible ploy.

That said, this prediction thing seems like fun, so I think I will get in on the action. I have been making forecasts for a couple decades now, and I humbly can say that I have the best market and economic forecasting track record in history, and I think it is time you folks starting rewarding me with accolades and cash.

In 2017 the stock market will be open most weekdays between 9:30 a.m. and 4:00 p.m. ET. Prices will fluctuate, sometimes wildly. At least one company everyone loves will collapse at some point during the year. At least one company no one has ever heard of will soar to uncharted heights and become a stock market darling in its own right for a period. Millions of lines will be drawn on millions of charts, with no real useful conclusion being drawn from such activity. There will be unanticipated geopolitical situations that roil the markets at some point during 2017. Pundits will predict all sorts of outcomes. Some will be right, most will not. If the world does end before then, NYSE traders will stop what they are doing on the last trading day of 2017 and sing “Wait Till the Sun Shines, Nellie.”

My forecast is far more likely to be correct than most in 2017, thereby extending my record of flawless punditry, and it has about the same chance of making you money during the New Year as all the others. As for me, there are a few macro pieces I read every year and consider, such as the KKR macro outlook and the outlook pieces from large commercial real estate brokers, but these tend to be more informational than predictive in nature.

Make 2017 the year you begin to react to what the market does rather than trying to predict what it might do. I predict you will make more money that way.

Ignoring Warren and Charlie


Originally published on May 2 2016 on Real Money

There will be a few jillion words written on Berkshire Hathaway’s (BRK.B) annual meeting but I am going to add my two cents anyway. After watching some of the live-stream broadcast and reading several commentaries, I came away with several strong impressions.

The first impression is one I get every year after the meeting. There are far too many people running around trying to be Warren Buffett and invest like Warren. You and I will never have the advantage he has enjoyed of free leverage in the form of insurance float, and odds are we will never get the phone calls for special convertible deals on companies such as Bank of America (BAC) and Goldman Sachs (GS) at incredibly advantageous terms.

Buffett has said many times that he is limited in what he can buy because of the sheer size of Berkshire. On Saturday he pointed out that size is the enemy of performance. He has admitted repeatedly that returns would be higher and that Berkshire would do more Graham-like investments if it had a smaller asset size. Even Vice Chairman Charlie Munger has said that would be his approach if he had smaller capital.

Investor Monish Pabrai wrote about his discussion on this subject with Munger last year at the Huntington Library saying, “I asked Charlie if he would still promote the buy and hold forever notion if he were running a small pool of capital. He said that he’d do it like he did when he ran his partnership, buy at a discount, sell at full price and then go back. With their present situation he said that it makes no sense to do that.”

Despite the above, too many investors are trying to emulate Buffett by buying huge companies with ever-elusive moats that they can hold forever and a day. What is worse is they do it without looking at where we are in the market and are quick to quote Buffett about ignoring day-to-day market prices. While that may be good advice in general, you need to go back and study when Buffett bought his biggest positions.

He started buying the Washington Post in the 1973 stock market collapse. He began building his Coca-Cola (KO) stake after the crash of 1987. His Bank of America and Goldman stakes came in the aftermath of the credit crisis. The big initial buys of Wells Fargo (WFC) were done during the banking and Savings & Loan panic in 1990.

Buffett may not worry about the quote and market conditions after he buys a stock but he is very aware of conditions when he is buying. Both he and Munger are crash buyers in the spirt of Hetty Green and Mr. Womack, which is the real secret of their success. Want to be like Warren? Stockpile cash between crashes and buy stocks during a panic.

If you are buying stocks, Buffett reiterated his suggestion that you should view it as buying the whole business — and you should be comfortable with being unable to get a quote for the next five years. This is probably one of his most ignored pieces of investment wisdom. Investors are far too concerned about liquidity and I believe they often overpay for liquidity.

We know from the Ibbotson studies that illiquid stocks with value characteristics provide the highest returns over time. Still, if you talk to most investors, they own very liquid shares of companies with growth characteristics and higher valuations. These are, of course, the stocks with the lowest long-term returns. If liquidity is a primary concern, you probably should not own stocks.

I hear the liquidity argument all the time when talking about investing in community banks. These little banks can be hard to buy and harder to sell. It can take weeks — even months — to buy a full position in some of them. That scares away many investors from what has easily been the most profitable part of my investment activities for decades now. Now is probably the best environment for buying community banks since the early 1990s, but most investors will miss it because of their ill-advised concerns about liquidity.

I will leave it others to discuss Buffett’s comments on sugar consumption, diversity, hedge funds and politics. The big takeaway for me is since I am not dealing with the issues of a $350 billion enterprise I should be thinking about smaller, less-liquid stocks and focusing on when I buy and what I pay for stocks. I can ignore market gyrations after I own them but they are pretty important when it comes to buying.

Right now, aggressively buying socks when the market is trading at 22x declining earnings strikes me as one of those “stupid games” Buffett was talking about Saturday.