“Risk, Fear and Depression”

By Arthur N. Budge, Jr.

Risk, Fear and Depression are key themes of the day.  The BP blowout in theGulf of Mexicois a classic example of failure in risk management.  There is plenty of blame to go around, but it appears that the culture at BP led to acceptance of inappropriate risk to save money, and the federal government, under both Republican and Democratic administrations, failed to fulfill its obligation of regulating the risk being taken by private companies with public assets.  Now we find ourselves with a terrible disaster.  A private company was allowed to take huge risk with a public asset without appropriate safeguards.

The same is true with the broader economy.  Throughout the financial sector, private companies were taking huge risks with the assets belonging to the public.  They used their state issued license to create money to bet at the casino, and the guarantee of the US Treasury as their insurance of last resort if they lost. 

In both of these cases, our government failed to define risk correctly.

Risk

As currently taught in our universities, the definition of risk in modern finance is:

The variability of returns from an investment. The greater the variability (in dividend fluctuation or security price, for example), the greater the risk. Because investors are generally averse to risk, investments with greater inherent risk must promise higher expected yields.[1]

Risk is defined as volatility.  Volatility is measured in statistical terms that are translated into probabilities.  Possible financial outcomes are then multiplied by these probabilities to get an “expected result” or “expected cost”.  For example, if the probability of a $1 billion dollar event is assumed to be 1/100^th of 1%, then the scenario has an expected value or expected cost of $100,000.  I am oversimplifying the process, but this is effectively the mechanic.  In many applications this type of analysis makes sense.  But it can be very flawed at the extremes.

The definition of risk as volatility always seemed incomplete and out of balance to me.  We hate to see our dividends or distributions decrease or the price of our securities or assets fall.  Conversely, we love it when our distributions increase or the value of our investments rise.   However, the pain of loss is greater than the pleasure of gain.   This definition of risk erroneously treats both upside and downside volatility the same. 

This definition also ignores the impact of the low probability extremes.  At Five States we have two risk management policies that always override our financial analysis in managing our business and your assets:

1. Never take risk for which you are not expecting an appropriate return, no matter how small the risk probability.
2. Never take risk that could bankrupt you, no matter how small the risk probability.

If we followed the financial definition of risk, we might easily calculate an expected value or cost that would lead to an unacceptable risk investment.  The expected cost of $100,000 in the above example could easily be interpreted as a risk that is acceptable.  This reasoning or acceptable risk rationalization has been at the core of many of the financial catastrophes over the last two decades.

Fear

Finance is sometimes described as a battle between fear and greed.  From 1981 until 2008, greed (with a few short setbacks) trumped.  Falling interest rates fueled a twenty-seven year bull market in every investment class, resulting in the greatest economic boom of all times.  This boom led to excessive debt levels in the public, corporate and private sectors, and acceptance of excessive investment risk because some managers believed “it was different this time” and the old rules did not apply.  Conventional wisdom for many advisors was that everyone would retire a millionaire if they just funded their IRA or 401(k), and everyone would all be able to sell their houses at retirement for big profits.  It was acceptable under this viewpoint to incur more debt because everyone’s net worth increased every year.  But increased debt always increases risk.

Now the economy has reached the end of the cycle.  Interest rates cannot be pushed any lower to further stimulate consumption, borrowing or leveraged speculation.   The momentum of the boom is gone.  All of the errors from the excesses and faulty risk assumptions are now causing these managers to face the cold light of reality.  There are a series of problems to be dealt with in the near future, such as the trillions of dollars of short maturity real estate debt maturing over the next three years, the sovereign debt risk of many industrialized countries and slow demand with the resulting unemployment.  These and other problems contribute to the fear of a “second dip” in the economy, a currency collapse, severe inflation or deflation.  There is a lot to concern us in our investment decisions.

According to the traditional definition of risk, this is just the other side of the equation.  Ironically, most investors did not see the “up” side as volatility. Those years felt good and everyone liked it.  But this current fear side feels a lot different than the greed side.

In managing the Five States portfolios during the “greed side” of the cycle, we were often criticized for “not being aggressive enough”.  The property sales in 2006 and 2007 generated more controversy than any decision in our history.  Now we are on the “fear side”.   Fortunately, we are financially well positioned to be active investors on this current side of the cycle. 

Depression

The pundits debate whether we are in a recession, headed into a depression or in a depression.  The stock market, oil properties, real estate: almost all assets are down in value about one-third from their high.  Unemployment is at a post Great Depression high.  But it seems to be politically incorrect to call it a depression.

Depression is an interesting term.  Several definitions of depression are:

1. a state of feeling sad : dejection,
2. a psychoneurotic or psychotic disorder marked especially by sadness, inactivity, difficulty in thinking and concentration, a significant increase or decrease in appetite and time spent sleeping, feelings of dejection and hopelessness, and sometimes suicidal tendencies,
3. a reduction in activity, amount, quality, or force,
4. a lowering of vitality or functional activity,
5. a period of low general economic activity marked especially by rising levels of unemployment.[2]

Many with whom I regularly interact are showing signs of depression because of the economic condition.  I find it interesting that the economic event described as depression and the emotional state described as depression are so intertwined. 

Whether we are in fact in a true depression is subject of great debate.  Regardless of whether you call it depression or not we are on the downside of the cycle, and it is uncomfortable at best.

Conclusion

For value investors, the current economic climate is creating great opportunities.  At Five States, we are pursuing new investments in oil and gas, real estate and private equity based on valuations I have experienced only once in my lifetime, during the Texas economic collapse of the early 1990s.  Then as now, real estate values collapsed, reaching their nadir in 1990.  Properties were valued at discounts to replacement cost with attractive current yields “where is, as is”.  During the early 1990s, our core investors made the best real estate acquisitions they have ever made. 

Throughout the late 1980s and 1990s we saw periods where oil prices fell to $10 per barrel or natural gas prices fell to $1 per MMBTU.  It was during these periods that we made the most outstanding and profitable acquisitions.  The one common denominator in the performance of the best performing Five States Acquisition Partnerships was the acquisitions were made when prices were low.

Ironically, investments that “would have had people standing in line” three years ago are currently met by many with skepticism.  For example, we have been purchasing new class A apartment buildings in FS Tonti Acquisition Fund I for about two-thirds of replacement cost with in-place yields materially higher than long maturity corporate bonds.  By historical standards these are incredible values. 

Fear and depression affect investor perceptions and judgment.  When investors are optimistic, many overvalue assets.  When they are afraid and depressed, many tend to undervalue assets.  Over the last thirty years, we have made our best investments in our core areas when the sectors were out of favor.  These are the times when value investors flourish.

The sentiment among our peers and colleagues in Texas with whom we were active in the 1990s is anything but fear.  In fact, it is more one of eager anticipation.  Like Yogi Berra said “It’s like déjà vu all over again!”  It looks and feels like it did in Texas in 1989, right before the bottom. We see an unfolding of value investment opportunities unlike anything we have seen in our careers.

A long overdue correction of an overinflated asset bubble began in 2008.  The politicians tried to stop it with bailouts and a trillion dollar stimulus package.  I am concerned that all they did was delay the inevitable.  A broken balance sheet cannot be repaired by supporting failed assets or borrowing more money.  It only delays the inevitable.  There are still trillions of dollars of commercial real estate mortgages that will mature in the next three years, and many of them have payoff balances greater than the current value of the properties. 

The oil and gas sector has been in fluctuation since the “crash” in 2008, with natural gas prices currently at a level that was considered a disaster scenario three years ago.  Cash is available for private equity only at an onerous cost.

But it looks like the perfect storm of opportunity for value investors!  What was described last year as the “new normal” is now perceived as just “normal”. The shock of the crash has passed, and private equity investment velocity is recovering.  Ironically, the only thing that has changed is perception.  The risk of ending up where we are today was every bit as real in 2007 and early 2008.  It’s just that most investors did not perceive the risk and did not know they should have been afraid.

I am still concerned.  I can see the case for a “second dip”, for deflation, further devaluation of the western currencies and the risk in the longer term of inflation.  But my experience tells me that this is the time of great investor opportunity.  As Warren Buffet says, “Be greedy when others are fearful and fearful when others are greedy.”   

Risks are more clearly recognized now and there are many issues of concern.  This is resulting in realistic valuations of many investment classes (there’s still a long way to go in others).  I believe valuations in private equity will provide us with good investment opportunities, and that these good opportunities will be available for several years.  As always, we will focus on managing the risk side of the equation in investing for our funds.  The upside will take care of itself!  We appreciate your confidence in allowing us to continue to represent you with your investments with the Five States family.

 

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