Austrian Economics & Investing
Austrian Economics & the Financial Markets
May 22, 2010
Joseph Calandro, Jr.
Contents
•
Background
•
Introduction – Austrian Economics & Investing
•
Investing & “Value Investing”
• Benjamin Graham
• Bottom-up v. Top-down
• Principle 1: Knowledge & the Circle of Competence
• Principle 2: Risk & the Principle of Conservatism
• Principle 3: Risk & the Margin of Safety
• Entrepreneurship & Franchise Value
1
•
Franchise Value: Management
•
Boom-Bust
•
Conclusion
•
Recommended Reading
•
About the Presenter
Background
•
I traded currencies & commodities in the 1990s, & did
exceptionally well for 4 years; year 5, I was caught in the “Asian
Contagion”…
•
Examining the mistakes I made led me to the study of Austrian
Economics & value investing, which was fortunate timing-wise
(in a sense)
•
2
•
In the late 1990s the “new economy” was booming: strong
parallels with the “new era” of the 1920s
•
“Austrian Business Cycle Theory” predicted the boom & bust
waves of both business cycles, which is useful information for
practicing investors
Research published academically—including in the QJAE—
which was expanded & published in book form: Applied Value
Investing (NY: McGraw-Hill, 2009)
This presentation is my opinion only. Not to attributed to any organization I am or have been affiliated with
Introduction – Austrian Economics & Investing
3
•
Good economics facilitates good investing
•
“… investment students need only two well taught courses—
How to Value a Business, and How to Think About Market
Prices.” -- Warren Buffett, 1996 Berkshire Hathaway Annual Report
•
“Where there is no free market, there is no pricing mechanism;
without a pricing mechanism, there is no economic calculation.”
-- Ludwig von Mises, Economic Calculation in the Socialist
Commonwealth (Auburn: LvMI, 1990 [1920]), p. 28
•
“Economics is the science which studies human behavior as a
relationship between ends and scare means which have
alternative uses.” -- Lionel Robbins, An Essay on the Nature and
Significance of Economic Science (Auburn: LvMI, 2007 [1932]), p. 15
Investing & “Value Investing”
4
•
“The capitalist-entrepreneur buys factors or factor services in
the present; his product must be sold in the future. He is always
on the alert, then, for discrepancies, for areas where he can
earn more than the going rate of interest.” -- Murray Rothbard,
Man Economy & State (Auburn: LvMI, 2004 [1962]), p. 510
•
“The books and the balance sheets are the conscience of
business. They are also the businessman’s compass.” -- Ludwig
von Mises, Bureaucracy (Spring Mills, PA: Libertarian, 1996 [1944]),
p. 35
•
Modern value investing “continuum”
•
Net Asset Value – balance sheet reproduction
•
Earnings Power Value – based on a level of historical earnings
that should be sustainable into perpetuity
•
Franchise Value – sustainable competitive advantage
•
Growth Value – least tangible & thus most risky
Value Investing: Benjamin Graham
•
Benjamin Graham founded value investing in the 1920s-1930s
•
Heavily influenced by the “new era” boom of the 20s & the
subsequent bust/Great Depression
•
Price discrepancy-based strategy: buying assets < liquidation
value resulted in a significant price discrepancy or “margin of
safety”
• Cornerstone of the approach, to this day, & is what
differentiates an “investment” from a “speculation” for
Graham & his students
•
Most famous student is Warren Buffett; others equally as
successful, e.g., Seth Klarman, Mario Gabelli, Mitch Julis, etc.
• Many value investors have substantially outperformed
market averages over time
5
Value Investing: Bottom-up v. Top-down
•
Micro v. Macro
•
•
Fundamental analysis v. Portfolio analysis
•
•
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Action v. Aggregates
Price discrepancies v. “efficient frontiers”
“It is certainly legitimate and necessary for economics, in
working out an analysis of reality, to isolate different segments
for concentration as the analysis proceeds; but it is not
legitimate to falsify reality in this separation, so that the final
analysis does not present a correct picture of the individual
parts and their interrelations.” -- Murray Rothbard, Man Economy
& State (Auburn: LvMI, 2004 [1962]), p. 270
Principle 1: Knowledge & the Circle of Competence
•
“The recognition of the insuperable limits to his knowledge
ought indeed to teach the student of [investment] a lesson of
humility which should guard him against becoming an
accomplice in men’s fatal striving to [achieve quick & easy
returns]...” -- F.A. Hayek, Nobel Prize Lecture (December 11, 1974),
words in red font were inserted by me
•
The “circle of competence”: focus on what you know
•
•
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“The size of that circle is not very important; knowing its
boundaries, however, is vital.” -- Warren Buffett, 1996
Berkshire Hathaway Annual Report
Validating assumptions via the selective use of experts
•
“Pawn Stars”
•
“Indirect experts”: the Sears case
Principle 2: Risk & the Principle of Conservatism
•
“… man does not always act correctly from the objective point
of view… either from ignorance of casual relations or because
of an erroneous judgment of the given situation, in order to
realize his ends he acts differently from the way in which he
would act if he had correct information.” -- Ludwig von Mises,
Epistemological Problems of Economics (Auburn: LvMI, 2003
[1960]), p. 34
•
You could be wrong for any number of reasons: quantitative,
qualitative &/or behavioral
•
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Address all assumptions/adjustments (B/S, P&L, strategic, &
growth-related) in each valuation conservatively
Principle 3: Risk & the Margin of Safety
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•
“… this world is a world of uncertainty. We shall never be able
to forecast the future course of the world with precision. Every
action, therefore, involves risk. This risk cannot be eliminated.
The man who keeps cash balances suffers the risk that [his]
purchasing power may dwindle; the man who invests suffers
the risk of loss; and so forth.” -- Murray Rothbard, Man Economy
& State (Auburn: LvMI, 2004 [1962]), p. 510
•
“They discover discrepancies between present prices of the
complementary factors of production and the anticipated prices
of the products minus the market rate of interest, and are eager
to profit from them.” -- Ludwig von Mises, Human Action (Auburn:
LvMI, 1998 [1949]), p. 544
•
“Margin of Safety”: rule of thumb, price should be at least 30%
less than estimated value
Value Investing: Entrepreneurship & Franchise Value (1)
10
•
“The business of the entrepreneur is… to select from the
multitude of technologically feasible methods those which are
best fit to supply the public in the cheapest way with the things
they are asking for most urgently.” -- Ludwig von Mises, Profit &
Loss (Auburn: LvMI, 2008 [1951]), p. 10
•
“A profit-seeking enterprise is supported by the voluntary
patronage of the public. It cannot subsist if customers do not
pour in.” -- Ludwig von Mises, Bureaucracy (Spring Mills, PA:
Libertarian, 1996 [1944]), p. 117
•
“The elemental physical nature of the good may be only one of
its properties; in [some] cases, a brand name, the ‘good-will’ of
a particular company, or a more pleasant atmosphere in the
store will differentiate the product from its rivals in the view of
many of its customers.” -- Murray Rothbard, Man Economy & State
(Auburn: LvMI, 2004 [1962]), pp. 665-666
Value Investing: Entrepreneurship & Franchise Value (2)
•
The GEICO case: Buffett’s franchise investment “masterpiece”
$120
$106.55
$90
$69.00
$60
$44.15
$30
$0
NAV
•
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EPV
GV
Paid ~$70/share--25.6% price premium at the time--growth
reflected a 54% margin of safety (Source: Applied Value
Investing, p. 56: valuation solely the work of the author)
Franchise Value: Management
•
“The profit motive is precisely the factor that forces the
businessman to provide in the most efficient way those
commodities the consumers want to use.” -- Ludwig von Mises,
Bureaucracy (Spring Mills, PA: Libertarian, 1996 [1944]), pp. 24-25
•
“One of the qualifications required for any higher position is
precisely the ability to judge people correctly. He who fails in
this regard jeopardizes his chances of success.” -- Ibid, p. 41
•
Successful managers
• Have entrepreneurial insight & discipline
• Know how to select, incentivize, develop, & retain talent
• Effectively assign decision rights
• Are fanatical about P&L (very, very rare)
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Boom-Bust (1)
•
“Buy during periods of pessimism & low prices; sell during periods
of optimism & high prices.” -- Benjamin Graham, The Intelligent
Investor (NY: Harper, 1949), p. 31
•
It could be easier doing this if you understand the macroeconomic
reasons for the pessimism & optimism
• Macro-based insights could be used to screen for potential
investment opportunities
•
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“In broadest terms the Austrian [business cycle] theory is a
recognition that an extra-market force (the central bank) can initiate
an artificial, or unsustainable, economic boom. The money-induced
boom contains the seeds of its own undoing: the upturn must, by
the logic of the market forces set in motion, be followed by a
downturn [or bust].” -- Roger Garrison, ”The Austrian Theory of the
Business Cycle in Light of Modern Macroeconomics,” Review of Austrian
Economics, Vol. 3, No. 1 (1990), p. 7
Boom-Bust (2)
•
Invest into a boom & exploit under-priced risk prior to a bust
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7
5
3
2
1
4
8
•
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Sources: George Soros, The Crisis of Global Capitalism, p. 52 &
Applied Value Investing, p. 133
Conclusion (1)
•
Pricing & valuation are predominantly about people
voluntarily buying & selling, & the resources allocated to
produce goods/services they want to buy & sell
•
Buying a security is like buying anything else…
• … you likely would not buy a CD based on a cross-section
of different musical genres (rock, country, rap, etc.) so why
do that for securities?
•
As an investor you must know: what you’re buying, why,
what you expect to get out of it, & when
• Value investing is a proven method of doing this over time
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Conclusion (2)
•
There could be value buying into a privilege early, e.g.,
business cycles, Burlington Northern (?), etc: be very
conservative here
• “The steel manufacturers seeking a tariff, the bankers
seeking taxes to repay their government bonds, the
rulers seeking a strong state from which to obtain
subsidies, the bureaucrats wishing to expand their
empire, are all professionals is statism. They are
constantly at work trying to preserve and expand their
privileges.” -- Murray Rothbard as quoted by Joseph
Salerno in the Introduction to A History of Money and
Banking in the United States (Auburn: LvMI, 2005 [2002]), p.
10
•
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Whenever the word “new” is used to describe market
phenomena--especially by a government official--get ready
for a bust (directionally, not timing-wise)
Conclusion (3)
• Good economics--Austrian economics--facilitates
good investing
• But good investing does not necessarily equate
to good economics
• “The curious task of economics is to
demonstrate to men how little they really
know about what they imagine they can
design.” -- F.A. Hayek, The Fatal Conceit
(Chicago: U of Chicago, 1988), p. 76
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Recommended Reading
•
Austrian Economics
• Economics in One Lesson by Henry Hazlitt
• The Mystery of Banking by Murray Rothbard
• Economics 101 by Murray Rothbard (audio lectures)
• The Root Causes of the Economic Crisis by Ludwig von Mises
• America’s Great Depression by Murray Rothbard
•
Value Investing
• Security Analysis 6th Ed. by Benjamin Graham & David Dodd (Seth
Klarman, lead editor)
• Margin of Safety by Seth Klarman
• Buffett: The Making of an American Capitalist by Roger Lowenstein
• Applied Value Investing (requires a working
accounting, finance & strategy; not for beginners)
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knowledge
of
About the Presenter
Joseph Calandro, Jr. is the author of Applied Value
Investing (NY: McGraw-Hill, 2009). He is also the
Enterprise Risk Manager of a global financial services firm &
a finance department faculty member of the University of
Connecticut where he designed & taught MBA courses on
value investing & risk management. He was previously a
financial consultant with IBM Global Business Services
Joe has published widely in journals such as the Quarterly
Journal of Austrian Economics, the Journal of
Alternative Investments, Strategy & Leadership, & a
number of others. A list of his publications is available at his
SSRN author’s page: http://ssrn.com/author=357310 He
has also presented papers at conferences in the U.S., U.K.,
& Canada
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