the investment danger of oversimplification

The Albanians, angry at being swindled in the "pyramid schemes" that swept their newly free market country, can teach us a lesson about the danger of oversimplification in investing. The Albanians turned the complex workings of a free market into "we can all be rich under capitalism!". The current crop of mutual fund television advertisements is turning the complexity of equity investment into "We can all retire rich with Analgesic Funds!". By the time investing has been reduced to a simple slogan, the prudent keep their feet firmly grounded in cashflow reality.

"People are learning about capitalism," said Gilbert Galanxhi, spokesman for Albania's ministry of foreign affairs. "Everyone has to realize, no one told the people to invest. It's not easy to get money, especially without working." The Globe and Mail, Tuesday, February 25,1997

After the fact, investment manias seem obvious. During the heady period before the speculative collapse eventually occurs, few words of critical analysis are ever heard or even wanted. A necessary condition of overvalued assets is an iterative process of gross oversimplification. This is a technique borrowed from the art of propaganda.

Albanian Pyramid Schemes

Take the Albanians for example. Recent television newscasts and newspaper photos have shown crowds rioting, expressing their anger at being swindled in a number of pyramid schemes that swept their newly liberalized country. After the heavy yoke of a closed Stalinist dictatorship was lifted from this small, underdeveloped and very poor country, a few sharp operators set up companies to take in investment deposits paying very high interest rates. In a classic pyramid set-up, the funds advanced from the later investors were paid out in interest to earlier investors. In this way, very high interest rates could be paid on deposits to lure in still more investors. In this financial game of musical chairs, however, the music eventually has to stop when new investors cannot be lured into the scheme.

From the huge sums ($1.5 billion U.S.) that have been reported to have been invested in these schemes, most Albanians seem to have been eventually caught up in this investment fervour. The question is why? Why would poor peasants flock to put their life savings into such a scheme?

Greed is the obvious motivation. As well as the delusion that accompanies mass, human activities. Without dwelling on the psychology of crowds, an easy-to-understand slogan or sales pitch is a vital ingredient. The wartime propagandist simplifies the intricate grey complexity of geopolitics into the simple black and white of "THEM (the evildoers who kill infants) AGAINST US! (our glorious and brave soldiers)". The Albanian hucksters running the pyramid companies distilled capitalism into"WE CAN ALL BE RICH! "(and have all the great consumer stuff we see on western TV). Just pass the cash for this worthless piece of paper.

Mutual Fund Mania

So what of our late 1990s North American binge into things mutual and equity? A well considered investment into the securities of a good company is beyond dispute. That good money managers exist and can deliver above market returns is also persuasive. Well-run companies have rising cashflows that boost their share prices and allow tax-deferred compounding of invested capital. Good money managers should be hired to take advantage of these opportunities for those less skilled in the art of investing. But what about this ceaseless "river of drivel" that passes for mutual fund advertising?

Perhaps I'm a trifle hard on the creative side of mutual fund advertising. Granted that regulators prevent performance discussion and indirectly encourage banality. The simple pitch is unmistakable: "INVEST WITH US AND YOU CAN RETIRE RICH!".

The problems with this gross oversimplification are obvious. Economies exist primarily to distribute wealth. Not everyone can be rich. Not even in retirement.

Financial markets price the cashflows of companies and securities. Sometimes even developed financial markets are gripped with the same valuation disability that recently possessed the citizens of Albania. The process of regaining financial reality can be deadly for the financially promiscuous.

What of today? We know one thing, it is impossible to pick the peak of the market until well after the fact. When markets depart from reality there is generally widespread agreement on what seems to be persuasive rationale. This gets reduced to simple slogans.

Let's review some of the valid investment insights that have been reduced to simple slogans:

• Mutual funds take the risk out of investing;
• Government pension plans are "bust" so you have to provide for your own retirement;
• Don't time the markets;
• Foreign investments are better;
• There's an upcoming shortage of equities;
• There's an upcoming shortage of bonds;
• Inflation is dead, never to return;
• Interest rates can never go up;
• Government deficits are solved;
• Demographics mean that "babyboomers" will be buying up equities;
• Always buy in a downturn because the market goes back up;
• Let a professional money manager reduce your risk;
• Managers underperform, so put your money in an index fund.

All these points have some validity. Just remember, they have nothing to do with the values of cashflows. Real companies making real money are worth something because of the cashflows they produce. It doesn't mean that you should pay extremely high prices to buy these cashflows.

Think of buying a car. Let's try a bit of our own sloganeering:

• Everyone needs a car;
• Cars are useful;
• Cars are modern;
• Cars have a resale value;
• Cars are fast.

These slogans have some basis, but are dangerous in their oversimplified form. A proper purchase of a car starts with consideration and research. You could pay $26,000 or $52,000 for the same car. The car is the same no matter what you pay for it. Obviously the best car for your purpose, at the cheapest price, should be your goal. You would probably start by talking to some friends, and by reading some auto magazines, and Consumers Reports to establish which model you want. You would check with a pricing report, or service, to find the selling prices for that model.

An investment is simply advancing funds in exchange for the promise of future cashflows. Since investments and finance intimidate most people, individual investors usually do not go beyond the sales pitch. There is no substitute for informed investing. A good investment should be simple to understand. Its cashflows should be identifiable.

A stock or bond is a claim to a cashflow. A mutual fund is a claim on a portfolio of stocks and bonds that an investment manager has assembled and manages. The price that investors are willing to pay for cashflows moves up and down with fundamental factors, and the emotion and sentiment in the market. Like the car above, we can pay $100 million (P/E ratio of 10) or $200 million (P/E ratio of 20) for $10 million in cashflows. In a recession, investors are in blue funk, and can only see decline and risk, and $100 million seems steep. Companies can be bought at market prices that are a fraction of the replacement cost of their assets. In a market boom, investors are swept along enthusiastically in a frenzy of optimism, and $200 million seems trivial to a market that has just increased 30%. This can't continue.

Shrewd investors, looking at stretched valuations, sell into the peaking market in a process known as "distribution". They know they have to leave something "on the table" to get out with their investment skin intact. At some point, those owning the cashflow producing companies will think the pricing of their cashflows is ridiculous and sell into the mania. The company owner, knowing that he can recreate the company for $150 million would obviously sell for $300 million. More and more cashflows become available at higher and higher prices, until the market clears. So much for the shortage of equities. As long as there is paper to print share certificates, equities are infinitely issuable.

But how, you might ask, do I avoid begging on the sewer grate? Through a well-considered, long-term, investment program. Good stocks, bonds, and mutual funds are always good investments. Don't expect to get rich quick through risky, and speculative investments. Jumping in with your eyes closed after a long market run is not a sign of investment courage. As the neophyte investors of Albania have found out, there's always someone with a simple slogan waiting to relieve you of your savings!

Article by John Carswell, Canso Investment Counsel Ltd.