Morgan Creek Capital Management letter to investors for the first quarter ended March 31, 2017.
Morgan Creek Capital Management - Not So Intelligent Investors: #GravityRules
The protagonist of our letter last quarter was Roger Babson, the acclaimed entrepreneur, investor and philanthropist, who was the first financial forecaster to call the 1929 stock market crash and subsequent economic Depression. Babson reluctantly attended MIT and studied Engineering. His reluctance came from his belief that University instruction “was given to what had already been accomplished, rather than to anticipating future possibilities.” The one thing he did value from his time at MIT was his study of the British scientist and mathematician, Sir Isaac Newton, and, in particular, his Third Law of Motion that states, “For every action there is an equal and opposite reaction” and his discovery of the laws of gravity. In addition to Newton, Babson was inspired by the book Brenner’s Prophecies of Future Ups and Downs In Prices, written in 1884 by Samuel Brenner (described on the title page as “an Ohio Farmer”) that laid out a cyclical model for the variation in commodities prices (that has been astonishingly accurate over the past century in identifying market peaks and troughs). Babson was particularly struck by a quote from the book that he linked to the Newtonian constructs of action and reaction and gravity, “There is a time in the price of certain products and commodities, which if taken by men at the advance lead on to fortune, but if taken on the decline leads to bankruptcy and ruin.” Babson concluded that prices could deviate from their normal levels only for so long before the law of gravity would bring them back to earth. Babson was so intrigued by Newton and his theories that he titled his own autobiography, Actions and Reactions, and he incorporated Newton’s Third Law into all of his inventions and business endeavors. One such invention was a proprietary economic assessment technique called the “Babsonchart,” which became famous when he used it to predict the Great Crash in September of 1929. Later in life, Babson became somewhat obsessed with gravity and even penned an essay titled Gravity - Our Enemy Number One , where he stated that his desire to find a way to overcome gravity was catalyzed by the childhood drowning of his sister. He described the event, saying “she was unable to fight gravity, which came up and seized her like a dragon and brought her to the bottom, where she suffocated from lack of oxygen.” Babson was convinced that “old man Gravity” was directly responsible millions of accidents and deaths each year, directly due to the people's inability to counteract gravity at a critical moment. The breaking point came in 1947 when Babson’s grandson tragically drowned and he became completely obsessed with “the weakest fundamental force.” While an average eccentric might be content to wallow in selfpity, Babson was a man of action and he reacted in the only way he knew how, as an entrepreneur and a businessman. He hated gravity so he decided to do something to attempt to get rid of it.
Babson established the Gravity Research Foundation in 1948, ostensibly to study gravity and to sponsor research that might help people learn to combat the forces of gravity, specifically to discover a means of implementing what Babson referred to as gravitational shielding (he envisioned a sort of suit someone could wear to counteract gravity, particularly when swimming). The Foundation also ran conferences, like the one highlighted in the picture above, that would bring together thought leaders in the field of gravity and investments. A curious aside, the Foundation’s headquarters was established in New Boston, New Hampshire, which Babson chose for a very interesting reason, he believed that New Boston was far enough away from the major metropolitan cities that it might survive a nuclear war if WW III were to commence (interesting that talk of WW III has arisen again recently) and created a tourist destination as the Gravity Center of the World. As part of the Foundation operations he also bought Invention Incorporated, which seconded three full-time investigators to the U.S. Patent Office to sort through all incoming patent proposals with a mission “to constantly be on the watch for any machine, alloy, chemical or formula which directly relates to the harnessing of gravity.” Babson believed that a gravity harness, in the form of a metal alloy that would act as a partial insulator, could lead to the development of a conductor (like a waterwheel) that would harness the natural waves of gravity and create a perpetual motion machine. Babson believed that harness could solve the world’s dependence on non-renewable fuels and would be “a great blessing to mankind” (again, an interesting parallel to today’s energy market discussions). The Foundation sponsored an annual contest for scientific researchers to submit essays on topics related to gravity. Though the contest awarded cash prizes of $500 to $4,000, a seemingly small sum, the contest has had a very material impact on the field of study and the contest has been won by a number of people who later went on to win the Nobel Prize in physics (for example, Stephen Hawking, who has won six times, George Smoot, Gerardus t’Hooft and Bryce DeWitt). Steve Carlip, a UC Davis physicist whose essay won in 2007 was quoted on the impact of the contest, saying “it encourages people working in the field to step back a little and give a broader overview of their research and it is nearly universally known among people working in gravitational theory.” Unfortunately, the Foundation ceased activity after Babson’s death in 1967, but the contest continues to this day and is run by George Rideout, Jr., the son of Babson’s business partner. Historians have written that the contest forever changed the field of gravitational research and has reinvigorated the age-old quest to understand gravity. Roger Babson would be disappointed to know that there still is no gravitational shielding device (although we will discuss later how investors may beg to differ), but he would be pleased that the interest in gravity has been renewed and maintained (well, at least in the scientific realm, if not in the investment world…more on this later).
Roger Babson would probably wholeheartedly agree with two statements from Investopedia. “Serious physicists read about Sir Isaac Newton to learn his teachings about gravity and motion. Serious investors read Benjamin Graham’s work to learn about finance and investments.” It turns out Babson was not the only person to have an interest in Sir Isaac. In an updated and annotated version of Benjamin Graham's 1947 classic The Intelligent Investor (called “The best book about investing ever written” by Warren Buffett), Jason Zweig of the Wall Street Journal included an anecdote in the Foreword of the Revised Edition (issued in 2003) about Newton’s adventures (or should we say misadventures) with investing in the South Sea Company. The South Sea Company was a unique “business.” Founded in 1711, the company was promised a monopoly on trade with South Sea colonies (South America) by the British government in exchange for assuming the government debt accumulated during the War of Spanish Succession. The Company listed on the British stock exchange and began trading in 1718. Investors were lured to invest by the idea that the Spanish colonies in the South Seas were willing to trade jewels and gold for wool and fleece (like Rumpelstiltskin spinning straw into gold). In January 1720, when the company’s shares stood at £128, the Directors discovered that the trade concessions were less valuable than hoped, they circulated false claims of success in the colonies and spun yarns of South Sea riches, pumping the shares to £175 by February. Using a modern lens (as the term was not invented until 1929), the South Sea Company represented a giant Ponzi Scheme (similar to Bernie Madoff) in that the company proposed to pay dividends not from profits but from sales of new shares for cash (sounds a little like Tesla here…). Our protagonist, Sir Isaac, enters the story here when he invested around £3,500 (about $800k today). In March, the company convinced the government to allow it to assume more of the national debt in exchange for its shares (sounds a little like QE here…), ironically beating a rival proposal from the Bank of England (they would get their chance to buy overvalued assets later). As investor confidence mounted (and the mania began to grow) Newton sold out in late April at around £350, having doubled his money to £7,000 (intelligent trade). If the story ended there, we wouldn't have a theme for our letter.
The South Sea Company was not the only speculative venture being offered at the time, as there was a flurry of speculation in the British stock market. Richard Dale points out in his book The First Crash: Lessons from the South Sea Bubble , “Life expectancy in 18th Century England was just 21 years old, owing to smallpox, typhus and other killer diseases, and an endless variety of wars. Who needed a long-term investment plan when no one ever reached retirement age? A career committed to the laborious acquisition of wealth over time was perhaps less appealing than taking a chance on some get-rich-quick commercial venture.” Newly floated firms were springing forth like tulips and 1720 actually became known as the “bubble year” when in June, Parliament (at the urging of the South Sea Company) passed the Bubble Act requiring all shareholder-owned companies to receive a Royal Charter. The South Sea Company received its Charter, a perceived vote of confidence from the government (as opposed to an anti-competitive device acquired through lobbying), and the price began to rocket higher. As the shares began soaring, they were pumped up by rumors spreading as investors had to rely on coffee-shop “grapevines” and the press for share price information. The biggest problem was that the press was interviewing the coffee-shop gossipers so the bubble became reflexive, feeding on itself as it grew (sounds familiar…). Newton had cashed in his stake for a very nice profit, but he watched with anguish, as his friends who had stayed invested were “getting rich,” so he dove back in at twice the price he had exited and this time invested his entire life savings of £20,000 (about $4.5 million today) at £700 a share. In the words of Lord Overstone, “no warning on earth can save people determined to grow suddenly rich.” As the dog days of summer approached, the shares went vertical and the mania turned to a delusional, speculative frenzy as investors from all walks of life begged, borrowed and stole to get money to invest in the South Sea Company. The share price quickly rose toward £900, which prompted some investors to sell, but the company instructed their agents to buy the shares to support the price and the shares surged to £1,050. The bubble finally burst in September (as all Bubbles are prone to do; interesting that it seems to always happen in the fall) and by mid-October South Sea shares had quickly tumbled back to their January price. One thing to keep in mind is that all of this activity was for a company that wasn’t profitable (no prospects for profits either, again sounds like Tesla) and, worse still, its trading activities (only source of potential revenue) had been suspended. The South Sea Company didn’t go bankrupt in the modern sense, but rather suffered a liquidity crisis because it was spending so much money to support the share price (sounds really familiar…). Given the ties to the government, it eventually had to be bailed out (again familiar) through a combination of debt forgiveness and liquidity injections by the Bank of England (history rhymes).
Sir Isaac had finally had enough and he exited in October and November, losing nearly his entire life savings and prompting him to famously quip “I can calculate the movement of stars, but not the madness of men.” It is said that for the rest of his days he forbade anyone to utter the words South Sea in his presence. We can learn a lot about human nature observing the scientist responsible for the law of gravity being sucked into a speculative foray that for a time seemed to defy gravity (in the end, Gravity Rules). Greed is an amazing phenomenon, clouding the judgment of even one of the smartest people on the planet. The perilous journey of the inventor or calculus into the South Sea Company is a reminder of how even the most intelligent people can be transformed into not so intelligent investors when they allow the irrationality of the crowd to overwhelm their reason. Graham described this phenomenon saying, “Even the intelligent investor is likely to need considerable willpower to keep from following the crowd. For indeed, the investor's chief problem, and even his worst enemy, is likely to be himself. Individuals who cannot master their emotions are ill-suited to profit from the investment process.” One of the most disconcerting parts of these stories is how the participants find ways to rationalize their behavior. John Martin, a prominent banker in Newton’s day who also lost a lot of money in the South Sea Company, was quoted as saying, “When the rest of the world are mad we must imitate them in some measure.” Similarly, during the Global Financial Crisis it was Chuck Prince (former CEO of Citigroup) who said a month before the collapse, “As long as the music’s playing, you’ve got to get up and dance, and we’re still dancing.” We would argue that you don't. You can believe that gravity exists and choose not to chase the bubble and destroy your wealth. Investors have been looking for the easy way to get rich for centuries and they have been chasing bubbles since the travails of Sir Isaac in the 1720. The South Sea Company was one of the greatest investment bubbles in history. In fact, it was the first time that the word “bubble” was used to describe a speculative run and subsequent crash in an asset. Sir Isaac taught us that every action has an equal and opposite reaction and the bigger the speculative excess, the worse the crash on the other side. Roger Babson spent decades unsuccessfully trying to defeat the laws of gravity and legions of investors are trying once again to defy gravity in the equity markets today, but they might be wiser to heed the quote on the Bubble Card (issued after the South Sea Bubble debacle) above “The headlong Fools plunge into South Sea water, but the sly long-heads wade with caution after. The first are drowning but the wise last. Venture no deeper than the knees or waist.” In other words, only fools abandon caution and blindly invest in things simply because they are going up. Wise investors always buy with a Margin of Safety. Graham described it this way, “The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. That margin of safety is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. The margin of safety is always dependent on the price paid.” Remember, there is no investment good enough that you can’t mess up by paying too high a price.
Jason Zweig included the story of Sir Isaac and the South Sea Bubble to draw a very real and tangible contrast between not so intelligent investing and the definition of intelligent investing that Ben Graham espoused in the book that Zweig felt so honored to re-introduce. Benjamin Grossbaum was born on May 9, 1894 (as an aside it is kind of fun to share a birthday with the father of Value Investing, so perhaps I come by my Value bias honestly) in London, England to Jewish parents. When he was just a year old his family immigrated to New York City, and they changed their last name to Graham (to try and mitigate the impact of discrimination against Jewish immigrants). Graham’s father died when he was very young and his family experienced significant poverty, which motivated him to become a serious student so he could contribute to supporting the family. Graham excelled in the classroom and attended Columbia University ahead of most of his peers, actually completing his graduation at twenty. Remarkably, given his challenging family life, Graham was awarded the Salutatorian title, which at the time was awarded to the second highest graduate of the entire class of college graduates in the United States. Like Roger Babson, he was offered a position as an instructor in English, Mathematics, and Philosophy, but declined in order to go to Wall Street where he joined Newburger, Henderson & Loeb as an assistant in the bond division where he earned the princely sum of $12 a week. At the time, common stocks other than Railroads and Utilities were considered speculations and there were very few positions dealing in equities, thus this period was virgin territory for securities analysis.
Graham made his mark in 1915 with an analysis of an arbitrage opportunity in the liquidation of Guggenheim Exploration Co. by going long the holding company and shorting the underlying copper producers (an early hedge fund trade). Graham wrote a series of three papers titled Lessons For Investors in 1919 (rather bold for a 25-year old) espousing the benefits of buying sound common stocks at reasonable valuations. One of the more notable lines in the papers was, “If a common stock is a good investment, it is also an attractive speculation,” a comment that would come back to haunt him a decade later. Graham was made a partner of the firm in 1920 and his rise in prominence on Wall Street during the Roaring Twenties Bull Market was nothing short of spectacular. In 1923, Louis Harris lured Graham away from Newburger, Henderson & Loeb to open a partnership with $250,000 (about $3.6 million today), Grahar Corporation, where Graham would be paid a salary of $10,000 (about $145k today) and investors would earn the first 6% return and then the partnership would be entitled to 20% of the profits above that (the first hedge fund). Grahar primarily made arbitrage trades and purchases of common stocks that appeared to be undervalued. After two and a half years, Graham had produced strong returns and some friends convinced him they could bring new accounts with a 50/50 profit split, so Graham proposed a new fee structure to Mr. Harris, who politely declined and they dissolved Grahar. On January 1, 1926 the Benjamin Graham Joint Account was opened with $450,000 (about $6.1 million today) of capital from friends and family. Jerry Newman joined Graham later that year and would become a colleague and partner for the next thirty years (until Graham retired in 1956). The partnership made 26% in the first year and then doubled the assets in 1927 to finish at $1.5 million. During the final year of the Bull Market in 1928, the partnership was up 51% and Graham’s take was an astonishing $600,000 (about $8.5 million today). The legendary Bernard Baruch summoned the young Graham (now all of 34) to his office and offered him the opportunity to become a junior partner, telling him “I’m now 57 and it’s time to slow up a bit and let a younger man like you share my burdens and my profits.” Tragically, Ben Graham believed (like Sir Isaac in the South Sea Bubble) that gravity no longer applied to him and that there was no reason for a “near-millionaire” (his words) to work for someone else, even the eminent Bernard Baruch.
Coming into 1929, the Benjamin Graham Joint Account was fully invested in many non-traditional equity positions (read highly speculative ) and a large number of arbitrage positions involving equity and convertible bonds. The capital of the partnership had grown to $2.5 million (about $35.6 million today), but with short securities proceeds and margin, the total capital was $4.5 million (almost two times leverage). As the market continued to roar higher during the summer months of 1929, Graham and Newman lost their discipline to fully hedge the arbitrage positions (they believed they were giving up too much profit from the losses on the shorts) and the net position of the fund grew larger. When “Babson’s Break” came in early September, Graham was clearly in the Irving Fisher camp believing that the markets had reached a permanently higher plateau, and they did not sell positions even as they declined. The partnership ended the year down (20%), not much worse than the (15%) loss of the DJIA. In early 1930 there was a small recovery in stock prices (the “Return to Normal” phase that occurs during the first phase of the Crash following every Bubble in history) and confidence returned to Wall St. and investors were convinced that despite the extreme valuations, it was a return to business as usual (despite growing storm clouds in the economy). That January, Graham met a gentleman on a trip to Florida, John Dix, a 93 year-old retired businessman, who told him “Mr. Graham, I want you to do something of the greatest importance. Get on the train to New York tomorrow. Sell out your securities. Payoff your debts and return the capital to the partners in the Joint Account. I wouldn't be able to sleep at night if I were in your position.” Graham thought the advice was preposterous and headed back to New York completely dismissive of Mr. Dix’s wisdom. 1930 would turn out to be the worst of Graham’s career as the Joint Account lost (50%) versus the DJIA (29%) decline as he scrambled to reduce the margin debt. Given the high degree of leverage, it was actually impressive that the entire equity was not wiped out. The next two years were down as well (although Graham managed to lose much less than the market), but over the four-year period, the Benjamin Graham Joint Account lost (70%) compared to the DJIA decline of (74%). The Laws of Investment Gravity proved true for Graham, and it turned out that for every action (bubble) there is an equal and opposite reaction (crash).
Read the full letter below.