Photo Credit: Falcon® Photography || In this story, TSB stands for “The Storage Bank”
This piece is another one of my experiments, please bear with me.
In his 2021 year-end letter, Baupost's Seth Klarman looked at the year in review and how COVID-19 swept through every part of our lives. He blamed much of the ills of the pandemic on those who choose not to get vaccinated while also expressing a dislike for the social division COVID-19 has caused. Q4 2021 Read More
“Measure Twice, Cut Once” — A very intelligent woman (I suspect) whose name never got recorded the first time it was uttered
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” — Warren Buffett
Imagine for a moment:
- The public secondary markets didn’t exist
- Investment pooling vehicles were all private, and no one published NAV estimates
- Stocks and bonds existed, but they were only formally offered through the companies themselves, and all private secondary trading was subject to a right of first refusal on the part of the issuing corporation. This includes short-term debts like commercial paper.
- Banks and life insurance companies still offer products to retail savers/investors, but nonforfeiture laws didn’t exist, and CD penalty clauses were very ugly. In other words, because of no public secondary markets, the price of liquidity was very high, with a strong incentive to hold financial instruments to their maturity date.
- Accounting rules are only partially standardized.
- Deposit insurance still exists.
- So does limited liability.
In this thankfully fictitious world, what would investing be like?
The main factor would be that liquidity would be dear. Because the “out” doors for liquidity are thin or closed for a long time, money would go into any investment only after great study. The 4 Cs of credit would be present with a vengeance — character, capacity, capital and conditions — and character would be chief among them as J. P. Morgan famously said.
This would be true even if one were investing in the stock of a firm, rather than the debt. Investing in such a world, even with limited liability, is tantamount to an economic marriage back in a time where divorce was mostly for cause, and not easy to get.
You’d have to be very certain of what you were doing. Perhaps you would diversify, but one would quickly realize how difficult it can be to keep up with a bunch of private firms — we take for granted how information flows today, but with private firms, you are subject to the board and management. What do they choose to share with outside passive minority investors?
Excursus: It is said that it is easy to teach a child to say “please,” because it is the equivalent of “gimme.” It is harder to teach them “thank you,” until they realize that it means, “I’d like an option on the next deal.”
Why would private firms choose to be open with outside private minority investors? They want a continuing flow of capital, and with no secondary markets, that can be difficult. Granted, there are always hucksters that say with P. T. Barnum, who is alleged to have said, “There’s a sucker born every minute.” Those characters exist regardless of market structure, but in a healthy culture, they are a small minority in the markets.
The same would apply to the debt markets. The fourth C, Conditions, would also impact matters. If you can’t get out easily/cheaply, then you will limit the term of the borrowing at which you are willing to lend, unless there are features allowing for participation in the upside, such as stock conversion rights.
You might also find that insolvency becomes a very personal matter, as prior capital providers who know the business better than others, are invited to “prepackaged reorganizations” when the business is illiquid or insolvent. The bankruptcy code might still exist, but gaining enough data on a firm in trouble would probably prove difficult. The board and management, unless legally compelled, might not find it in their interests to be open. Control is a valuable option, one that is only surrendered when the situation is virtually hopeless.
That said, a man very good at estimating character and business value could make some amazing profits, because “in the land of the blind, a one-eyed man is king.” And, the opposite would be true for many, as they get taken advantage of by less scrupulous management teams.
Back to the Present
“…[R]isk control is best done on the front end. On the back end, solutions are expensive, if they are available at all.” — Me, in this article, and a bunch of others.
The purpose of what I just wrote is to get you to think about an illiquid world as a limiting concept. All of the problems of our world are there, usually in a form that is less severe than we experience because of the benefit of liquid secondary markets and vehicles for diversification.
If valuable for no other reason, market panics make liquidity disappear, and it is useful to think about what you will do in an absence of liquidity before the time of trouble happens. The same is true of corporations needing liquidity. Buffett said something to the effect of, “Get financing before you need it; it may not be available later.”
It’s also useful to consider more carefully the financial commitments that you make, so that you don’t make so many blunders. (True for me, too.) The ability to trade out of investments is useful but limited, because we don’t always recognize when we are wrong, and mechanical trading rules can lead us to the “death by one thousand cuts.”
Beyond that, realize that character does matter. A lot. The government tries as hard as it can, but it is far better at punishing fraud after the fact than it is catching fraud before the fact. It will always be that way because the law is tilted in favor of the one in control; it has to be, or property rights are meaningless. But consider those that try to warn about financial disasters — they do not get listened to until it is too late. Madoff, Enron, housing bubble, various short sellers alleging improprieties, etc., etc. Very few listen to them, because seeming success talks far louder than an outsider.
My counsel is the same as always, just look at the risk control quote above. But to make it stark, ask yourself this, a la Buffett, “Would you still buy this if you couldn’t sell it for ten years?” Then measure twice, thrice, ten times if needed, and cut once.