Buffett vs. the Technologists, Round II

“The historical track record of old white men crapping on new technology they don’t understand is at, I think, 100%.”

                                         Marc Andreessen, Venture capitalist and Bitcoin investor

Andreessen made his dismissive comment this summer at a forum discussing the future of Bitcoin, a crypto-currency I mentioned in a prior blog. The old white guy he was dissing was Warren Buffett, who had made some comments skeptical of the intrinsic value of Bitcoins.

Andreeseen was technically correct about Buffett’s predictive track record. He just had the value sign wrong. Buffett’s track record of forecasting the value of new technologies is indeed 100%, but the Sage of Omaha has been correct, not incorrect. Back in the late 1990s, Buffett published a comprehensive takedown of the technology bubble in Fortune magazine. At that time, tech enthusiasts dismissed him, indeed often ridiculed him for being old and out of touch. But Buffett was right. Investors in high-flying tech stocks lost most of their money as the tech-heavy NASDAQ index fell by almost 80% between March of 2000 and October of 2002.

Paying respectful attention to Warren Buffett is an intelligence test for any investor. So in trashing Buffett, was Andreesen ignorant, arrogant, or both?

The answer, I suspect, is neither. He was simply, as the tech world puts it, “talking his book.” (Thanks for that phrase, Mike.) Andreessen is a smart guy. He was one of the inventors of Mosaic, the first web browser, and a founder of Netscape. He reaped billions from his early tech career. Now a venture capitalist, he’s recently invested millions in the Bitcoin ecosystem — the range of companies working to provide support services to facilitate the deposit, spending, and transacting of Bitcoins and/or other crypto-currencies.

Most of what is happening around crypto-currencies is absolute nonsense, entirely reminiscent of past bubbles from the tech bubble to the original South Sea bubble in the early 1700s. (A new crypto-currency named after the tooth fairy? Really?) Will any part of the Bitcoin phenomena persist? Hard to say.

What is easier to understand is the overall track record of venture capital since the collapse of the tech bubble. Over the last decade and more, the return on venture capital as an asset class has been roughly zero. (As Jayne Cobb said, “Ten percent of nothing is, let me do the math here, nothing into nothing, carry the nothin’. Nothing.”) That does not mean there have no profitable new technologies. In fact, Andreesen was an early investor in Twitter, Facebook and other key tech plays. But it does suggest that, across the span of new business initiatives, the universe of venture capitalists have been unable to discriminate between promising and dead-end technologies, or perhaps between good and bad business plans. (Some successful first-generation venture capitalists, like Bill Janeway formerly of Warburg Pincus, refer to the approach of many current VCs as “spray and pray.”)

Back in 1997, the last time tech stocks were flying high, I went on a bike trip in France. One of the other cyclists was a famous venture capitalist, whose firm had bankrolled some of the most successful tech breakthroughs of the prior decades. At that time, he was contemplating leaving his firm and starting over, because his partners were not aggressive enough. He wanted to go into the freshman dorms at MIT to fund new Internet startups. Understand that he did not really think those freshmen were likely to have any genuinely valuable business ideas. He simply saw them as a source of new merchandise to peddle to the eager suckers.

This is a capital markets model, not a business model. I suspect part of the reason for the lousy returns may be that venture capitalists have gone from trying to invest in a broad range of technologies that solve actual human problems to trying to manufacture product for credulous investors.

Perhaps I am over-complicating the issue. It may be as simple as too much money chasing too few genuine economic opportunities. In any case, here at TGS we remain entirely comfortable have exactly zero direct exposure to venture capital as an asset class. Or as Jayne would say, “Nothing, carry the nothing. Still nothing.”

Progress on Pensions

This morning I was making my usual tour through my two go-to news aggregation sites, the Markets and Politics sections of the Real Clear franchise. There was a link to an article in the WaPo titled “Gina Raimondo reins in Rhode Island pensions, propelling a bid for governor.”

Since I’ve posted several times on the pension issue, I checked out the article. Several elements of the story seemed especially interesting to me:

1) Raimondo is a Democrat, in a small state entirely dominated by Democrats. She won the gubernatorial nomination over two other Dems supported by the public-sector unions, both of whom opposed her reforms.

2) When she was elected Treasurer in 2010, she began a process of education of the citizens of her state, respecting their intelligence and showing the various stakeholders the consequences for other public-sector spending of the growing costs of pensions. Her message was, “I’m a progressive, and unless we do something now the future costs of pensions will squeeze out other interests (health care, schools, roads) that every progressive must support.”

3) Having won agreement on pension cuts, she remains highly popular. Telling the truth about public finances need not be political suicide.

Just as it is not clear how Chris Christie’s success attacking the issue of unfunded liabilities in New Jersey will translate into success on the national stage, it is also uncertain whether Raimondo’s success will lead other Democrats to follow suit in states with even larger unfunded entitlement problems. (Illinois, New Jersey, Connecticut and Massachusetts are among the worst.)

But it seems possible that voters may be more intelligent and deliberative than most politicians think, and that an electoral conversation based on an honest presentation of the numbers is at least possible. This suggests that our public finances, and the social democratic programs they support, may be endangered, but we are not necessarily doomed.

Oranjeboom, Espanabust

It has been a great World Cup. Not as once-in-a-lifetime awesome as four years ago, when my two boys and I visited South Africa for a month during the 2010 World Cup. (Thank you again, hosts Gavin and Yvette!) But an exceptional sporting event, with high scoring, dramatic comebacks, and huge upsets. Not to mention a big U.S. victory against the run of play versus World Cup nemesis Ghana, followed by a tie against Portugal and a trip through to the knockout round.

None of the upsets were bigger than the Netherlands victory over holders Spain, in a rematch of the 2010 final with a very different result. (Spain beat Netherlands 1-0 in the last minute of extra time in 2010.) Netherlands dismantled Spain 5-1 in the first week, a demolition completed by Chile when they beat Spain 2-0, guaranteeing an early exit for the former World Cup champions. Three of the last four World Cup champions have failed to escape the group stage.

I’m a fan of the Oranje for two reasons. First, the Dutch are a small nation with a great football tradition. Johan Cruyff, one of the best players ever, pioneered the idea of Total Soccer with Ajax and Barcelona in the 1970s. They play attractive, attacking football, and have enjoyed success on the world stage out of proportion to their small population. Second and more important, I am one-quarter Dutch, and consider that ancestry the source of my congenital stubbornness and love for cheese.

You could say, “What a difference four years makes,” except Spain’s dominance lasted far past the last Cup. In 2012, they beat Italy 4-0 in the Euro 2012 final. Just a year ago, experts were declaring this Spanish side the greatest national team of all time. As of June 7, when FIFA froze its rankings prior to the World Cup, they were the #1 rated team in the world. “How are the mighty fallen.”

There is an interesting cluster of principles here. The first is about our desire to know what will happen. Since human beings dislike uncertainty, our brains impose patterns on data where none exist, to preserve the illusion that we can predict and thus control the future. Philadelphia sports fans suffer from a particularly virulent strain of this defect, alternating between shameless front-running (when the local team wins) and instant despair (at every unanticipated loss).

A second insight from football concerns the pursuit of excellence. In a free economy, or a competitive sports landscape, success spawns imitation, but it can also lead to innovation. When Holland lost to Spain in 2010, they did not go back, disassemble their unique style of soccer, and adopt Spain’s tika-taka passing game. Similarly, Barcelona demonstrated extraordinary dominance of club soccer early this decade, beating their opponents by a cumulative 16-6 in the knockout stages of the 2011 Champions League. They looked literally unbeatable. With the world’s best player, Lionel Messi, supported by Iniesta, Xavi, Dani Alves et al, how would they ever lose?

Yet just two years later, Bayern Munich beat Barca 7-0 in aggregate in the semi-final. And the year after that, Real Madrid in turn beat Bayern in the semis by an aggregate of 5-0.

It is hard indeed to stay on top.

As investors, we can perhaps draw some lessons from soccer. First, what is best practice? Is someone else doing something that confers a durable advantage for their clients? If so, we need to duplicate or clone that strategy. Second, we must always be skeptical of the idea of permanent superiority, whether of individual company, money manager, or investment style. Durable advantages are few and far between in the investment business. What appears to be out-performance is usually style, and no asset class out-performs forever.

We’ll be downing tools here at TGS at 4 p.m. tomorrow, when the U. S. Men’s National Team plays Belgium in the Round of 16. Go Yanks!

Cover-Up 1, Tech Support 0

There may be someone still out there who doubts that the IRS targeting of conservative groups was a deliberate strategy with the intent of suppressing political activity. For the rest of us, the news that Lois Lerner’s hard drive “crashed” in 2011, that her emails could not be recovered by tech support, and that the drive was “recycled,” is as damning at it is unsurprising. Her hard drive was not the only one. As Politico reported, “Earlier this week, Ways and Means Republicans said as many as six IRS employees involved in the scandal also lost email in computer crashes, including the former chief of staff for the acting IRS commissioner.”

So here is what we know:

1) The IRS selectively and comprehensively targeted conservative 501(c)4 groups for elevated scrutiny and denial of approval, for a period of several years including the 2012 election cycle.

2) Individuals associated with new conservative 501(c)4 groups were also targeted by the Department of Labor, the EPA, and other Federal agencies.

3) Since this came to light in early 2013, the IRS has stonewalled Congress and the Department of Justice has failed to investigate with even the appearance of seriousness.

I was a Democrat during the Watergate years. Back then, the fact that Nixon abused the powers of the IRS, on a retail basis, to go after individuals he considered political enemies, was immediately recognized, by observers across the political spectrum, as cause for investigation and ultimately grounds for impeachment.

More than a year after this scandal broke, we have no special prosecutor, and the left-wing and mainstream media are largely silent. I have to ask my many friends on the Left — do we really want to support empowering the explicit use of the taxing authority as a means of political intimidation? Will you be OK with this when and if the Republicans eventually win the Presidency?

My essential anguish on this issue is due to the fact that, unlike back in the 1970s, we have lost a bipartisan understanding of what constitutes an abuse of power, and whether it should be punished. The fact that we can no longer agree on whether the law should be uniformly enforced is one of the most frightening aspects of the current climate of political division. To say that most of the media has been more lapdog than watchdog since Obama took office is to rehearse the obvious. (Not everyone. Ron Fournier, a left-leaning journalist who was once an Obama enthusiast, continues to do solid work on the IRS scandal.)


A Tale of Two Kitties

Bill Gross Recently wrote a post about his cat Bob, mourning the loss of a long-time feline companion. Bob followed along wherever Bill went, ever-present, alert and on-guard.

Bandit, one of my two cats, is different. He is a large, black, neutered male. He does not guard anything. Instead, his habit is to lie on the floor right in the middle of the traffic pattern, staring vacantly into space. (Some cats are smart. Not Bandit.)

If you watch Bandit, he seems inactive. Observing his size and girth, you might suspect that his fat has compromised his mobility.

Until he moves. Suddenly, the huge, quiet beast is transformed into a flying ball of fur, a black blur scampering up the stairs chased by the dog, or hurtling around the family room, leaping over furniture and sometimes smashing glassware, in pursuit of our older and smaller cat Millie. (Millicent T. Katt, for those not on a first-name basis.)

Bandit’s apparent inactivity is an illusion. He is simply waiting for his moment, keeping his energy in reserve until some silent alarm goes off in his dim, strange brain, telling him it is time to go. Sometimes I think we should have named him Barkley, after the Round Mound of Rebound who once played for the 76ers. Like Sir Charles, Bandit may look fat, but he has serious hops.

They say pets come to resemble their owners, and vice versa. And maybe not just in appearance.

Bob was quite a lot like his owner Bill Gross, who runs PIMCO, one of the largest bond managers in the world. PIMCO pursues investment advantage within the opportunity set of fixed-income, continuously looking to add a basis point here, two hundredths of a percent there, making the advantages of size, perspective and trade execution gradually accrue returns for their investors.

At our little firm (we run less than one-third of a billion dollars, while PIMCO runs over $2 trillion), we are asset-allocators, like Jeremy Grantham of GMO or Rob Arnott of Research Affiliates. Our advantage is not continuous but episodic. As investors, we spend lots of time sitting and pondering, observing the markets, back-testing different approaches.

But like Bandit, sometimes we move in a hurry. We may react to a threat, when the barking dog of over-valuation chases us partially out of a frothy asset class. (Tech, anyone?) Sometimes we chase the black-and-white cat of investment opportunity, over-loading a cheap asset class in pursuit of gains. Often, we believe our allocation moves may offer both lower risks and higher potential returns.

It is rare when our portfolio adjustments are immediately rewarded. Like the other asset allocators named above, our advantage is usually both delayed and discontinuous. If we buy emerging markets because we think them cheap, it is rare that they begin to out-perform right away. Much more likely is a continued decline.

Sometimes we move quickly, sometimes we wait, and sometimes it is the markets that change fast. But when our results do show up, they are often significant and abrupt. Here is a recent example. For the year ending February 28, U. S. large-cap growth substantially out-performed value, driven in large part by tech stocks:

S&P/Citi Growth: +28.70%

S&P/Citi Value: +21.88%

As you can see, growth had almost a 7% advantage over value. Since we were (as usual) over-weight value, these numbers drove under-performance by the U. S. equity portion of our target portfolio.

But things changed abruptly in March. For the month of March 2014, Large Cap U.S. Growth declined -2.51%, while Large Cap U.S. Value advanced an almost perfectly symmetrical +2.52%, a net swing of 5%. Through last Friday’s close, April saw growth down 3.8% and value down 2.2%. In a bit less than six weeks, a year’s worth of advantage for growth stocks has been reversed.

Of course, any amount of short-term performance surplus or deficit cannot prove a long-term performance advantage or lack thereof. Certainly, I’m not suggesting that these recent numbers demonstrate the likelihood of a continued trend of value out-performance.

What I will observe is that the benefits of asset allocation, when they manifest, often do so significantly and will little prior warning. Let’s enjoy them while they last.

Rumors of War

Back in the 1970s, my college history thesis was on British appeasement of Hitler in the period before the Second World War. At that time, the general outline of the facts of appeasement were known to anyone with a serious interest in European history or international relations. Chamberlain appeased Hitler, sacrificing allies and abandoning treaty commitments along the way, only to end up in the war with Germany he had tried so desperately to avoid, and having to fight from a position of disadvantage and not strength.

Back in the 1970s, most important political figures at the national level had served in the military in some capacity. While the agony of Vietnam cured policy-makers of reflexive military responses to any act of aggression, it did not end the basic understanding, familiar to anyone who had an unpleasant playground interaction in junior high, that plausible deterrence is a necessary component of keeping the peace.

Our political elites are a very different group today. Few individuals at the top ranks of politics, the press, universities, or major corporations have ever served in the military. As I’ve noted before, to an unprecedented degree the Obama administration consists almost entirely of members of the chattering classes, with few individuals who have ever had to make a payroll, construct a building, perform a medical procedure, or fire a weapon in anger. And the teaching of history has largely collapsed. I would not be surprised if neither Obama nor Kerry even recognized the name Anthony Eden, never mind Duff Cooper or Leo Amery.

As I’ve also noted, Obama is careless with words. He fashions his dialogue for immediate advantage, without appreciation for the long-term consequences of an empty promise or threat. Hence his lies about keeping your plan and doctor under Obamacare, and his red line over chemical weapons in Syria, both statements abandoned when they became inconvenient.

In 1938, Hitler commented to Mussolini about Chamberlain and Daladier, the leaders of Great Britain and France. “I saw them at Munich. They are little worms.” The German dictator judged the resolve of the two democracies by his observation of two individuals. A persuasive reading of history suggests that Hitler believed Britain and France would not actually fulfill their treaty obligations to Poland. In that sense, the war he ended up fighting and losing (thank God), was a war that took him by surprise. Churchill called it, “the unnecessary war.”

Putin has clearly made a similar judgment about Obama, whom he sees as lacking in essential courage, as someone whose words are without weight. Putin neither fears nor respects Obama either as man or President. It seems fair to say that his disdain for Obama is part and parcel of his lack of respect for the United States and its European allies.

Vladimir Putin is a man from another time. When the President observes that Putin is acting contrary to international norms, he is making a statement that is accurate, but not dispositive. If Putin can re-make the world to his advantage, because we lack the means and will to resist him, what cause has he to regret the passing of that more peaceful and polite world? One of the lessons of the failure of appeasement is that means and ends cannot be separated. A nation that violates international law to incorporate ethnic minorities is a nation that violates international law, and will do so again any time it perceives such violation to be in its interest.

Obama spent the early part of his time on the international stage apologizing for the United States’ past actions. To paraphrase, he told listeners, “Sorry about that whole Great Power thing. It won’t happen again.” Yet for the entire modern era, until very, very recently, a balance of Great Powers has been essential to preserving peace.

There was a brief period in the early 1990s when it appeared Russia would become a normal nation, a responsible member of the international community, a peaceful democracy and an ally of the West. Unfortunately, that period of international hope for Russia was coincident with a period of chaos and poverty for ordinary Russians. Putin stepped into the vacuum left by Yeltsin, restored order, and rode rising oil prices to a temporary recovery of Russia’s economic fortunes, in turn raising living standards.

For most of the 20th century, the Soviet Union was the center of a slave empire consisting of hundreds of millions of people. Putin calls the disassembly of Soviet tyranny a geopolitical disaster. Today, Putin’s Russia is a gangster state, run without regard for basic human rights. Putin kills journalists by the hundreds, murders opponents of his regime in foreign capitals, arms genocidal dictators.

The response of the President and the NATO allies has actually been encouraging over the last two weeks, but there remains a crucial series of unknowns. What are Putin’s intentions? How does he believe the West will act, given any specific provocation? How will the West act? At the intersection of these judgments, what are the risks of actual armed conflict?

It seems possible that we are entering a new era of geopolitical instability, the dimensions of which are difficult to predict. The costs of restoring a stable balance of power, based as it must be on credible deterrence, once that order has been violated, could be terribly high.


What is Money?

A few months ago, I had a conversation with another parent at my son’s school. The gentleman was an enthusiast for Bitcoin, a type of crypto-currency. I had a strong impression his interest was more than theoretical. He exhibited the sort of nervous energy characteristic of speculators hoping a large bet comes good.

Bitcoin’s origins remain obscure. In February, an energetic Newsweek reporter “outed” an unemployed electrical engineer, claiming him to be the source of the computer code that underlies Bitcoin. It appears that identification was wrong, and a lawsuit likely to follow.

Bitcoins create both benefits and problems on multiple levels. One obvious benefit is having access to a virtually untraceable form of buying power, outside the supervision of governments. This has appeal to terrorists, organized crime figures, folks with privacy concerns, and those who fear any government, including our own. (No, I’m not suggesting that Tea Party members are terrorists. I’ve never known any terrorist who walked around with a copy of the U. S. Constitution in his pocket.)

Bitcoin also has appeal for those not members of Al-Qaeda or the Russian Mafia. It is not fiat currency. The algorithm that creates new Bitcoins is designed to strictly limit the number in circulation, in theory preventing the inflation that gradually erodes the purchasing power of paper money in most countries. (Quickly, if you live in Venezuela or Argentina.)

Ironically, the anonymity of Bitcoins, and the lack of regulatory oversight, creates unanticipated risks. In February Mt. Gox in Japan, the largest trading exchange and depository for Bitcoins, sought Japan’s version of bankruptcy protection. Initial reports suggested the firm’s customers might have lost almost $500 million. At the time it went dark, Mt. Gox handled 70% of the world’s traffic in Bitcoins.

Another problem with Bitcoin as money is taxation. The Internal Revenue Service has determined that ‘spending’ a Bitcoin is a capital transaction. If the value is more than you paid, the result is a taxable capital gain.

The very name Bitcoin suggests the intention to create money, also reflected in the term ‘cyber-currency.’ So is Bitcoin money? In more general terms, what is money, and what do we want it to do for us?

The classic purpose of money is to be a medium of exchange. Instead of trading your two sheep for my ten chickens (which would require that you want chickens, and that I have some), you can sell me your sheep, receive cash, and spend that cash on other things you want, including goods that I do not possess. So far, so simple.

An ideal currency would be easy to use, widely accepted, and capable of being used to purchase goods anywhere in the world. By these measures, the U. S. dollar gets high marks. Perfect money should also be a stable store of value. If a sandwich cost $2 in 1980, you should be able to buy that same sandwich for that same $2 in 2014. By that measure, the U. S. dollar falls short. Inflation since 1980 has reduced the dollar’s purchasing power by 84%. (Still much better than the Zimbabwean dollar, which was abandoned in 2009 when inflation hit an annual rate of 6.5 quindecillion novemdecillion percent. You know you are in monetary trouble when you have to use words to save zeroes.)

The appeal of Bitcoin in part reflects dissatisfaction with the money otherwise available to us. The most significant defect of fiat currency like the U. S. dollar is its failure to preserve real purchasing power. Might Bitcoins have avoided that 84% loss in buying power?

Bitcoins weren’t around in 1980, but gold was. Anyone who bought gold in 1980, at the prior inflation-adjusted high, and held through the end of the 20th century, lost 69% of their nominal dollar value and over 90% of real value. Meanwhile, they missed out on a 2,427% bull market in U. S. common stocks.

Buying any asset at a time of euphoria usually works out poorly. How about if you bought gold when it was out of favor? If you had invested $10,000 in gold back in 1968 (illegal at that time in the U.S.), you’d have acquired 286 shiny ounces. Today, 46 years later, you would own the same 286 ounces of the yellow metal. In fiat dollars, the value of your holdings would have grown to $357,000; in real dollars, to $55,000.

So gold can be a successful or unsuccessful speculation, depending on price and sentiment, just like Beanie Babies, baseball cards, or penny stocks. But gold is not useful as money, because it does not reliably preserve real purchasing power, even if held for decades. If you had enough gold to buy a cheesesteak in 1980, by 1999 you might have been able to afford a pack of gum.

Does this mean we must ignore the erosion of wealth caused by long-term inflation? Certainly not. Warren Buffett believes that inflation will gradually confiscate the value of dollars over time. Thus far, he agrees with the goldbugs. But he believes the best hedge against inevitable long-term inflation lies in ownership of growing businesses, not shiny yellow metal. If you invested $10,000 fiat dollars in Warren Buffett’s Berkshire Hathaway in 1968, by the end of last year your shares were worth over $58 million. (Still fiat dollars.)

Would you really be happier to have assets worth $357,000, instead of $58 million, simply because what you held was not a fiat currency?

Saying you want only want physical currency is kind of like saying we should only permit live, not recorded music. Unfortunately, you cannot operate a modern international economy with physical metal, any more than you can carry around fifty symphonies and two thousand popular songs in the form of vinyl LPs. You need those countless trillions of ones and zeroes flying around the world over fiber-optics and copper wire to make the banking system work, just as you need digital data to make your iPod function.

Money is a medium of exchange, useful as a mechanism to make commerce work, hopefully with value that is not ephemeral. It is never an investment. Gold is lousy money in any modern economy, and is never a sensible long-term investment. In fact, gold is not an investment at all, since it produces no economic return. It is, always and forever, simply a speculation on future sentiment. Likewise, Bitcoins are no substitute for actual money, and have no intrinsic economic value. They may retain scarcity value, or they may not. What they most resemble is a kind of Ponzi scheme, since early “miners” of Bitcoins (presumably, those who created the underlying computer code) got lots of them dirt cheap, while later miners extract few coins at great effort.

Bill Gross had a recent comment on this whole issue of money. Conceptually, he suggests we think of all liquidity, including money, simply as diverse forms of credit. I’m not sure this entirely works. With borrowed money, there are two known parties, at least initially. Though once you add in credit-default swaps and securitization, maybe it is no longer possible to differentiate paper assets from real.

An aside — the night I met that other parent, Bitcoin was trading at over $1,000. Yesterday’s close was under $500, a more than 50% loss. Ouch.