Friday, July 19, 2013

The Future of Higher Education


If you think the world is coming to an end in two weeks, go to a college campus…it will take at least two years.
---Mark Twain

Innovation has touched every aspect of our lives…except education. There is no aspect of the human experience that has been more vacant of innovation than education, especially higher education. Innovation in education offers more opportunity for the advancement of society than any other endeavor that could be pursued by mankind. Colleges and universities continue to deliver their service in the same manner as they have for centuries: A professor stands before a class of students delivers a lecture and students read a text book. This is an archaic system that is on the threshold of a massive transition. Certainly, established institutions will resist the change as they always have throughout history. The concept of efficiency, productivity and efficacy in the delivery of knowledge and skill has had no place in the world of academia. We are now entering an agonizing period whereby the educational delivery system will be completely restructured by innovation and enabling technologies. The landscape in higher education is about to change dramatically.

Today’s education delivery system:

The educational delivery system throughout history has been characterized by:

1.      Students show up to classrooms where professors deliver lectures.

2.      Students read textbooks

3.      All students, fast learners and slow learners are delivered the same instruction.

4.      All courses are the same length (a semester or quarter) regardless of the amount or complexity of the content

5.      All classes operate on one hour cycles (45 minutes of lecture, 15 minutes to change classes) and are delivered at a specific time and place convenient for the professor and university.

6.      Class sizes are limited to 25-30 students and the physical plant is geared to that sizing criteria.

7.      Degree programs are structured to graduate students in four, or five, years, assuming class availability and reasonable student progress.

This is the “straight jacket” in which higher education has lived for centuries.

Innovation Transforms Education:

Enabling technologies have emerged that provide the power to transform the delivery of education. While in its infancy, it is clear that we are at the doorstep of enormous changes in higher education, if not indeed in the entire educational delivery system. This is being brought on by the emergence of on-line courses and programs. These were pioneered by for-profit enterprises, but are now rapidly proliferating throughout the non-profit institutional space. Emerging companies, such as Coursera, Udacity and EdX have led the way by providing an infrastructure for the delivery of what are known as MOOCs or Massive Open On-line Courses. But this is just the “tip of the iceberg”.

We can best understand this through an example.

A Stanford professor of mathematics recently posted his course on differential equations on Coursera’s on-line site. He put considerable effort into making the course interesting and an effective learning presentation supplemented by good graphic illustrations, video and other learning materials. He built in student progress assessment mechanisms that permit the course program to triage learners into fast-forward or remedial instruction tracks. In a course, such as differential equations, like majority of others, there is little, or no, benefit to student interaction. 120,000 students took his course. As he puts it, “I have spent many man-hours every semester for years teaching this course to only twenty students at a time. Through the Coursera program I have taught more students in three months than otherwise in my lifetime. It would have taken 1,000 professors six years to teach the course to that many students.” In this example, we have seen a glimpse of the future. 

But more is happening…much more.

Most MOOC courses are free and not for credit and therefore do not apply toward a degree. That is beginning to change. The first MOOC courses offered for credit were introduced in January, 2013 and in May, 2013, Georgia Tech launched an entirely MOOC-based Master’s Degree for $7,000.  Students anywhere can take this Master’s Degree program without ever setting foot in Georgia. This dramatically expands the market for this Georgia Tech product.

A small university in New Hampshire offers a number of on-line degree programs. These degree programs generated over $130 million in revenue for the university during the last academic year and produced an operating surplus of $29 million. While their brick & mortar campus served 2,750 students, the on-line program enrollment was 25,000. Students on campus paid an average of $112,000 in tuition, plus room, board, books and other expenses for their degree. The cost of the same degree on-line is about $38,000. Only twenty-five faculty members are required to provide the instruction on-line.

This is a tidal wave that is forming and will transform higher education.

There will be vigorous resistance to this change by faculty and administrators. They will argue that there is no substitute for the classroom experience, the interaction between students and the teacher. This is just so much B.S. and will ultimately give way to the power of competition and economics.

While not all courses are well-suited to on-line instruction, a huge portion are and can be delivered more effectively through that modality. They will not be delivered by TAs or average faculty members. Students will learn from the best.

So, what will change?

At the most fundamental level we can expect important transformations in the way education is delivered.

1.      Courses will become “productized”. Many courses are commodity-like and can be structured into well-designed instructional “products.” Top professors and universities are developing these on-line format courses in a way that facilitates the learning of the content material and makes it more interesting for students. These courses will not just be videos of “talking heads’, they will be well-designed courses that deliver the material in a compelling, easy-to-learn way.

Examples of well-suited courses include: accounting, chemistry, physics, biology, mathematics (algebra, statistics, calculus, geometry, etc.), psychology, economics, astronomy, language studies and more.

2.      Competency-based degree and course credit programs will replace time period based instruction. The empowering character of MOOC, MOOC-variant programs and other on-line technologies will empower the implementation of, and drive the demand for, competency-based education. While largely in an experimental and developmental stage, this approach to education is set to expand rapidly, fueled in part by innovations in the application of technology. Competency-based systems allow all learners to progress at their own pace, yet assure that the student has adequately mastered the subject to merit the award of the course credit and ultimately the degree.
3.      The pace of learning will become variable; linked to the individual. Fast learners, and those that work harder, will progress through the learning experience at an accelerated pace, not held back by those of average or sub-par learning abilities. Slower learners will progress at a pace geared to their abilities and work ethic.
 

4.      The rigid structure of class periods, semesters and degree timelines will break down. There is no good reason why all courses should take exactly one semester. There is no reason why class cycles should all run one hour. There is no reason why all students should take four years (or more) to graduate.
 

5.      Instruction will cease to be linked to the academic year schedule. There is no good reason why students must begin their classes, all at the same time, in the fall or at the beginning of a semester. They will be able to commence their study at any time of the year.
 

6.      The physical classroom will become obsolete for many/most courses.

Universities will need to rethink the structure and function of their physical plant.
 

7.      Much of the curriculum becomes commoditized. When we examine the typical undergraduate college curriculum we discover that a majority of the courses can be delivered better through well-designed internet-based programs than through the terrestrial classroom format. These courses are basically those that benefit very little by the interaction between a teacher and students or between students.
 

8.      Social Media will play an increasing role in education. The interaction between students and teachers and the interaction between students has long been a vital part of the educational process. Young people coming of age now are much more into interaction through social media. Companies like Piazza are providing an on-line gathering place for students to interact with university faculty and other students in much the same way that they might in a classroom. However, through this platform, interaction is available 24/7, not just during classroom of office hours. Through platforms such as this, students will have social interaction with classmates all over the country and the world. It is a growing new medium for student interaction focused around their learning experience.
 

9.      Textbooks will become obsolete. Courses developed for on-line delivery will increasingly use excellent graphics, audio and video with text presentations and will be programmed like a computer. Tests, or built-in progress assignment mechanisms, will allow fast learners to skip forward while rerouting others into remedial channels. This will be far more powerful than textbooks which are linear in nature and have no way to know how well the student understands what is presented. The on-line course will become the textbook in the future.
 

10.  Degree Programs will be formed from a composite of courses offered by multiple universities. Universities will begin constructing degree programs that select, bring together and bundle courses from other institutions to construct better academic offerings. Through this, a student might take an approved course in mathematics from Stanford or the University of Michigan, and economics course from a prominent faculty member at the University of Chicago, a science class from MIT and a cluster of core courses from the degree-granting university.
 

11.  Prices will come down. For decades, the cost of a college education has been rising. It has been rising faster than any other product or service that consumers purchase (including healthcare). The will soon come to an end. Ferocious competition is arriving at the doorstep of higher education. Historically, universities have competed within fairly narrow market segments, characterized by price, brand, geography, academic offering and other factors. With the onset of course “products” and internet delivery modalities, any university can compete anywhere anytime.
 

12.  Large populations of faculty will become obsolete, unneeded. The transformative in commodity type courses is likely to result in at least half of all faculty positions at universities becoming unnecessary. Because of the tenure system, universities will struggle to reduce their “headcount” consistent with the decline in need for these employees.
 

13.  The Economic Model of Higher Education will change. The amount of labor (faculty and administration time) to deliver on-line instruction is small, especially when spread across a large number of students and multiple years. Up-front there are capital costs to develop the courses, but all the repetitive costs of professor lesson plan preparation and classroom delivery of material will be eliminated. Thus, the costs per student will drop enormously in this business model.
 

14.  Competition will intensify…significantly. The ability of any university or professor to deliver courses anywhere, any time at a competitive price (not burdened by labor or facilities costs) will transform the markets for higher education. A university in New England will go after students in the “backyard’ of a university in California (and vice versa). With gross margins near 90 percent in the on-line offerings, price competition will flourish. Universities with strong programs and strong brand equity in certain academic specialties will do well in diverse geographic markets, while those without distinction will struggle. Universities will need to learn how to become effective at marketing. They can learn a great deal from the for-profit sector regarding those strategies. The days of charging big tuition prices will come to an end.
 

15.  An opportunity to improve educational efficacy. When we look on the bright side of what technology and innovation will bring to education, the picture is exciting, but challenging. It offers to free educators from the “mundane” instruction that they deliver in the traditional format of today’s system. That will be empowered to focus on more valuable learning experiences for students. There is much that technology cannot do well. Many areas benefit from interaction with the teacher and other students. Communication and thinking skills are among these. The social and philosophic development of young people also requires beneficial interactivity. How do you teach critical thinking, analytical processes, and problem solving? How do you teach a student to persuasively convey his or her ideas? How do they harness the power of interrogative means to get to the bottom of an issue?  In the new world, educators will be challenged to step up to the full intellectual and personal development of the whole person.

Innovations enabled by technology need not spell the demise of (all) universities. But certainly big adjustments must be made. With compellingly more efficient, more effective, less costly means to deliver a large part of college education coming soon, it is imperative that academic leaders rethink their business models and their strategy.

University leaders always put down for profit education companies, yet they are soon to enter their domain. For-profits education companies have advantages. They do not carry the heavy costs of athletic programs, bloated bureaucracies and expensive facilities. They also focus on delivering customer value, i.e. education and placement instead of “research”. They have also developed a core competency in marketing; in recruiting customers (students). They are unburdened with the baggage of tenure and are free to hire the best faculty and get rid of weak performers. Non-profits are wise to learn from these competitors.
      
            In pursuit of the provision of value

All goods and services are measured by consumers by the value they deliver (i.e. what one procures, divided by its cost). Strangely, neither producers nor consumers of higher education have focused on this concept. The title wave of intense competition that is coming will change that. Universities have benefited, especially recently, from the strong demand for their services, giving them the opportunity to increase prices aggressively, in lock-step. This has been fueled by a weak job market. High school graduates cannot find employment, so they opt to go to college. Also, college education promises better jobs when they graduate, a promise that many are finding vacant. Also, fueling this demand is the excessive availability of student loans with lenient borrowing standards. This is another factor driving prices up at an unsustainable and unreasonable rate. Because of the unwise public policy making such loans easily available, many young people will ultimately suffer under the burden of the ill-advised acquisition of debt they accumulated to get their education. A huge portion of young people pursue academic majors that offer little prospect of gainful employment. They simply have a good time in college studying fun subjects that interest them, but have little value in preparing them for a viable career or for any meaningful employment. They graduate with a mountain of debt, but without the economic ability to live independently. This is just plain wrong.

Educators must change this equation. The concepts of educational productivity and efficacy must become imperatives in their profession. They must embrace the idea of delivering more educational efficacy through innovation and enabling technologies. They must be willing to let go of the old ways of doing things and aggressively look at new modalities for the delivery of education. They must focus on the comprehensive intellectual and personal development of students. Moreover, priority must be given to providing young people with the skills and knowledge to become employed as productive members of society.

            Evolution and Revolution

Early adopters/innovators will benefit from the massive transitions that are beginning. Like the progressive university in New Hampshire, incremental revenue and operating surplus can be generated from the extension of their business model into cyberspace. Such offerings will dramatically extend their market reach. On-line programs will also expand the market to include “customers” that are geographically “challenged” such as those in military service or others in families employed overseas where access to college education is limited. American Public Education (APEI) has made a very successful business serving this market and has current enrollment of 130,000 students. Working adults have always been a good market for these programs, but there is no reason that they need to be limited to the adult education market. Soon the lines will become blurred between adult and traditional campus programs offered to high school graduates.

However, while initially the market will expand and first movers will prosper, the advent of elevated competition, price pressure and the conversion of campus-based enrollment to on-line will pose a very serious challenge for most universities. Traditional, high-tuition-paying enrollment will drop significantly as students increasingly choose a less costly and better educational experience on a cyber-campus. For those laggard institutions that do not seize the moment to transform their operating models, revenues will decline sharply and many universities will face extinction.
 
Within 15 years, half of the universities in America will become insolvent.

Friday, April 15, 2011

Looking over the Horizon - US Economic Challenges beyond the Near Term

As our political leaders gather to raise the debt ceiling and debate yet another profligate budget, many now increasingly ask “Where does this lead?”; How will this all end?” It is a worrisome consideration for all of us.

America’s Financial Situation

The national debt (Federal only) now exceeds $14 trillion (putting that painful number on paper, it is $14,000,000,000,000). Over the last decade that number has been soaring. Historically, the US debt load has been about 35% of GDP where it was just 12 years ago. The IMF projects that by 2015 it will reach 100% of the GDP (about the level of Greece today). America has an addiction to debt. It will come to an end. If we do not deal with it through our own (painful) public policy initiatives, it will be imposed upon us by the global capital markets.

Federal spending now exceeds tax revenues by 42% and was 12% of GDP in 2009 and 10%+ in 2010. There is no end in sight for the spending binge by our political leaders. If one thinks about this in the context of a business, it would be like a company that was losing 42% on revenues every year. It would be like a family that spends 42% more each year than they earn. For any such company or family, it could only be accomplished by borrowing from the future to have a better life today. But some day the future comes around…and it is approaching us today.

Another troubling way to look at our financial plight is to examine the growth of government as a fraction of the US economy. Government spending (federal, state & local), as a fraction of the economy, stood at about 12% a century ago. By the 1930s it had grown to 22%; by 1960 it grew to 28%. Then it began to accelerate especially in the last decade, reaching the 47% level currently. Think about that. Government spending is now almost the same size as the private economy. This is scary, since the government produces nothing, uses the nation’s wealth rather than creating it and is not the source of tax revenues. The burden of carrying the economy falls exclusively on the private sector.

When we think about a nation’s currency, it is useful to think about it like the stock of a company. Would you want to own the shares of a company that was running such big losses, experiencing very little growth and deep in debt? Furthermore, printing money is like issuing a lot more stock. It dilutes the value of the currency…in the same way that issuing more shares in a company dilutes the ownership of shareholders.

Next 2-3 Years

We are currently in a relative period of calm. The US economy is showing signs of improvement, albeit tepid. Inflation and interest rates are low in America. The US Dollar is gradually weakening, but trading calmly, helped by its reserve currency status. As the world’s reserve currency, US dollars are used to trade oil and other commodities. Therefore, foreign governments and companies must buy our currency to affect their transactions. According to the Bank for International Settlements, the US dollar was used in nearly 87 percent of all international currency transactions during 2010. Central banks around the world, especially in emerging nations, continue to purchase large amounts of US Treasuries (keeping interest rates low).

But increasingly our nation’s creditworthiness is coming into question. By the beginning of this year, many other nations had credit ratings better than the US (among them Finland, Sweden, Singapore and Norway). In coming years our nation’s creditworthiness is certain to slide further, increasing our borrowing costs. It is noteworthy that PIMCO, the world’s largest bond investor, sold all of its US Treasuries in April this year. The global financial markets are already sorting out the differences between those nations that have low debt burdens and low government deficits and those that do not. In addition to being reflected in the credit rating of nations, it also shows up in the value of their currencies. One can see the effect of this in the chart showing the two-year appreciation of currencies of a sample of nations that exhibit solid growth but are comparatively unlevered with debt and operate with low government deficits.

This is a serious problem and our nation’s political leaders must find the courage to deal with it. The political debate has heated up, talking about the nation’s debt and deficits…but it is doubtful that anything meaningful will be done. In their Panglossian way they will ultimately push the problem down the road into the future.

Also, propping up our economy these days is an unprecedented accommodative monetary policy. With the Fed at a near zero interest rate policy level and printing money like it is “going out of style” (as it may), it is no wonder that things have (superficially) improved a little.. But this cannot go on forever and what happens when the stimulus is withdrawn? The headlines say that the US GDP is growing in the 3 ½ percent range. But if one were to subtract out the 10 percent of GDP that the government is spending in excess of its revenues (the deficit), the nation’s growth would be negative. Can the private sector, that has been “jump started on hormones”, keep growing and begin carrying the nation forward?

Where does this lead us?

This leads us to the question “What happens over the horizon, beyond the next 3-5 years?” To assess this, we must ask some tough “What if?” questions. What if foreign buyers of our national debt (mostly emerging market central banks) lose faith in our government’s creditworthiness; our political will to manage our country’s financial affairs in a conservative, responsible way? Or what if they simply want to repatriate those funds for their own domestic purposes…or they decide to diversify away from holding almost exclusively US dollars as foreign currency reserves? Under any of these scenarios, the US dollar drops sharply, interest rates move up and inflation accelerates as the cost of imports rise sharply. This is not a pretty picture.

As we look out beyond 2020, the costs of embedded entitlements, defense spending and debt service become untenable, consuming most of our national resources. It is often said that the national debt is a burden that we place “on the next generation”. It now appears that the storm is approaching faster and will probable set in in sooner, rather than later.

What it means is that America must live within its means and begin doing so soon. Austerity is tough medicine as the people of Greece and Ireland are learning. This will come at a price. It will lower the standard of living in this country and slow the progress in developing nations around the world, since we are their biggest customer. But it must be done to avoid catastrophe. However, many nations have gone through the process moving from socialistic excess to responsible fiscal management, and have gone on to more prosperous times. Think about the turnaround that Margret Thatcher engineered in the UK during the early 1980s.

An American transition to “living within its means” also has significant foreign policy implications as our nation pulls back from being the world’s policeman and providing many nations with economic aid.

America remains the greatest nation on the planet earth, but has lost its way. It can regain its strength and prosperity only by returning to the principles that made it great in the first place (individual freedom, rewarding hard work, risk taking and investment, promoting/nurturing private sector enterprise, shrinking the size & spending of government). Those principles created our national wealth. No country can be generous that does not first achieve and sustain its national wealth.

The growth of government and tax policy began to change that, decades ago. The nation’s tax system was created to cover the cost & investment in those things that were in the common good (infrastructure, education, defense, law enforcement and public safety). At some point it became a system for the redistribution of wealth, to take from the producers and to give to the users in our society. This has been accelerating as politicians see their opportunity to give away benefits to a larger cohort of voters, instead of advancing public policies that make our economy more efficient, innovative, and enterprising on the world’s competitive stage. In the end, we live in a competitive world, where labor, capital, and prosperity migrate to the strongest player.

Post note: This essay was written originally on April 15, 2011. On the following Monday, Standard & Poor’s downgraded the US credit outlook to “negative” the lowest level since the Pearl Harbor invasion in 1941.

Tuesday, December 14, 2010

The Investment Landscape: 2011+ - Opportunities and Hazards

While the “great black swan” event of 2008 has past, the aftermath has left us in a changed world. The investment landscape is more heterogeneous than in the past. From a global macro point-of-view, some economies are prospering, some are failing and some are struggling with the new realities. This presents a more complex set of opportunities and risks than we experienced historically. Indeed as we look forward "there are many wild cards in the deck" for 2011 and beyond which present challenges for even the most sophisticated investor. While we may form a position on the likely scenario going forward, we must keep in mind that these "wild cards" can show up at any time.


Inflation: A Contrarian View?

At least 90% of all investors polled expect inflation to emerge in the US economy. One only needs to look at a recent auction of treasury inflation-protected securities (TIPS) which sold at a negative yield to know where investor sentiment is on this issue. Imagine that, paying someone to hold your money and give it back later. It is easy to understand why most might hold this view. The monetarists' theory asserts that when the US prints money (particularly the high quantities that the Fed is today) then inflation follows.

I hold a contrarian view. In the US, deflation is a bigger risk and a much more frightening scenario to contemplate. We know how to deal with inflation and it’s not so bad in modest doses. On the other hand, if deflation gets entrenched, it is very difficult to contain (as Japan, ravaged by deflation for two decades, has learned) and can be devastating as asset values drop, family wealth disappears and leveraged assets (such as real estate) go underwater. Our current circumstances demand that we look beyond the simple monetarist theory. I believe that the Fed is very worried about this and it is one of the unstated reasons that they are printing so much money. If deflation gets traction, it can be very “sticky”; it acts like a spiral down.

In order to examine the contrarian argument one must look at the fundamental forces that influence the inflation rate. Such observations reveal many potent deflationary drivers in the US economy:

Unwinding The Credit Binge

The US economy is undergoing a massive deleveraging in the aftermath of a decades-long credit “binge” (consumers, banks/lending entities, investors & businesses: virtually all components of the private sector). Why are banks stingy with lending? It is because they are reducing the ratio of their loan portfolio assets to their capital (deleveraging). Consumers are paying down their credit cards and walking away from underwater mortgages.

In deleveraging economies there are more sellers than buyers; causing asset values to fall and final demand to decline. As aggregate credit contracts the economy shrinks. This is a very deflationary force. Seeing asset prices fall (real estate is, of course, the big one) buyers tend to delay their purchases, waiting on a lower price and not wanting to own something that will decrease in value. The purchase of a new home is typically accompanied by a surge in other consumer purchases (household appliances, tableware, furniture, insurance, etc.). So delayed asset purchases also decrease other consumer spending and this slack demand leads to a loss of pricing power by producers. All of this is a closely linked, integrated syndrome.

Real estate prices will be under long term pressure for other reasons: a big pipeline of forclosues, a large shadow inventory of sellers that have not yet put homes on the market, an increasing practice of homebuyers simply walking away from their underwater mortgages/homes leaving them vacant and owned by lenders and a huge inventory of unoccupied homes resulting from years of overbuilding (2nd homes and spec homes). Approximately 11 million homes in America are unoccupied at this time.

The situation is only slightly better in the commercial, retail and industrial sectors of the real estate market where a long period of overbuilding has left the US with excess capacity and a flat to negative absorption rate trend. We simply have too many stores, too much office space and too much industrial space. This surplus in real estate assets must be worked off over time, a process that is likely to take years.

Idle/Slack Capacity

The economy is flush with idle capacity (labor markets and industry) and weak final demand. This leaves producers without pricing power at the point-of-sale and backward through the supply chain (wages, facilities, suppliers, etc.). Unemployment is, perhaps, the biggest negative catalyst in our economic system. It is not likely to get better for a long time.

Commodities are the only area where prices are firm because they are portable between economies and elsewhere (emerging markets) on the planet demand is strong. However, the commodities component in the US inflation picture is overwhelmed by the other, larger forces.

Mindset

Consumers are worried about the economy and businesses are cautious about expansion. Both are saving at unprecedented rates, rather than spending. Consumers in mainstream America are reigning in their spending and moving down market on item price points. This is not necessarily a bad thing, except that it means that the economy will not grow. Nothing will change on this in any substantial way until/unless there is an improvement in the unemployment situation, a scenario that looks quite unlikely. However, we can expect a modest improvement in spending in some of the better-off consumer categories as people have become a little less concerned about losing their jobs and are a little more optimistic about the future.

A Mixed Landscape

While America and the EuroZone may face deflation, those nations that have growing economies (China, India, Brazil and other Emerging Nations) face inflation pressures. Even in the US it will be a mixed issue since we are likely to see prices firm or up in some categories (energy, agricultural commodities and industrial metals (iron ore & copper). On the other hand… housing, labor, consumer & industrial goods and other items are likely to see falling prices.

Currencies: a Growing Issue

What will happen to the US dollar? What will happen to the Euro, the Yen and others?

To be sure, this is a growing issue between nations. There is growing talk of “currency wars” as some endeavor to keep their currencies from rising or to lower their value in order to help them compete in the world markets…so that they can keep their own domestic economies healthy.

Except for the rare economies that have capital controls and/or fixed exchange rates (China, Saudi Arabia and a few others) this is a futile effort. The world’s markets will move the exchange rates as they wish.

If the USD was not the world’s reserve currency, it would decline severely. There is little to support its value from a fundamental stand point (profligate government spending, public debt, weak economy, unfavorable trade balance, etc.) Offsetting this is the international demand for US dollars. Oil is bought and sold in dollars across the world. The same is true for most other commodities. When mines in Australia sell/ship iron ore and other industrial metals to China, Japan and Korea they are paid in US dollars. This creates a demand for US dollars and our Fed is happy to print more to serve the needs in the growing parts of the world.

Perhaps the biggest driver of the dollar’s direction is the level of fear and uncertainty in the world. When fear rises, money flows into the USD. When fear wanes, the dollar falls (as it is driven by unfavorable fundamentals). If there is a break out of war on the Korean peninsula, the dollar will move up. If more European nations (Portugal, Spain, and Italy) fall into financial jeopardy, the dollar will rise. In the absence of these, the dollar will fall…particularly against

Emerging Market currencies of nations that have political stability. Near term, that is the most likely case.

When one contemplates the direction of the US dollar, it is essential that we ask “versus what?” With currencies, it is a relativity issue. The US dollar may hold its own or strengthen against the Euro, Pound and Yen…but weaken against the Asian currencies (e.g. Singapore, Indonesia, Korea) and natural resources-rich nations such as Australia, Brazil, Norway, Chile and Canada.


In an economic paradox Germany, the world’s second largest exporter (only last year passed by China) is benefitting greatly from a weak Euro, dragged down by other troubled European countries. The favorable exchange rate has boosted the competitive position and profitability of its industries (autos, industrial/equipment, chemicals, pharmaceuticals, etc.).

A huge amount of the support for the US dollar also comes from the economic fear that is widespread across the planet…largely resulting from the credit/liquidity crisis of 2008, but now exacerbated by the financial crisis facing Europe. This fear drives capital into “safe havens” and the US is the primary beneficiary. If fear wanes and an appetite for risk returns, capital will flow out of the USD and its value will decline.

The Euro is doomed!

The biggest risk to the world’s economy is Europe and the Euro. In my opinion it is highly unlikely that the euro will survive as a currency. The economies, political conditions, financial strength, and values of the different nations that make up the union are simply too different. The huge public debt load of the Club Med countries, Ireland and others is an overwhelming burden that cannot be solved without massive restructuring. Currently, member countries are happy to “kick the can” down the road and implement austerity measures in an effort to solve the problem. It will not work and eventually they must face the fact that the debt cannot be repaid. In Ireland, the public debt load is about 170,000 euros ($220,000) for every man, woman and child. There is no chance that bond holders will get paid in full. In Greece, the austerity measures, high taxes and declining economy are causing a massive exodus of businesses, wealthy families and investment capital. The problems of Greece and Ireland, with Portugal, Spain and Italy at risk promise contagion across the region as European banks are forced to write off sovereign and other debt, leaving their balance sheets wasted in the process. If they had their own currency, they would devalue it, but they are lock stepped together which limits their individual options. The EU will vigorously defend the euro, because unwinding it would be traumatic. However, ultimately the huge challenges of defending it by the few strong nations may mark the demise of the currency.

This is not a good scenario for the world as we are all interdependent to some degree.

Bond Market/ Interest Rates

In most of the world’s markets interest rates are determined largely by market conditions (credit quality, duration, currency risk). Rates in the US have been pushed down artificially by public policy initiatives of the Fed. While this is an effort to stimulate the economy, it is also self-serving in that the Fed’s big brother, the US Treasury, is the biggest borrower on the planet. So the Fed & Treasury want to keep borrowing costs low in order to feed the huge deficit spending activities of our government.

The other motivation is to avoid exacerbating the mortgage and banking crisis. If interest rates were to rise, more mortgages would go under, foreclosures would accelerate and the hit to bank balance sheets would be devastating. Even now, if these mortgage assets were marked to market values, perhaps all bank capital would disappear. Therefore, we can expect that monetary policy will continue to be “accommodative” for years to come. Also holding down rates is the fact that there is little private demand for credit, due to sluggish economic growth and the deleveraging of the consumer sector and lending institutions.

The mood of the Fed may be changing, however. Many members are becoming more conservative and the three new members expected in 2011 will probably be conservative leaning, thus Bernanke strategy may come under pressure. Furthermore, QE2 may be his last instrument for holding down rates. Then the market, a much more powerful force, will take over.

Investors are now confronted with a dilemma: US Bonds with investment grade credit quality pay very little yield. To get yield, investors must go out on the maturity curve to longer durations. That territory is loaded with risk since rates are near decade-old lows. If rates go up, bond prices will drop like a rock. If they invest in short duration instruments, the yield is paltry. Bonds with lower credit quality have had a good run as the economy has improved and liquidity has returned to the capital markets. However, it is likely that such gains have come to an end. The great bull market for bonds is likely to be near its peak.

A cautionary consideration regarding this belief is that, if deflation becomes entrenched for an extended period of time, bonds could appreciate, even from this elevated point.

One possible answer to this dilemma is to invest in foreign bonds that trade at market rates without excessive public policy manipulation. While one must have the “stomach” for currency risks, intelligently placed bets offer a currency attribution opportunity that can add to the returns of those international bonds…and provide diversification away from the US dollar. However, one must be very selective in the selection and vetting of such foreign bonds.

Will The European Union Implode?

Perhaps the biggest risk facing the markets and the world economy in the near term is the financial instability of the Eurozone. In that arena there is a lot to be concerned about. Earlier we addressed the euro’s risks, but the region’s economic challenges go well beyond its currency. For the most part the economies of old Europe are inefficient, uncompetitive and burdened by restrictive labor laws, a profligate welfare system, declining fertility rate and a population that values leisure more than work effort and entrepreneurial initiative. It must be a huge concern that the contagion of this economic disaster spreads from Greece to Ireland, to Portugal to Spain, to Italy…and brings down “the Union”. There can be no question that this leads to a bad outcome.

Germany is the lone exception. They make good products, work hard, have conservative economic values and are one of the most amazing exporters on the planet. Think of a nation only one third larger than the size of Ohio that is so productive and competitive that they out-export the United States, Japan and stand equal to China. The time will come when they grow weary of propping up retirees in Greece and the other people enjoying the good life in the club med countries of the European Union. If the “sugar daddy” pulls out, the euro sinks. Eventually, they will want the deutschmark back.

Is China a “Bubble”?

Many say “China is a bubble.” I have a contrasting view. My opinion is that the growth of China will continue for decades. Perhaps not at the same rate but certainly at a very high rate compared to the nations of the developed world.

The reasons for this are simple and powerful:

1. China has a strong balance sheet. It has no sovereign debt, a huge trove of foreign reserves and substantial natural resources (although it has little in the way of oil reserves).

2. Its people are hard-working, industrious, self-reliant and entrepreneurial.

3. The middle class is growing rapidly. According to the IMF about 300 million in China can be classified as in the middle class. Their way of life is getting better and they have an optimistic view of the future.

4. Chinese consumers are unleveraged, most have zero debt. They rarely use mortgages when purchasing real estate and most do not have credit cards. On the rare occasions when they purchase a home with mortgage financing, they must put down a minimum of 30 percent.

5. The consumer economy is beginning to “boom” in China. Retail sales are growing at the impressive rate of 18% annually and every major retailer across the planet is opening stores there. Demand is very strong. China auto sales this year were 16 million units vs. 10.5 million in the US and they are not just buying small inexpensive cars.

6. Government policy action is very constructive for the economy. In America, stimulus to fight the downturn flowed mostly into unemployment benefits, bail-outs and other spending type uses of the funds. China also deployed a “stimulus” but it was an “investment” type of expenditure…putting funds into infrastructure, modernizing the power grid and building power generation facilities, expanding the school system (and building new universities), upgrading the communications network…and many other things to make the China economy more efficient and more competitive. China has a long term view and it’s recently announced 5-year Plan is a very thoughtful roadmap for the future.

7. In spite of its communist political system, the Chinese government is very business-friendly. It will often support or partner with private enterprise on development activities and, for the most part, will allow companies a great deal of freedom from burdensome regulation. Things tend to get done fairly quickly without a huge debate.

Despite these positives, any investor in China or business entering that market should be aware that you are “playing on their home court…by their rules”. A Western investor or business man would be na├»ve to approach their endeavors without understanding the differences in the cultural, business practices and the political/legal system.

Certainly, China is not without risk considerations also. The rapid construction rate is not sustainable over the long term and will surely slow. Real estate prices could decline, but because buyers typically do not finance their purchases, there is virtually no chance of a mortgage market driven collapse such as occurred in the US and some other developed nations. There is also a legitimate concern over the aggressive lending practices of China’s regional banks. This could lead to a problem, but because they are state owned, a collapse is unlikely. The government recognizes these risks and is in the process of tightening controls on speculative activity while moving forward with infrastructure investment at the same time (95 new airports, 200 new universities, a fast rail system to interconnect key parts of the country, power generation and grid, etc.).

China is not alone in this track to prosperity. Much of Asia (ex Japan) is on a similar trajectory. Also, other developing/emerging nations are also on a very positive track (Brazil, India, Israel and others). Even some “Frontier Nations” are showing good economic growth. What they have going for them is that they are relatively unleveraged with consumer or public debt, have strong growing middle classes, people with a strong entrepreneurial work ethic, have little legacy entitlement social welfare programs and supportive governments. The emerging story of these countries is less today their export dependency (and competitiveness) but the strong growth of their internal, domestic economies.

The Equity Market Outlook

My general opinion is that the equity markets will move up in 2011. A key consideration is investor’s appetite for risk. We have been in a period where that appetite has been low for a few years now. Investors have been “hunkered down” primarily focused on capital preservation strategies. That is beginning to change. There is a huge amount of money on the sidelines, earning essentially nothing. The flood of money into the bond market has caused it to be overbought. If bond prices start to fall, there will be a “stampede for the door” which will accelerate the decline. We may look back on this as a “bond bubble” in the future. A significant portion of those funds will move into the equity markets…which now look comparatively inexpensive.

While there is trouble brewing in Europe, the US economy is showing a few signs of firming. Economic data is showing a positive trend. No one reasonably expects a strong recovery, but likewise the threat of a “double dip” seems to be waning. This makes investors more comfortable moving into risk assets.

We are also seeing volatility decline. The VIX (volatility index) has dropped from a peak of 60+ to 17.25 over the last two years. This signals a drop in the anxiety level of investors and therefore, a move to equity exposure.


While many companies are stuck in neutral, many are financially strong and beginning to show top line growth. Among the vast number of public companies there is a cohort that is doing incredibly well. So some observers look at the correlation of S&P stocks at 80% and say, there is no way to add alpha by stock selection (which has been true for large funds limited to S&P market cap size companies). However, it is not true across the wider spectrum where many excellent companies are prospering, while others struggle. Share prices are now making this distinction. Furthermore, within the large cap sector, it seems likely that the correlation trend will reverse going forward as fundamentals are beginning to drive market prices once more.

With stock prices trading at reasonable levels (most estimates put the S&P 500 at a 13.4X multiple), the aversion to risk showing some signs of waning and capital beginning to move back into the market from the sidelines, there is good reason to expect equities to move up in 2011.

As a prognosticator, I would expect the stock market to be up at least 15% by the end of the year.

Risk Factors

Most investors share a common view of the principle risk factors that form part of the landscape as we move forward in 2011. Bear with me to list them.

1. Expansion of the financial trauma in the Eurozone.

2. Deceleration of the growth engine in China, lessens its effect of lifting the world economy

3. Financial problems of US State & Local governments may magnify

4. Fed policy of accommodation may shift with the likely addition of three new conservative members to the Board (filling vacancies).

5. Unemployment may move back up over 10%

6. Geopolitical risks from rogue nation actions (N. Korea, Iran, etc.) or a growing realization that we will not succeed in Afghanistan.

7. Terrorist attacks

8. Public policy changes arising out of political power shifts.

Even though the credit crisis has past, we are reminded that we live in a world with many dangers.

Investment Themes and Strategies

Reflecting on the landscape conditions discussed above, the question becomes “What action should an investor pursue in this environment?” The following are a few thoughts on that matter.

1. In an environment that presents a higher degree of uncertainty, it is best to maintain a higher degree of flexibility (less illiquid exposures). It is also a good idea in the actively managed part of portfolios to place funds with skilled managers in structures that provide those managers with decision making flexibility. Obviously long-only funds in equities, bonds or other asset classes do not have this attribute, since they are pure directional “bets” that cannot dynamically adjust market exposures when conditions change. The hedge fund structure does provide this flexibility.

2. Currency exposures have become increasingly important in investment strategies. It seems wise to diversify away from the USD, Euro, Pound and Yen (currencies of nations with very high sovereign, consumer and bank debt) and gain exposure to currencies of economies that have low debt, solid growth, abundant natural resources and are competitive in the world markets. One could also trade weak currencies short, or pair-trade them against more favorable currencies.

3. Investors should lower their interest rate exposure. With treasuries selling at decade long highs the risk is elevated that long bonds could steeply decline in value if interest rates rise. With bonds being massively over bought any movement of capital away from this asset category (as we have seen in the last week or so) would bring prices down quickly. So it is time to be cautious about longer duration bonds.

4. As an alternative to fixed income exposure (that has interest rate risk), seek exposure to absolute return-type hedge fund strategies with low equity beta characteristics (low market correlation). There are a wide range of hedge fund strategies; some which are correlated to markets to varying degrees and some that offer little or no equity or bond market exposure. The latter offers a portfolio alternative, which is a proxy for bonds, but without exposure to interest rate cycle risk. Such strategies seem attractive in market conditions such as is likely to exist in 2011.

5. The likelihood that equities will move higher in 2011 implies that investors should maintain some good degree of equity exposure during the year. While there are a number of “wild cards” out there that could “spook” the market, the trend seems toward more stability and therefor more accommodative for risk (the VIX has been on a trend down for the last two years). This should favor equities as investors move away from low yielding “safe” assets.

6. While there are a good many “bottom fishers’ in the real estate category, I believe that it is unlikely that there will be any rebound in prices for many years to come. So, keep exposures low and heavily targeted in this asset class. Investors should select investments in real estate for income purposes, not appreciation and should have a long term investment horizon.

7. In the private equity sector favor buyout funds over venture capital, unless you are able to gain access to top quartile funds. As always, in this asset class, manager selection is critical since performance spreads are very high in this industry.

Final Thoughts

When forming a view on the direction of the economy or the markets, an investor must always ask themselves “What if I am wrong?”. For that reason it is important to examine multiple scenarios, even those that one believes are less likely. It is a part of good investment discipline.

On the downside, there is a measurable risk that the sovereign debt crisis in Europe accelerates during the year, reaching crisis proportions. This would drag down the world economy and adversely impact the markets. Austerity action by troubled countries may not work. In fact it may have the pejorative effect of exacerbating the problem by throwing those economies into a downward spiral.

The mood of US and EU investors (particularly individuals) remains quite pessimistic. The evidence of this is everywhere you look. There is an unprecedented amount of investment capital on the sidelines (earning nearly nothing). The bond market for the highest credit quality securities (US Treasuries) is at a decades-long peak. It is an extremely crowded trade. Any negative event (skirmish in Korea, financial troubles in Ireland, etc.) leads to a big rush into “safe haven” instruments such as treasuries or gold. Projections for the US economy are very weak and worries are high that the economy will sputter once the stimulus winds down. No one believes that a recovery might be poised to perform better than expected.

That might be wrong. It is possible that the recovery might go better than expected. Even if it follows a weaker track than other post-recession recoveries, it could surprise many investors and observers. Perhaps the biggest driver of investor psychology is unemployment. If unemployment improves more than expected, the stock market will take off. Retail sales during the upcoming holidays may surprise the markets on the upside. Consumer confidence has been steadily improving. If this scenario unfolds, investors will be fearful of getting left behind. All that capital on the sidelines, earning near nothing will get tired paltry yields and move toward equities boosting the markets unexpectedly.

Nevertheless, we are navigating through “uncharted waters” where there will be a much higher variability in performance among asset classes and strategies. The macroeconomic landscape is more complex and demanding for investors.

Perhaps 2011 will show some improvement in the US economy, but our obdurate political leaders have not faced up to the longer range, fundamental issue that public sector spending is simply out of control and not sustainable. We are putting off the pain of doing the right thing today to push our problems down the road into the future. As John Henry Boetcheu said in 1016 “A nation cannot spend its way to prosperity”.

Wednesday, August 11, 2010

Rethinking Modern Portfolio Theory

The world of institutional Chief Investment Officers and Risk Managers was a very orderly place until the credit crisis of 2008. As the correlation between asset classes went to 1.0, all asset values declined at the same time and risk metrics proved worthless…the defects in the application of “Modern Portfolio Theory” became highly visible and leading investment professionals began the search for better methodologies. In this paper I endeavor to explore some of those important issues.


Firstly, the basic principle of Modern Portfolio Theory appears sound; its frailties show up in its application, more particularly in the effort to apply quantitative methods. The basic concept is that an investor can optimize the risk adjusted returns of a multi-asset class portfolio by configuring the mix of asset performance characteristics. The application of this principle is far more complex than has previously been practiced. How often have I seen the seductive charts showing the “Efficient Frontier”, as if one could simply compute the best mix of investable assets. If only life were that simple.

The Fatal Flaw: Risk and Volatility are not the same

A fatal flaw in the application of the principle was the assumption that risk and volatility were the same thing. The formulation of Modern Portfolio Theory required data to be inserted in equations. Leading economists and academics struggled with this fact and, so, decided that volatility (for which they had ex-post data) was the measure of risk. Further they assumed that the historical volatility of each asset group would be predictive of the forward volatility/risk. From a macro point-of-view, much of the volatility data used in today’s models relates to historical periods that are not relevant looking forward. For the five year leading up to 2008, volatility was low and markets were stable. Then in late 2008 and early 2009 volatility went through the roof. Going forward which data do you use? Perhaps neither characterizes the forward risk situation..

A practical example of the frailty of the assumption (that volatility and risk are the same) came in 2007 with the notorious collapse of the Bear Stearns’ High Grade Structured Credit Strategies Fund which exhibited very low volatility statistics until it completely collapsed to near zero value (in a couple of months) with no warning. Even the title of the fund implied quality and low risk. Contributing to this insidious development was the fact that there was no underlying trading of the fund’s assets, therefor the manager (Bear Sterns) was marking the value on investors’ monthly statements to a model, not to an actively traded market (because there was none).

The Bear Sterns fiasco points to another flaw in the use of volatility statistics, namely that they can be misleading when applied to illiquid asset categories, such as real estate, private equity and some hedge fund strategies. Furthermore, if a security or portfolio trades with high volatility through a wide range, but experiences more “up days” than “down days”, moving higher over time, does that imply that it is high risk? To a pragmatic investor, risk is the likelihood of losing money…not the range of price variation over relatively short periods of time. Such variations do not reflect the investor’s holding period or the fact that he/she has the choice of exit timing. While there certainly is a wide range of risk characteristics of different asset classes and individual investments, risk cannot be quantified with any degree of precision. It therefore must lie in the domain of business judgment.

The fundamental issue here is that it is pure folly to think that one can mathematically determine risk to a couple of decimal points using statistical ex-post volatility data to project ex-ante outcomes. The assessment of risk must consider a range of issues and scenarios…but ultimately requires a high level of investment judgment. Within any asset class, investment strategy or fund, the range of risk characteristics must be evaluated by the investor on a prospective basis. Such risks might include the stability of a fund’s investment leadership, its team, the degree of liquidity of its assets, its net market exposure and the amount of leverage it uses or does not use.

Efficient Frontier

The efficient frontier has been described by a line plot on a graph that presents risk vs. reward (expected returns). It is used to create a collection of assets that optimize the overall risk-return characteristics of an investment portfolio. Since it is not possible to reasonably quantify risk or the returns that will be realized, one might question the application of this type of analysis. So, is there an “efficient frontier” and where is it? The principle is sound, but the challenge comes in its application. One cannot draw a line on a two-dimensional piece of paper that describes it.

For the efficient frontier methodology to work, it must rely on a few key assumptions; namely that the markets are rationale, that it prices securities in an efficient manner and that forward risk can be quantified with some degree of precision using historical volatility data. Increasingly, investors are coming to the realization that none of these assumptions are true. Another assumption intrinsic to this methodology is that the distribution of expected outcomes (returns) may be characterized by a Gaussian curve. In fact, many asymmetric or by-modal curves may describe expected returns on an ex-ante basis.

Diversification

In spite of the fact that diversification offered no safe “hiding place” during the 2008 credit crisis, it continues to be an important discipline in constructing portfolios that manage the two strange “bedfellows” of risk and opportunity. However, it is not a two dimensional phenomenon as has been historically displayed on risk-return charts. Missing from the picture is the consideration that many asset classes are cross correlated to the same risk drivers, so the benefits of diversification in such cases can be minimal. A weakening economy may put downward pressure on equity prices, but also would cause commodities and real estate to drop in value. Thus, in such a case, diversification across these asset classes offers little risk mitigation value. One must look at the correlations between asset classes to understand whether diversification can deliver risk abatement value or not.

Also, diversification should not lead an investor to buy some of everything. Portfolio construction should reflect a carefully constructed mix of asset classes and investment strategy types should consider correlations, lack of correlations and counter-correlations. The mix of these should reflect the scenarios that the investor believes are most likely to develop. As important as the risk considerations are, it is even more important that the portfolio mix reflect the investor’s judgment of the profile of opportunities that are expected during the time horizon.

Another important consideration is the risk parameters and capital market assumptions that one puts into the asset allocation process. The validity of outcomes can only be as good as the quality of the inputs. Here also it is easy to fall into the trap of characterizing a situation with single numbers. The risk profile of any asset class can be better described through a probability distribution rather than a single number. The shape of that risk profile curve varies depending on future scenarios of events not known at the time the asset allocation strategy is formed. The same can be said for the capital markets assumptions (ex-ante return projections). In an environment with many unknowns and unknowable’s, the investor’s judgment comes seriously into play. Historical data can only be a small guide to future expectations. To rely upon it exclusively, is foolhardy.

The Skill Factor

Economists all neglect the effects of skill on investment risk and outcomes. Helicopters may be unsafe when flown by an amateur pilot, but may be very safe when operated by a Marine copter pilot with thousands of hours of experience. It is the same with investment managers. This shows up, in particular, in those areas where managers have a high degree of discretion and ability to affect the course of events. When one looks at the investment categories of venture capital, private equity, hedge funds, real estate and some others, one observes a wide range of performance outcomes. The dispersion of return performances from the top quartile performers to the bottom quartile is substantial. On the other hand for managers of traditional long-only equity funds, mutual funds and bonds, the variations (from market benchmarks) are narrow.

Since economists deal with statistical methods, it is necessary to have a big sample which lumps good, bad and average managers together. In this the attribute of skill is lost. This principle also comes into play on a fund-specific level. Many fund managers seeking to avoid risk or variance from benchmarks build large diversified portfolios with sector allocations that track closely to their benchmarks. I call these “benchmark huggers”. In doing so, they dilute to positive effects of skill in the performance of their portfolios. In the hands of a skilled investment manager, a sensible level of concentration and directionality is a good thing.

Liquidity

A basic economic principle is that one must pay a higher price for liquid assets than illiquid assets. While, in general, this may be true, investors overlook the advantages of flexibility offered by liquid assets. Most investors look at the need for liquidity to be a use-of-funds or spending requirement. They overlook the value that it has in providing the ability to quickly adapt to changing conditions or unforeseen events. Harvard Management learned this lesson the hard way during the recent credit crisis when they found their investment portfolio to be substantially committed to illiquid holdings at a time when rapid change put a premium of flexibility. In addition to causing distress, this lack of capital flexibility presents an opportunity cost since such portfolios cannot seize the opportunities that emerge during such periods. In many situations, the flexibility to easily sell an asset and re-deploy one’s capital in order to re-align investment exposures can be very valuable…worth the extra price. In portfolios with a mix of liquid and illiquid assets, one must be aware of the tradeoffs and intelligently weigh the benefits of an illiquid investment against the cost of compromising flexibility. It is not always the case that the illiquid investment offers a better return opportunity.

Strategy

In an environment of uncertainty, with tools of limited value, what is an investor to do? It gets down to a matter of practical judgment. Often investment managers set asset allocations for the long term. Investment environments change. They are dynamic. It is not a good idea to fix asset allocations, to let them become “straight jackets” over a long time horizon. There is much opportunity in getting tactical allocations right and, conversely, a lot to be lost in getting them wrong. Therefore, it is important to bring the best thinking to the process of dynamically allocating assets from a tactical standpoint. ”Tactical” implies time horizons of 1-2 years whereas strategic implies a longer timeline from an asset allocation standpoint. In making such tactical allocations, one must recognize the uncertainty of the decision making environment and the imperfection of even the best investor’s ability to judge the future. For this reason it is important for every investor, in setting tactics and strategy, to ask themselves “What if I am wrong?”. Good investors deal with this by factoring into their decisions the prospect of less likely scenarios.

The look forward is perhaps the most important determination that an investor will make.

The process of asset allocation is best accomplished by carefully thinking through and researching the various high probability scenarios that are likely to develop. In doing so an investor must anticipate changes that are likely to develop and their impact on the various asset types and strategies in their portfolio. Only then can one consider the mix that presents the best composite return potential and the lowest risk profile.

The degree of concentration in cross-correlated assets depends on the investor’s level of conviction on his/her primary scenarios. If there is a high degree of uncertainty about the catalytic drivers of the scenarios, then a more uncorrelated asset mix (diversification) is warranted. Conversely, when uncertainty is low and conviction is high, more concentrated, directional strategies can be employed. At the end of the day, it is a matter of optimizing the probability of successful outcomes while assuming the level of risk that fits an investor’ tolerance level and objectives.

Investors live in a world characterized by uncertainty and change. As they continue in the challenge to manage the two strange “bedfellows” of risk and opportunity, it is important to constantly re-examine the validity of the tools and theories practiced in the investment industry and look for better methodologies.

Tuesday, April 27, 2010

American Democracy at a Crossroads


Most people in America are growing increasingly concerned about the direction of the country and, particularly, its political leadership.

When we reflect on the values that made America a great and prosperous nation, we see those principles eroding. Our nation is comprised of a generous and principled people. When helpless European nations were invaded by Hitler’s Germany, the US put the blood of its young men and its balance sheet on the line to save the people from tyranny. The same can be said for South Korea, the Philippines, Eastern European nations of the Soviet block, Kuwait, and others. We have devoted extraordinary funds and effort to help mitigate AIDS and corruption in Africa and rushed to help when disasters struck in Haiti, Indonesia and other places. America is a nation that has sent its young people into struggling parts of the world to help through the Peace Corps.

The democratic principles on which our nation was founded have been an inspiration to freedom seeking people across the planet; to all that search for a better way of life.

At home also, we have been a generous nation, providing a social security benefit for the elderly, healthcare for the poor and public education that affords opportunity for all citizens without regard to their economic, ethnic or gender status.

However America now stands at a crossroads. The principles that made it great are: an independent thinking, self-reliant people; an innovative, entrepreneurial society; a small, efficient government; an absence of bureaucratic obstacles that discourage individual initiative, a value system that rewards and celebrates hard work and achievement…and a tax system that did not transfer wealth from the nation’s most productive individuals and distribute resources to those that rely on society’s generous welfare system.

No nation can be generous that is not prosperous.

Thus, America must return to, and stay true to, those fundamental principles that made our nation prosperous. However, we all see our country increasingly moving away from those principles.

In America it has become politically “fashionable” to demonize business leaders. These are the individuals in a society that create employment, generate national wealth and tax revenues. Yet instead of nurturing business enterprises or supporting their leaders with good public policy… we abuse them. A top business executive that earns as much as a top athlete, a musician or film star…is chastised for it, in spite of the fact that his/her effort does more to generate prosperity in the nations economy. It has become politically popular to take the rewards from those that have worked hard, taken risks, created successful enterprises and redistribute their economic earnings to others with less. Thomas Jefferson once said “Democracy will cease to exist when you take away from those who are willing to work and give to those who would not”.

A core issue that will determine our nation’s future lies in its political domain. Historically Americans voted for what they believed to be in the best interest of the nation. As more and more entitlement programs proliferated across the political landscape, Americans began voting more for their self-interest. This pernicious shift in the political process leads a nation down the path where public policy is redirected from the generation of national wealth to the redistribution of it. Ultimately, the “pie” begins to shrink as the creation of output is penalized and the idle in society are rewarded.

Unfortunately, this leads to a less efficient and less competitive economy. We live in an increasingly competitive world. When our government increases the cost of doing business for American companies by supporting unions, increasing the tax burden on investment and business enterprises, adds restrictive bureaucracy & regulation, it makes American companies less competitive…and foreign companies “beat us out” for business, resulting in lost jobs in the US. The insidiously titled “Employee Free Choice Act” (working its way though Congress) is a perverse example of this. It eliminates the secret ballot for union organizing, regressing back to the days when intimidation and coercion were used to form a union shop. It would also put government bureaucrats, not employers, in the loop in determining worker’s pay. It is convoluted thinking to believe that raising worker pay and benefits above market rates through organized labor or legislative initiatives will make them better off. The ephemeral benefits of this soon give way to the ultimate power of competitive displacement by more cost efficient alternatives overseas…and again politicians would complain about the outsourcing of jobs to foreign companies. It is inevitable.

There is another insidious trap that continues to develop. It is an easy political process to borrow from the future to make things better today. The ballooning public debt should concern all Americans. The US government is pursuing a profligate spending binge and an extraordinary expansion of (unfunded) entitlement programs. It seems that our political leaders and voters are all too happy to “party today” and “kick the can down the road” for future generations to deal with. The absence of a prescient perspective of where this leads us and the courage to do the right thing in the face of adversity reflects the temerity of human behavior. The challenge here is aggravated by the high degree of economic illiteracy in our society.

No nation, business or family can spend its way to prosperity.

We, the American voters, now stand at the crossroads. Do we have the backbone, the courage to redirect this great nation back to its core principles… or will we take the easy path and gradually descend into mediocrity? On this small planet no course of events is assured. The bright star that has lifted the hopes of people around the world could one day fade. What would the world be like then?

I cannot help recall the ending of the movie classic “Planet of the Apes” when Charlton Heston, walking down the beach of that strange land comes across the fallen structure of the Stature of Liberty and realizes the errant history of mankind that has gone before him, he exclaims… “Oh my god, what have we done!”

Let’s not let that happen to our great nation.