It's Never Different This Time

The Daily Reckoning PRESENTS: Over the last fifty years, the idea of what qualifies as a profitable investment has changed drastically, as more and more people try to ‘beat the market.’ However, as Christopher Hancock points out, the wisest investment decision you can make is to go back to the basics. Read on…


Beating the S&P has become like a golf handicap: expressed in a number that gets bandied about, and maybe embellished a point or two, to impress any financial “mind” polite enough to listen.

The goal is simple, But for many, the attempt is futile and childish, grossly naïve in its fundamental premise. Most try, but few succeed.

Fifty years ago, keeping your head above water meant saving a dollar. Now, squeaking by has become the 13% annual return that nearly ruins a manager’s financial career/reputation by narrowly clearing the S&P by a mere 50 basis points.

But there’s a new American generation… an entitlement class of children playing children’s games… a generation weaned on the bottle of instant gratification. They’ve been told to expect more for less… they’ve been assured that it’s OK to spend more than they make… because in the end, the government will be there to brace their fall.

Unfortunately, mommy and daddy are broke. And so is Uncle Sam. But the American family keeps spending despite that the consumer savings rate for all of 2006 remained a negative 1%.

The 2006 figure proudly surpassed the negative 0.4% savings rate in 2005. These two years produced the most reckless lack of savings since the negative 1.5% savings rate in 1933, during the Great Depression.

So while most Americans woefully stare at double-digit APRs as they cut another check for the minimum monthly payment, the debt continues to rise.

It won’t be long before the notion of keeping your financial head above water will require more effort than signing your name on the back of yet another new credit card.

Hardly anyone beats the market for more than a few years, so why do we waste so much time and money trying? And more importantly, why do we deem our investing success relative to what a bunch of strangers are doing? It’s comical when you stop and think for a second. As Jason Zweig cleverly points out in Ben Graham’s The Intelligent Investor, no one’s gravestone reads, “HE BEAT THE MARKET!”

Expectations today shun returns below double digits. Earning 9% won’t cut it if someone else is earning 10%.

That type of thinking negates what Warren Buffett calls the very first rule of investing: “Don’t lose money.”

As investors, we’re looking for a margin of safety… companies trading near or below their intrinsic value with an established earning power. That’s basically it.

So here are four basic criteria you can expect from Free Market Investor. You may recognize the thinking. Warren Buffett coined the parameters. It’s a bit cliché, but we’ll humbly concede that if the wheel ain’t broke… well, you know the rest.

So let’s begin. We always ask ourselves these four things:

1)      Is the business easy to understand?

2)      Does the business sell at a fair price?

3)      Does the business operate with a long-term competitive advantage?

4)      Does the foreign stock trade on a U.S. exchange?

For explanation’s sake, we’re going to lump the first two rules together in the following example.

Is the business easy to understand and does it sell for a fair price?

This is a fictional story of a small biotech company. We’ll call the firm “CureAll Pharmaceuticals.” CureAll currently holds patents on two mildly significant drugs that treat a rare blood disorder. Proceeds from those sales pay the rent, but the company continues to operate in the red. The company’s immediate future rests on a breakthrough pipeline drug capable of curing prostate cancer.

Here is where our story begins.

One of the world’s most respected financial newspapers reports that the small biotech company CureAll Pharmaceuticals, based in Raleigh, N.C., cleared Phase II clinical trials for a remarkable new drug researchers suspect has a 90% probability of effectively curing early-stage prostate cancer.

The drug can be administered in pill form. Effective treatment will require one pill every three months. The FDA has signaled that passing Phase III trials seems likely. Anticipation builds.

Prostate cancer affects more men than any other form of cancer. The American Cancer Society estimates 220,900 new cases of prostate cancer were diagnosed in the U.S. in 2003 alone. No males are immune. The risks increase with age. Family history also increases the likelihood.

The breakthrough of such a drug would mean a great deal to a great many people. There’s no way to quantify the benefits.

Even before Phase III clinical trials begin, the company’s stock takes off. Investors are willing to forego 120 years of future earnings for a single share. Who could blame them? This is the miracle cancer drug we have all been hoping for.

Two years pass, and FDA approval looms even closer. The stock price continues to climb. The atmosphere around CureAll’s stock feels strikingly similar to the sentiment for Internet search engines in the early 1990s.

You may remember, back in 1994, Yahoo’s search engine started as a simple directory for the then-small universe of Web sites. The stock price rose side by side with the market all the way to its peak in 2000. On the last day before the new millennium, Yahoo closed at $432.69. Its diluted earnings per share that year were 6 cents on the dollar. And investors and pundits were predicting that Yahoo was set to go even higher.

We termed the 1990s the “new economy.” We said times had changed. Many considered earnings to be irrelevant. We all know how that story ends.

By the end of 2000, Yahoo closed at $25, down 94% in less than a year.

But it’s now 2007. Times have changed.

Investors argue CureAll maintains a tangible revenue-producing product. The dot-com companies had nothing like this, they said. That is why speculators got burned. “It’s different this time,” they claim.

CNBC and the financial press jump on board. They interview a host of potential candidates for this cancer-curing drug. Even pundits left of the far left begin cheering capitalism’s conquest. They jump on the business-minded bandwagon. They claim seed money from cutthroat VC firms is finally being put to good use. Society and Wall Street are meeting face to face for the very first time.

Soon, management announces a press conference. The greatest minds in medicine start making public statements. This looks to be the breakthrough society has been anxiously awaiting. The stock takes off. The share price now trades for 200 times earnings.

Among a host of reporters, doctors and investors, CureAll’s management discloses final FDA approval. The room explodes with applause and cheering.

Wall Street wholeheartedly jumps on board. The stock climbs even higher… by the end of the trading day, CureAll’s shares are going for 250 times future earnings.

Here’s where our story takes a turn.

In all the hype, investors confused the tangible benefits of the drug for the tangible benefits of the stock.

Unfortunately for investors, the costs of producing this innovative drug are astronomical. Gross margins are less than 5%. Operating margins are then even half of that.

Critical inputs come from shaky supply sources. To make matters worse, CureAll’s current blood disorder drugs are about to go off patent. The future pipeline contains the only high-margin, cash cow product that could effectively put the company firmly in the black. But FDA approval for that drug requires successful DNA rebuilding in the Jensen sarcoma as well as full atomic models with sugar phosphate nucleic acid structures of 25 different lab rats.

That’s tough to read, much less to comprehend.

Like Yahoo, the hysteria surrounding CureAll’s drug eventually surrenders to the financing and fundamental earning power behind it. Although cancer patients are rewarded, investors suffer. The stock falls 94% by the end of 2007.

The story of CureAll demonstrates two common traps that readers of The Offshore Speculator will be encouraged to avoid: First, steer clear of businesses you don’t fundamentally understand. And second, never pay too much for an asset, regardless of how great that asset may be.

You see, all market bubbles eventually come to an end. There’s no telling what triggers the retraction. Some average investor woke up one day and realized that he’d probably not recoup his investment on a company with an earnings multiple well above 200. It’s really common sense.

Value investors like Benjamin Graham and Warren Buffett know that throughout history, the average price-to-earnings ratio of the stock market has been 15.3 – which means investors have traditionally been willing to pay $150,000 or so for $10,000 in earnings.

Yesterday, it was Yahoo, and today, it appears to be Google.

Growth projections are large, and they’re built on a very fragile assumption. They assume Google will be the leading search engine for years to come. They assume a competing programmer will fail to construct a better algorithm. They assume real competition will not enter the market. In an industry with little to no switching costs, that’s a pretty risky assumption.

As value investor Christopher Browne points out, there is nothing wrong with owning a great business that grows at fantastic rates… it’s a matter of paying the right price for that business.

Browne goes on to say that investors should determine an intrinsic value, wait for someone to overreact or under-react to news and buy the stock when the market prices the shares for less than they’re worth.

In the case of CureAll Pharmaceuticals, investors would have been wise to short the stock the day after the cancer-fighting drug received FDA approval.

But so it goes.

Google’s just another name for the same story. It’s a story whose message is focused on hubris and greed. Regardless, investors today are singing the same historical tune: “It’s different this time.”

It’s never different this time.


Christopher Hancock
for The Daily Reckoning
May 22, 2007

P.S. It’s time to separate yourself from the investing masses, especially if you are headed toward retirement. And as an investor, it’s time to protect your assets, so they can grow as well. Successful investing will require a combination of patience, realistic expectations and, most importantly, buying shares of businesses at the right prices.

Editor’s Note: Christopher Hancock has spent the last two years doing investment research primarily focused on emerging markets, specifically China and Hong Kong. After working with Citigroup in Hong Kong on the challenges and opportunities associated with the forthcoming RBM flotation reform, Christopher left many of his friends behind and decided to return to the States to pursue a career in equity research.

Christopher’s desire to work for an independent firm led him to Agora Financial, where he now is the editor of Free Market Investor. Christopher travels extensively and utilizes his contacts across the globe to recommend the best international investments in the world right now for his subscribers.

The older we get, the younger we are. We have been laughing at the Chinese…for it is obvious that they are new to the ways of runaway markets. Throwing off their drab Mao suits…and fresh off the farm…these bumpkins act as if they fell off the turnip truck just last week.

But it is we who must have been born yesterday. We open our eyes, look around – the more we see the less we’ve seen anything like it. More details on last week’s art auctions have come our way…each one increasing our puzzlement.

Mao to the left of us…Mao to the right…he’s almost as big as Che!

Only seven months ago, art lovers took a look at one of Andy Warhol’s concoctions and judged it to be worth $17.37 million. It was a photographic portrait of Mao Tse Tung, taken out of a 1963 edition of Newsweek magazine, and then silk-screened, multiple times, over a green background. Warhol was an adman. He knew a good image when he saw it.

But how he transformed his slick images into collectible ‘art’ is one of the greatest triumphs of mass marketing and mass delirium in history. The International Herald Tribune struggled to explain it: Of the Mao confection, “the uneven repetition conveys the impression of a recurring obsession that the viewer in vain seeks to shake off,” it says. Or the impression that Warhol didn’t apply the ink very well.

But now, in May of 2007, a group of bidders – everyone of them apparently of sound mind – ran up another of Warhol’s works to$71.7 million, a new record, and more than four times the previous record. This second Warhol masterpiece is reproduced for us in Friday’s IHT. It is a photo of a burning car tinted all in green. Warhol, stretching the limits of his creative genius, called it “Green Car Crash (or Green Burning Car).” It was last seen at auction in 1978, when it went for just $70,000. In 30 years, it has gone up 100,000%.

What else has gone up 1,000 times in 30 years…or more than 300% since last November? We can’t think of anything. Which must mean that these art buyers are even smarter than the Chinese lining up to open brokerage accounts in Shanghai…or luckier.

Chinese shares hit another record high yesterday, after a sharp drop Friday. The market shuddered at the end of last week because the Peoples Bank of China said it was raising interest rates – to try to sop up some of the speculative juice in the market. But it’s a bubble; and in a bubble all news is good news. And so, Monday, the Middle Kingdom rocked and rolled, ending the day with stock prices more than 1% higher than the previous high.

Meanwhile back to the world of art…

The auction at Christies “exceeded the experts’ highest expectations, [and] revealed a hitherto unparalleled urge to buy,” IHT concluded.

We conclude something a little different.

First, we look at the paintings. Some are cute. Some are clever. Some are decorative enough for a laundry room. But who would spend serious money to buy them? We don’t know.

But what we do know is that whatever value buyers saw in Warhol and similar artists a few years ago, they see a lot more of it now. Prices have gone up dramatically in the last few years. Remember, these are objects with no ‘earnings’ – save the pleasure owners get from looking at them. Since the paintings themselves have not changed, we have to conclude that the buyers have changed. For some reason, as yet unexplained, they want to own these paintings more than they did before…as evidenced by the fact that they bid against each other to see who is willing to pay the most to take them home.

So remarkable is this whole phenomenon to us that we decided to spend the whole of last night in meditation and prayer, trying to make sense of it. Unfortunately, the whiskey ran out by 11 PM…so we went to bed without getting to the bottom of it.

But even in our few hours of contemplation we were able to realize that OECD is probably right. Cheap money is making a lot of things a lot dearer than they used to be – especially status. Landmark buildings all over the world are being sold at prices that were unheard of a few years ago. Rent yields are so low…it looks as though the buyers want to lose money. Luxury yachts are crowding harbors from St. Tropez to Santa Monica.

Stocks, too, are hitting records – and not only in China. The S&P 500 hit a new high yesterday too – breaking a record set seven years ago. Meanwhile, oil has climbed over $70 a barrel…but still, at the top end, gas-swilling private planes are becoming much more fashionable. “The popularity of executive jets has never been stronger,” says today’s Financial Times. But pity the poor status-hungry hedge fund manager. He puts in his order for one of the leading models, and then discovers he has to wait a couple of years to get delivery. What’s he going to do? Go to Christies and buy a Warhol?

More news:


Addison Wiggin, reporting from Baltimore…

“The Shanghai index rocketed a full 1% higher yesterday. The freakish index has now grown 52% in 2007 alone. The Chinese central bank also announced another interest rate increase yesterday – the second of the fastest back-to-back hikes in 17 years.

“The dollar slept on the news. But the Chinese foray into the capital markets may awaken speculators very soon…”

For the rest of this story, and more insights into today’s markets, see

The 5 Min. Forecast


And more thoughts:

*** Everyone is feeling the effects of the high price of crude when they fill up the tank of their car – but wait until people start paying closer attention to their electricity bills…

“I almost fell out of my office chair when I recently opened our Connecticut Light & Power bill. WOW! The bill jumped almost 30% year over year with little change, if any, in usage,” reports our resident energy expert, Kevin Kerr.

“Neighbors and friends reported the same spike. The reason? The electric companies are now dividing charges into two parts: transmission and the actual production. The bottom line is prices are skyrocketing right along with the rest of the energy complex. Remember, most electricity is derived from natural gas-fired plants. Some are nuclear and hydro, but natural gas is the real culprit here. Last year, prices were down because natural gas prices fell, but if extreme weather sets in, so will high natural gas prices.

“As investors, we must hedge ourselves against these market events. There are ways we can protect a measure of our portfolio from Mother Nature’s wrath.

*** Another way you can protect yourself (and turn a nice little profit) from rising energy costs – and a falling dollar – is by taking advantage of EverBank’s World Energy CDs.

The World Energy CD is a new FDIC-insured deposit account where you can automatically hedge any U.S. dollars you put in, simply by spreading them evenly – and automatically – between all four politically stable, energy-centric currencies: the British pound, Norway’s krone, Australian dollar and the Canadian loonie.

Seeing the way all four of these currencies have soared against the greenback lately, this CD might just be the best and easiest way available to both hedge against a falling dollar and profit from a rise in oil, simultaneously.

We’ve secured an exclusive offer to this CD for Daily Reckoning readers. If you call or e-mail now, you can lock in the World Energy CD before your local utility hikes rates again. But this exclusive offer ends next week…so get to it.

*** All the ancient literature has much the same theme: a great man is ruined by his own success and his own vanity. He begins to believe that he’s invincible. And then, he over-reaches, tempting the gods to put him in his place.

That’s why humility is such an important quality. A truly humble person is less prone to the kind of exuberant excesses that plague presidents, company executives, entrepreneurs, homeland security drudges, teenagers, emperors, investors and celebrities.

That is why we work in France. It humbles us.

We were reminded of this great benefit yesterday, at a meeting. Three lawyers, one architect, one insurance agent and two administrators sat down with approximately a three-foot stack of documents to try to figure out what went wrong with one of your editor’s biggest investments – a seminar center in France.

The lead lawyer was a mature man with a self-confident air. He was enjoying himself, partly because he was getting paid $400 a hour and partly because it was clearly entertaining for him to see a foreigner – an American to boot – who had let himself be ripped off in France.

“Ha ha…I guess you thought you could sign the contract and that was all there was to it…ha ha… But didn’t it ever occur to you to check this architect’s documentation…or to make sure that he had gotten the proper permissions from the authorities…? You didn’t even check his invoices. I wish we could all be so lucky as to have American clients. They’ll believe anything.”

The renovation project began well enough. The architect in question was the friend of a friend. He spoke well. He had an answer for everything. He seemed to have good taste. And he seemed to know what he was doing.

Visiting the job site, we saw nothing wrong. It was dusty…walls were broken down and rebuilt…rotten beams were taken out…concrete was poured.

“When you get into an old building, you never know what you are going to find…and you always find a situation that is worse than you imagined,” said the most senior of the lawyers. “And then, too, you never can tell if the people working on it know what they are doing until you get to the end and turn on the water…and plug in a hairdryer.”

When we visited the project, there were workers putting in pipes every which way. Wires ran hither and thither. How were we to know they were running the wrong way?

The architect attending the meeting was the not the first architect on the job. Nor was he the second. Nor the third. He was the fourth. He seemed honest, competent, direct – just like the three before him. He dressed in a conventional way – with an open rust-colored shirt. The only thing that gave away an artistic streak was his eyeglasses, which were rectangular and a turquoise color.

He, too, seemed to be having fun. Not merely because he had just signed a contract which would bring him thousands of dollars for doing what the previous three architects had failed to do, but also because it is always fun when you get paid to criticize others’ work.

“The electrical system can hardly be called a system,” he explained. “We tried to make sense of it, but it is incomprehensible. Now, you’d think an electrician would instinctively connect wires together. It’s not rocket science. But there are a lot of wires that aren’t connected. Not to anything. And half the outlets don’t work. The fire alarm system doesn’t work either. Lights go on for no apparent reason and off for no apparent reason. My colleagues and I were frankly baffled.

“You could, of course, go to the electrical contractor and demand that he correct his work. But I wouldn’t do that if I were you. He plainly had no idea what he was doing.

“You are aware, of course, that this is deemed, by law, a public building,” continued our fourth architect, trying to suppress a smile. “So you are required to have exit signs and the like…not to mention a fire alarm. Well, your electrician put the signs up…but in the wrong place. He has exit signs leading into the kitchen…where the fire is likely to be.”

It was a long day. A stupidity followed an incompetence followed a fraud. As each one came to light the lawyers’ and architect’s eyes twinkled with contentment. They had before them a fool…(your humble editor) and they were happy to help prove it.

“You paid to have the walls of the bathrooms painted,” continued the fourth architect. “But the bathroom walls are covered with tile. They are not painted. So, too, you were charged for painting some of the walls that have wallpaper on them. You also seem to have paid one contractor who did nothing at all. In fact, there is no record of his ever showing up on the job site.”

“I’ve seen a lot of this kind of thing,” said the lead lawyer. “I’ve done a lot of work in Africa. There, you take it for granted that you are going to get ripped off. It’s just their way of doing business. You build it into your budgets…it’s not a big deal. But even in Africa there are acceptable limits…a code of behavior. You do a project and you expect the local architects and contractors to steal about 15% of the project costs…people get mad if they steal more than that.

“You know, I had a client who told me a story. There was an African politician who came to Paris to visit a French politician. He was invited to the French politicians house. The house was beautiful…furnished with fine antiques…and valuable paintings. So the African asks: ‘How can you afford all these luxuries on your salary?’

“The Frenchman points out the window. ‘I’ll let you in on a little secret. See that bridge. I got that bridge built. And I put 10% of the contract costs in my pocket.’

“A few years later, the Frenchman goes to Africa and visits the African politician. He discovers that the African’s apartment is richly decorated too…with antiques from Paris…and paintings that looked like they came from the Louvre. So he asks: ‘How can you afford all this on your salary?’

“‘I learned it from you,’ the African replied. ‘Look out the window. See that bridge?’

“‘No…I don’t see any bridge,’ says the Frenchman.

“‘No, you don’t. Because I took 100% of the contract costs.’

“So you see,” the lawyer continued, “we don’t mind a little bit of corruption. But when people get carried away, you end up with nothing. And it looks to me as though your first architect got a little carried away.”


The Daily Reckoning