Classic “Intrinsic Value”

The central concept of classical security analysis is “intrinsic value”.

This term is defined as follows in the first chapter of “Security Analysis (1940 Edition)” by Benjamin Graham and David Dodd:

	"Intrinsic Value" is a fuzzy concept

… intrinsic value is an elusive concept. In general terms, it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a mistake to imagine that intrinsic value is a definite and as determinable as is the market price.

Our notion of intrinsic value may be more or less distinct, depending on the particular case. The degree of indistinctness may be expressed by a very hypothetical “range of approximate value”, which would grow wider as the uncertainty of the picture increased … It would follow that even a very indefinite idea of the intrinsic value may still justify a conclusion if the current price falls far outside the maximum or minimum appraisal.

The “facts” on which “intrinsic value” was to be based were considered to be relatively simple and easily acquired at the time Graham & Dodd published the first edition of “Security Analysis”, which stated:

	1910 ad for "Standard" stock index cards

Descriptive analysis consists of marshalling the important facts related to an issue and presenting them in a coherent, readily intelligible manner. This function is adequately performed for the entire range of marketable corporate securities by the various manuals, the Standard Statistics and Fitch services, and others.

Because of this assumption (reasonable at the time), almost the entire volume of “Security Analysis” (often considered to be the Bible of “fundamental analysis”) was devoted to the analysis of data from these standard, easily obtained secondary sources. Little attention was devoted to the job of collating and researching data from original sources (OSINT).

Intrinsic value and the Efficient Market Hypothesis

In 1965, nine years after Benjamin Graham had retired and at about the same time that his star pupil, Warren Buffet, was closing his partnership, Eugene Fama, a graduate student at the University of Chicago published a paper advancing what came to be called, the “Efficient Market Hypothesis”.

	The 1960s: Rising prices didn't float all boats.

These were the “go-go” years of the 1960s with soaring stock prices, “performance funds”, and a wave of mergers and acquisitions. However, rising prices did not float the “fundamental analysis boat”.

The following quotes from “Buffett”, by Roger Lowenstein, indicate the problems that classical security analysts were having in a market in which current prices generally exceeded “intrinsic value”:

At the start of 1967, Buffett felt compelled to advise his partners that some of the newer mutual funds had better returns than his own. Moreover, he warned that his stream of new ideas was down to a “trickle”. Though he was working day and night to keep them coming, his tone was ominous. If his idea flow “should dry up completely, you will be informed honestly and promptly so that we may all take alternative action.”

	Mr. Buffett's home office in Omaha (far from Wall Street)

The strategy of classical security analysis was to acquire securities for which market price was considerably lower than “intrinsic value” and then hold these securities until market prices caught up with intrinsic value.

Warren Buffett’s partnership operated like a hedge fund; he invested other people’s money (along with his own), earning a fat percentage on capital gains that exceeded a certain base return. When market prices, in general, exceeded or equaled what he considered to be “intrinsic value”, there was no reason to continue in the business. The honest thing to do would be to return the partner’s money and become a long-term investor — which is what he did by setting up Berkshire Hathaway.

	NYSE floor (1963) The "go-go" years

In the “go-go” climate of the 1960s, it is easy to see how a young graduate student, with no experience in Wall Street and with a historical perspective that went back only a few years, would not understand the investment climate of the New Era boom and bust of 1927-1933 that shaped the thinking of Benjamin Graham (an actual investor and fund manager in those years).

Eugene Fama, the graduate student, surrounded and encouraged by theoretical economists at the University of Chicago, could easily conclude that markets were indeed “efficient”, populated by “rational men”, and that market price was equivalent to “intrinsic value” — as so many non-scientific economists postulated.

The Efficient Market Hypothesis flourishes

Although markets had ups and downs over the next generation, there was no true “learning moment” like 1929 — until the Crash of 2008.

The reasons for this lack of awareness can be found in Federal Reserve flow of funds accounts over the period that show how Security and Exchange Commission Rule 10b-18 of 1982, permitting massive market manipulation of a scale never before seen, together with growing trade deficits that followed the final de-linking of the dollar from gold in 1971, created an irrational, over-priced stock market, leading to a shortage of equities and blind belief in the “Common Stock Legend” — an environment that persisted for more than a generation. See: The Hidden Equity Shortage.

For most purposes, classical security analysis was now abandoned in the US market, primarily because it was exceedingly difficult to find securities that were “under-valued” in the sense employed by Graham & Dodd and because the availability of information far exceeded the disposition of analysts to exploit the tsunami of raw data.

	Like a fungus, the EMH took over markets

Now, theories proposed by economists without practical experience in either fundamental security analysis or market operations, came to the fore.

Statistical analysis of market price trends and abstruse mathematical formulae based on unproven theories, took the place of commonsense. Like a fungus living off the remains of classical security analysis, the EMH spread through markets.

Some continued to call themselves “fundamental analysts”, professing allegiance to the teachings of Benjamin Graham, but the world had changed. The old concept of “intrinsic value” was increasingly difficult to apply in practice. It became ever harder to find companies with the organizational, legal, and operational simplicity of the 1930s.

Warren Buffett now ran Berkshire Hathaway, using his legendary commonsense to manage a long-term portfolio of a relatively small number of selected equities, sometimes with a controlling interest. Graham & Dodd continued to be a best-seller in the finance section of bookstores, along with a bevy of titles on “Buffettology”.

However, “Modern Portfolio Theory” and un-managed “Index Funds” were now in fashion. Billions came from those that the SEC considered to be “sophisticated” investors and poured into highly-leveraged “hedge funds”, the managers of which, unlike the fair deal offered by Mr. Buffet a generation earlier, earned exorbitant fees on wildly speculative portfolios, whether investors won or lost.

Increasing complexity and changes in perception

Meanwhile, and most importantly, markets had become much more complex, expanding across the globe into hundreds of new jurisdictions, subject to foreign laws, taxes, regulations, and operational rules that no one could completely grasp. A common stock in Algeria was not the same as an equity share in Indonesia. On top of this jurisdictional confusion, investment instruments became more abstruse and difficult to understand, while factual coverage by the remaining small oligarchy of financial publishers was reduced relative to the expanded size of the market.

	The 2008 Crash: Many false hypotheses died

The Crash of 2008 produced some notable changes in perception:

1. The Efficient Market Hypothesis died. See: British CFAs reject the Efficient Market Hypothesis , “The Economist” trashes Modern Economic Theory, and Free information and the Efficient Market Hypothesis.
2. Traditional sources of information were not trusted. See: Why rating agencies may overlook toxic assets, How the rating agencies helped bring down the economy , and Innovation in investment research: dealing with free information.
3. The competency of financial institutions to understand markets and instruments, including their own operations, was severely questioned. See: Is big bank complexity irreversible? The McKinsey Heresy and Some banks have become too complex to manage.

What this meant was that security analysis was now ready to move beyond Modern Portfolio Theory and the Efficient Market Hypothesis and that new approaches could now be entertained.

No return to the 1930s: Post Modern Intrinsic Value

Some aspects of classic security analysis are as valid today as in the 1930s. For example, the emphasis on facts, commonsense, maintaining an independent mindset, and skeptical analysis.

However, the world of finance has changed so much that it is better to think in terms of Post-Modern Security Analysis rather than a return to Graham & Dodd. (See: Investment Analysis: Moving beyond Graham & Dodd and The heroic, solitary investment analyst is long gone.

	Some securities became too complex to understand

The concept of Intrinsic Value is worthwhile keeping, although with changes to bring the notion in line with current market realities:

1. Multiple Intrinsic Values: Graham & Dodd considered “intrinsic value” to cover an indistinct “range of values” that could be compared to market price. This definition needs to be modernized to include multiple bands, with different intrinsic values for different types of investors under varying monetary systems and legal jurisdictions. The same dollar bond has a different intrinsic value for a resident of Indonesia, thinking in terms of Rupiah, than it does for a resident of New Jersey thinking in terms of dollars. Each has a different tax situation and monetary frame of reference. Legal safeguards may vary with the nationality of the investor, along with transaction costs and other factors. Securities are essentially legal rights and obligations, generally involving payment at some future date, in one or more specified currencies. However, these legal rights are not the same for all investors. An investor in one jurisdiction will be taxed differently from investors in another jurisdiction. Some countries treat foreign investor with preference or prejudice, compared to local investors.
2. Multiple comparative values: The classic definition of “intrinsic value” was that of an indistinct band of values to be compared to a market price. This led to the presumption that security analysis was mainly concerned with the maximizing of capital gains. Graham & Dodd was written in a deflationary environment and in terms of a dollar that was still pegged to gold (although no longer directly convertible). Today, we are in the realm of un-pegged fiat money with persistent inflation, even in recessions. Furthermore, contemporary readers of Graham & Dodd were thinking in terms of US dollars or British pounds, with securities traded in New York or London, under some variant of English Common Law. Today, investors hold securities under Japanese, Chinese, Indian, Brazilian and many other legal systems and traded on many exchanges, often subject to rules they do not know and written in languages with which they are not familiar. In this environment, a prudent investor should be interested in much more than intrinsic value versus market price, but also in such things as protection offered by the law, defenses against inflation, and in the liquidity and settlement guarantees offered by a particular trading system. These other comparisons are not necessarily expressed in monetary terms, but, nevertheless, are useful. For example, does security A offer more or less protection against inflation than security B?

	Which is better, A or B?

In this light, intrinsic value is a concept involving comparisons made by individuals in terms of their own particular requirements. Think of an oculist measuring your eyes for glasses. He asks, can you see the bottom line better with this lens, or with this one? You can’t put a monetary value on the comparison, but the question is worth answering.

Also, you don’t care if Dr. See Good fitted glasses perfectly for Harry if he can’t do the same for you. In the final analysis, investment is personal. Would you be happy if your eye doctor told you that your prescription was based on the average eye exams of the last fifty patients and that you should have a 85% chance of seeing more of less adequately with your new glasses. Of course not. However, this is the level of treatment investors routinely received from investment fund managers during the age of Modern Security Analysis.

Above all, post-modern security analysis should be aimed at improving the fortunes of investors.

Definition: Post-modern Intrinsic Value

We may now define “Intrinsic Value” in a way as to be useful in markets that follow the Crash of 2008.

We can’t exactly return to Graham & Dodd, but we can retain the core ideas and the spirit of reliance on fact, rather than theory, with the following definition:

The Intrinsic Value of a security is its comparative worth, based on relevant factual evidence, and measured in terms of one or more other values that are pertinent to the goals of a specific investor, such as probability of falling significantly below current market price, protection against inflation, capacity to afford cash income, persistence of liquidity, or safety of principal.

The Intrinsic Value of a security is not measured in precise monetary terms, but rather is expressed by comparative qualifiers, such as “about equal to”, “less than” or “more than”, which may be further qualified by adverbs or adjectives such as “somewhat”, “significantly”, or “far”, with a clear indication of the trait being measured. For example: “Stock A is far less liquid than the government bonds of Country X”; or “Bond B is about equal to US Treasury Bonds with regards to safety of principal”; or “Stock C, in terms of cash dividends, likelihood of continued payment, and earnings coverage, offers a significantly higher value for price than comparable securities of its class in today’s market”.

This Post-modern definition of “Intrinsic Value” does not attempt to qualify a security as “cheap” or “expensive” in a general, imprecise way, but rather to make a series of strict comparisons with respect to various aspects of a security that are relevant to the interests to a specific investor (or type of investor). In this sense, there is no single generic qualification of a under-valued or over-valued security, but only comparisons based on named characteristics.

Next lesson: The economics of security analysis

Photo credits: “Lenses” by Mr. John from flickr.; “Out of Focus” by Sara ‘New Killer Star’ from Flickr ; “Warren Buffett’s home in Omaha”, by Joseph Vieira (adapted) from Flickr; “Abandoned Boat II” by Vito from Flickr; “Through the Fungi” by Jnthnhys from flickr; “Management of Complexity” by Michael Heiss from flickr.

Definition of “Security Analysis”

Security Analysis is the study of facts about negotiable instruments for the purpose of determining whether a particular instrument is appropriate for a specific investor at a particular time and the intrinsic value of the security compared to its market price, if any.

	Observe closely and get the facts ...

This analysis is usually conducted by gathering facts about the legal jurisdiction governing the security, the terms and conditions of the issue, data on the organization issuing the security, and information on operations, laws, rules, and other factors related to the instrument or the issuer.

The determination of the appropriateness of a security is made by a critical evaluation of a wide range of facts about the instrument in terms of the current price and the needs of a specific investor. Security analysis is not able to predict the future price of a security. It is an art, rather than a science, aimed at arriving at practical determinations as to prudent behavior, based on commonsense.

See: “Is security analysis a science?”

A security that may be appropriate for one investor may not be suitable for another.

The success of security analysis should not be measured in terms of price appreciation of a security over a particular period, but rather with respect to how well a recommendation matches the requirements of a specific investor with regards to safety of principal, income, and liquidity.

For example, a seventy-five year old pensioner living off investment income might have been better served with a portfolio of short or medium term US Treasury Bonds than with a highly leveraged hedge fund in the Crash of 2008 — although the hedge fund may have appreciated more in the years preceding the market collapse.

The dual tasks of security analysis

Because security analysis is defined in terms of the determination of appropriate investments for particular individuals, the technique needs to be divided into two distinct practices:

	Truth ... above all

1. Fact gathering and analysis: This is the practice of finding, collating, and analyzing data that is relevant to the aims of security analysis. This task can be judged in terms of the truth, relevance, completeness, and manner of presentation of the facts assembled. It is the first and essential task of the security analyst. With insufficient, false, or misinterpreted data, the purpose of the analysis is defeated. Fancy statistics and clever sophistry can not overcome a false factual basis for decisions.
2. Matching securities with particular investors: Every investment opportunity is different, as are the needs of investors with regards to ability to accept risk, assurance of income, safety of principal, and the eventual necessity of re-converting an investment into cash.

Many who claim to be “security analysts”, even with impressive certification, fail in their professional duty because of sloppy work in one or both of these two essential elements.

See: A security analysts greatest challenge: Laziness

So-called analysts on financial news channels commonly issue “buy, sell, or hold” recommendations, without any qualification as to the relevance of their opinions to specific classes of investors. Nor do they provide sufficient information about the facts on which their “recommendations” are based for an audience to judge merit.

Stock-brokers and investment bankers routinely issue ratings and recommendations on securities without matching the securities to the needs of specific investors.

Standard & Poor’s, one of the largest securities rating services, publishes “stock reports” on equities with “buy, sell, or hold” recommendations and a “star system”, without qualification whatsoever as to the validity of the recommendation for particular classes of investors. (These reports also publish summaries of recommendations of other “analysts” without detailed explanation of any kind).

See: Why rating agencies may overlook toxic assets

The Crash of 2008 revealed professional short-comings in securities analysis, both on the part of well-known rating services and of analysts of leading investment banks and brokerage firms.

The profession of “security analyst”?

A   security analyst is any person who performs the tasks described above. Most security analysts are private investors trying to select investments for their own portfolio or for their family.

	How do we measure an analyst?

In the United States, anyone can call them-self a “security analyst”.

The US Securities and Exchange Commission does not define the term nor require that “security analysts” be registered or licensed. There are no educational requirements. However, whoever engages in providing investment advice for a fee to more than a certain number of clients may be required to file a form with the SEC. (Some countries have more rigorous requirements for the profession of security analyst or investment advisor.)

The US SEC does not oversee the issuance of credentials for security analyst, financial analyst, or investment advisor. A person may have no education and still advertise as a securities analyst. At the same time, anyone can establish a “diploma mill” and issue “degrees” or “certifications” in security analysis. In most parts of the United States it is more difficult to become a licensed securities broker (or even a manicurist) than a securities analyst.

In view of the failure of the US SEC to protect investors in cases such as the diversion of dividends to corporate executives through the mechanism of stock buybacks (See: The Great Misleading) or by timely investigation of the Bernard Madoff fraud, it is best that the SEC does not, in fact, try to “certify” security analysts, for this certainly would do more harm than good.

Qualifications for security analysts

The only reliable way to judge the qualifications of a securities analyst is to assign him or her the task of researching a particular security and by comparing the written, documented results against those of someone who is known to be an accomplished and careful analyst. However, this “test” could take weeks (or months) and would not be practical as a hiring method for institutions.

See: “Wiki reputation” for how this might be accomplished.

Often, security analysts are evaluated not in terms of proven research skills but rather on the basis of short-term market returns on recommendations. However, since market results can easily be due to chance (and be totally unrelated to depth of research or the appropriateness of an investment to a particular investor), by the “results” method one might as easily choose a monkey with a handful of darts as a skilled security analyst.

	Hard work is essential in security analysis

The following background, skills, and traits are useful for post-modern security analysis:

1. Computer literacy, especially skills in Internet research.
2. Curiosity, skepticism, independence of mind, and the ability and eagerness to be self-taught in new areas as necessary.
3. Persistence, patience, determination, perseverance, diligence, industry, and the ability to focus and concentrate on a task for a long period until resolved.
4. An elementary knowledge of accounting (what is a debit, credit, balance sheet, and income statement).
5. An elementary knowledge of law (contracts, instruments, corporations, different legal jurisdictions and systems).
6. A logical mindset. The ability to sort, select, outline and organize facts.
7. Basic familiarity with the scientific method.
8. Elementary mathematics.
9. Writing skills of a high level.

A person with these traits, even without formal training in economics or finance, may be an excellent security analyst.

Note: Benjamin Graham, perhaps the most famous security analyst and the mentor of Warren Buffet, studied Greek and Latin Philosopy, English, and Mathematics. He wrote a Broadway play (”True to the Marines”), patented an improved slide rule, translated Mario Beneditti’s “The Truce” into English, and had the hobby of translating Homer into Latin and Virgil into Greek.

The evolution of security analysis

Security analysis developed slowly over five hundred years, from early commercial paper negotiation in Medieval Italy, to securities trading in the 17th century coffee houses of London, to the formation of the US Securities and Exchange Commission in 1932, down to the complex derivatives markets of modern times.

	Earliest analysts were business people

Many thousands of books and pamphlets have been written on the subject, but all have one thing in common — they all deal with the type and quality of information available and relevant to the practices at the time written and almost all become obsolete subsequently. (Exceptions are such things as books describing the mathematics of calculating bond yields.)

The four main epochs of security analysis are as follows:

1. The Pre-Classic Period: This includes everything prior to 1934, when the US Securities and Exchange Commission began operations and the first edition of Graham & Dodd’s “Security Analysis” was published.
    
   During most of this period, securities markets were small, most “analysts” were investors, making decisions for their own account, financial information was sparse and difficult to obtain, and the security analysis was not recognized as a distinct profession, but rather just part of ordinary business skills. Markets were often dominated by speculators and stock manipulators. Fraud was common.

   	East India House, Leadenhall Street, London, 1828

   Investment during this period might be best classified as “venture analysis”, often based on commonsense and first-hand knowledge of the people involved, combined with rudimentary financial analysis. The bond market drew more investors than the stock market and emphasis was placed on collateral and guarantees. Towards the end of this period, governments would exchange money for gold or silver at a fixed rate and income taxes were non-existent or minor.
    
   This was also the time of fanciful, exotic speculative techniques, such as W.D. Gann’s “Theory of Vibrations”, or the variety of practices based on price and volume patterns, from Japanese candlestick charts to ticker tape reading — all relevant to short-term trading. (Many of these techniques employed charts, numerology, and astrology and persist to this day.)

2. The Classic Era (1934-1966): During the Great Depression, World War II, and the early post-war years, New York City has the financial capital of the world and dollar bills were no longer convertible into gold. Security analysis was profoundly influenced by the text of Benjamin Graham and David Dodd (1934), as well as by a paper published by John Burr Williams on the valuation of common stock (1938).

   	The "Golden Age" of fundamental analysis.

   This was the golden age of “fundamental analysis” — the notion that either by commonsense and attention to the facts (Ben Graham) or by using John Burr William’s formulas, the intrinsic value of common stock could be estimated. When this was far less than market value, an opportunity for profit existed.
    
   During this period, the yield on common stocks was generally higher than the yield on bonds. Only a small percentage of the population invested in securities. Furthermore, coming out of the Great Depression into post-war boom times, the climate for investment, in general was favorable.
    
   

   
   By the end of the period, mutual funds were being sold door-to-door and the price of stocks, relative to bonds, had risen. The dividend premium vanished. It was getting harder to find under-valued securities.
    
   Benjamin Graham retired in 1956. His star pupil, Warren Buffet, closed down his investment partnership in 1966.
    
   The first exams for Certified Financial Analyst were held in 1963. A new era was beginning.
3. “Modern” Security Analysis (1967-2008): The era of so-called “modern” security analysis lasted about two generations and encompassed massive structural changes in capital markets, as well as new theories that influenced the behavior of security analysts. The principal changes that impacted the markets were as follows:
   • Mass entrance of unsophisticated shareholders into the US markets: Following World War II, equities began to be marketed to the masses, by means of door-to-door sales of front-loaded mutual funds. In 1953, the New York Stock Exchange opened a campaign, “Own a share of America”. Tax deferred Individual Retirement Accounts were introduced in 1974 with the “Employee Retirement Income Security Act (ERISA)”. In 1952, only 4.2% of the US population held equities; by the end of the century, more than half of American households were shareholders.
   • Stock manipulation legalized: In 1982, the US Securities and Exchange Commission issued Rule 10b -18 that granted “safe harbor” to corporations that wanted to use shareholder funds to manipulate stock prices in order to give value to executive stock options. Over the next 26 years, about $5.7 trillion (2008 dollars) were diverted to this end, driving prices upwards during the period, despite market crashes in 1987 and 2000.

   	During the modern era, there were many false gods

   • Rise of the Efficient Market Hypothesis and Modern Portfolio Theory: In 1952, Harry Markowitz wrote a paper proposing that security risks should be measured in terms of past market fluctuations, rather than fundamental facts indicative of potential financial or operational dangers. In 1959, Miller and Modigliani published a paper suggesting that unrealized capital gains were just as good as dividends and that debt was equivalent to equity.
       In 1961, William Sharpe wrote a treatise on the “Capital Asset Pricing Model” that further promoted the mathematical theories of Harry Markowitz. In 1965, Eugene Fama published the “Efficient Market Hypothesis” that claimed, in effect, that market prices were equivalent to intrinsic value, leading to the development of unmanaged index funds and the decline of fundamental analysis as taught by Benjamin Graham and David Dodd in the earlier era. In 1973, Black and Scholes produced mathematical formulae for pricing options.
       None of these theories or hypotheses were based on scientific evidence or analyses of real markets and none were proposed by analysts with actual capital market experience. Nevertheless, the leading proponents of these strange ideas earned Nobel prizes (except for Eugene Fama) and their theories were firmly in the curricula for certification of financial analysts by the end of the century.

   	Foreign trade based on dollars

   • The US trade deficit and the bond market: In 1971, President Nixon took the US off the gold standard, leaving world currencies free to fluctuate. At the same time, the United States encouraged free trade and globalization, while most of the rest of the world embraced neo-mercantilist policies. The result was an ever-expanding trade deficit, leading to foreign investors holding $16.8 trillion in US financial assets by 2009. Since most of these foreign-held assets were invested in US fixed income securities, bond yields declined for twenty years — contributing (along with stock buybacks) to the persistent rise of equity prices and the widely-held belief that an unmanaged, diversified portfolio of common stocks was the best investment for the long-run (the “Common Stock Legend“)
   • The Internet and the information explosion: In the last decade of the 20th century, the Internet was developed on a global basis. At the same time, new securities markets were being created in developing and former communist block countries.

     	Libraries, web servers, home computers ... a new world

     The traditional sources of data for security analysts, such as Standard & Poor’s and Moody’s were unable to keep up with the flow of information, while markets, instruments, institutions, and operations became infinitely more complicated than in the days of Graham & Dodd.
      The Crash of 2008 was largely a crisis of information in which, long-lulled by the false promises of the Efficient Market Hypothesis, bankers and investors suddenly realized that they were unprepared to determine the intrinsic value of securities.

The Post-modern era of security analysis

	Modern Economic Theory Meltdown

The era of “modern” security analysis ended abruptly with the Crash of 2008. The reputations of the major financial statistic publishers were in tatters. Security analysts no longer trusted doctrines that they had been required to memorize for professional certification a few years before.

“The Economist” magazine showed on its cover in July 2009 that “modern economic theory” was melting down. Nobel prize economist Paul Krugman expressed what many others had concluded, saying that much of the past 30 years of macroeconomics was “spectacularly useless at best and positively harmful at worst”.

Between the high in stock prices on October 9, 2007 and the low point on March 9, 2009, the market value of US equities, as measured by the Wilshire 5000 index, declined about 9 trillion dollars. Worldwide, in all instruments, losses were perhaps double that.

Clearly, “modern” security analysis had not lived up to its billing.

However, the world and markets had changed. It was not possible to go back to Graham & Dodd and earlier times — things were too complicated now and there was too much information to dig up and analyze.

New techniques are needed to meet this challenge.

These techniques might be called “post-modern security analysis.”

Next lesson: Intrinisic value.

	Predicting the future is often not scientific

Ben Graham definitely did not say the security analysis was a “science”, but his comments implied that he would like to have the discipline move in that direction. He specifically made comparisons to the use of mathematical techniques in “actuarial science” and suggested that the practice of bond ratings was somehow scientific in nature.

By the time of the Crash of 2008, the emanations of “science” had cast a cloak of statistical pretense over the profession of securities analysis, as this abstract of the article, “The Statistics of Sharpe Ratios” (Andrew W. Lo, Financial Analysts Journal, July 2002), indicates:

The building blocks of the Sharpe ratio—expected returns and volatilities—are unknown quantities that must be estimated statistically and are, therefore, subject to estimation error. This raises the natural question: How accurately are Sharpe ratios measured? To address this question, I derive explicit expressions for the statistical distribution of the Sharpe ratio using standard asymptotic theory under several sets of assumptions for the return-generating process—independently and identically distributed returns, stationary returns, and with time aggregation. I show that monthly Sharpe ratios cannot be annualized by multiplying by √12 except under very special circumstances, and I derive the correct method of conversion in the general case of stationary returns. In an illustrative empirical example of mutual funds and hedge funds, I find that the annual Sharpe ratio for a hedge fund can be overstated by as much as 65 percent because of the presence of serial correlation in monthly returns, and once this serial correlation is properly taken into account, the rankings of hedge funds based on Sharpe ratios can change dramatically.

Now this sounds very “scientific”, especially if one has no knowledge of the scientific method and tends to believe in astrology. However, on examining the underlying assumptions of Modern Portfolio Theory (see: Fallacies of the Nobel Gods), under the harsh prism of the scientific method, problems with this approach become evident.

The above abstract seems to criticize the use of the Sharpe ratio, as a serious subject, but would a real scientific journal waste time evaluating the tenants of Medieval Astrology?

Many non-scientific practices are useful

We take our automobiles to the repair shop when they break down and are thankful for the skill and knowledge of an honest, professional mechanic who can get the machine running again. However, few would consider the auto mechanic to be a scientist.

	Medieval minds linked science to God

Actuaries calculate the life expectancy of classes of individuals, based on mortality tables, but would not attempt to predict how long a specific individual will live (unless the subject is already falling from an airplane).

Much of security analysis has the purpose of determining whether the value of a security in the future will be higher or lower than the current value. A honest, competent security analysts will make such estimates based on careful and laborious study of relevant facts, and present conclusions properly hedged as to the general impossibility of predicting the future (in a non-scientific field of endeavor).

This is a valuable and useful service in itself and does not need to be dressed up in the pretense of science to become more useful.

In fact, scientific pretense can actually mislead investors (and analysts themselves).

Where pseudo-science harms investors

Leading up to the Great Crash of 2008, millions of hours of analyst time were wasted on drawing up tables with betas, Sharpe ratios, and other mathematical gimmicks that did not actually contribute to the understanding of an issue, but instead gave investors (and analysts) a false sense of security.

I would argue that this time (and many more hours) could have been better served digging up the facts about specific issues and examining operational and legal details under the cold light of common sense.

For example, would billions have been lost on auction rate securities if analysts had spent more time carefully researching the details of these issues and asked hard “what if” questions about the actual functioning of the Dutch Auctions on which their liquidity was based?

The principal problem with the pseudo-scientific approach to security analysis is that the methods often give analysts an excuse to avoid the much harder research work of going back to original sources of information and digging and digging for more facts until all relevant issues have been examined.

See: A security analysts greatest challenge: Laziness

Illustrations: Wiki Commons: The first illustration is from the Aurora consurgens, an illuminated manuscript of the 15th century in the Zurich Zentralbibliothek (MS. Rhenoviensis 172) — a medieval alchemical treatise that contains thirty-eight miniatures in watercolor.

	January 1945

Benjamin Graham (of Graham & Dodd fame) wrote in the affirmative.

Lucien O. Hooper (a founder of the Security Analysts Federation, and a vice president, director of research, and analyst of W.E. Hutton & Company) took the contrary point of view.

In time, Benjamin Graham’s point of view was adopted and the first CFA exams were held in June 1963.

However, some of Mr. Hooper’s initial objections are worth remembering.

Lucien Hooper’s objections

Although written 64 years ago, some of Mr. Hooper’s objections to the issuance of CFA credentials are relevant in light of the Crash of 2008.

He wrote:

Unless our employers, the investing public, or some government regulatory body force regimentation upon us, we earnestly desire to remain free from this unnecessary formalism.

It is not a matter of record that the Securities & Exchange Commission, the New York Stock Exchange, the Association of Stock Exchange Firms, or financial institutions have shown even an academic interest. It is not charged that the practices of the profession are honeycombed with abuses which need immediate and radical correction. Nor can it be contended that the mere establishment of the rating of Qualified Security Analyst (analogous to Certified Public Accountant) would make security analysts any more moral, more intellectually honest, less lazy, or more competent. Most analysts of experience will agree that laziness is our professions most virulent enemy.

	The fourth deadly sin: sloth (Laziness)

So far as incompetence is concerned, every one of us knows that it more frequently is due to unwillingness to put in the required number of hours of work than to the lack of any formal education.

… the rating itself would be meaningless unless the rating authorities are able to enforce penalties. Lawyers are disbarred, doctors may have their licenses taken away, and a man who loses his C.P.A. rating often sacrifices an important part of his earning power.

No penalties for the lazy or incompetent

It is often recognized that failure of securities analysis and investment research was an aspect of the Crash of 2008. The analytical ability of the major credit rating agencies has been severely criticized by Congress. Failure of analysts to warn investors of problems with auction rate securities or insured municipal bonds have been noted.

	No one was defrocked or burned ...

As the Crash evolved, leading investment banks confessed that they were unable to value billions of dollars of securities held in their own portfolios.

This clearly indicates a problems in the profession of “security analyst”.

However, not a single credentialed analyst lost his or her certification. The SEC imposed no penalties on S&P or Moody’s for sloppy work. As Lucien Hooper indicated three generations ago, the CFA credential is largely meaningless, measuring neither competence nor commitment to professional responsibilities.

In fact, the credential is useful mainly in getting a job and as a marketing gimmick to dress up a firm’s portfolio of analysts.

It is also the source of substantial income for the CFA Institute that runs the certification program for fat fees.

Will there be changes in the profession of security analyst?

It is unlikely that there will be any significant reform of the credentialed profession of “security analyst”. As Mr. Hooper pointed out, the value of credentials for this profession is questionable. This weakness is compounded when there is no ongoing discipline associated with continued certification.

	No shortage of diploma mills ...

Furthermore, even if the CFA Institute were to raise standards of the profession, say by regular re-examinations or disciplinary actions for sloppy analysis (if that were even possible), there are many credential mills willing and able to churn out some combination of letters to attach to a person’s name to dress up a job resume.

Mr. Hooper seemed to suggest that anyone with above-average intelligence and a willingness to work hard at digging out information and thinking about the value of securities could do a better job than a credentialed analyst that succumbs to laziness, or whose time is devoted to trading securities or marketing chores, rather than research and analysis.

Security analysis requires not so much the possession of certain knowledge for which one might be tested, but rather the skill and determination to work hard at researching new areas, without predetermined conclusions or knowledge.

Between 1963, when the first CFAs were certified and the Crash of 2008, capital markets became increasingly complex, covering many more types of securities, institutions, jurisdictions, and instruments. Consequently, the work required to get the research job done properly today has increased considerably over the decades.

Furthermore, the traditional focus of a security analyst — financial statements and market prices — needs to expand to cover legal and operational aspects of complex instruments in exotic jurisdictions and circumstances, many, or even the majority, invented after certification may have been granted.

As indicated in the article, “British CFAs reject the Efficient Market Hypothesis“, elements in the curricula of analyst certification often fall behind the reality of today’s market.

Moving away from certification of knowledge

The lesson of the Crash of 2008 might be that future security analysts should be trained on-the-job, in actual research, with less emphasis on fixed curricula and studying for certification exams.

After all, if the structure and details of the market are constantly changing, with ever-increasing complexity, and if an analyst must be able, above all, to learn new things as one goes along, everyday, throughout his or her career, why not get right down to it, rather than waste time studying for exams on sterile topics?

	Follow the horsemen

One of the tenets of Capital Flow Analysis is “Follow the horsemen“, referring to the “Five Horsemen of the Investment Apocalypse”, one of which is “New Economic Theory”.

Just because “The Economist” has finally figured out that something is radically wrong with “Modern Economic Theory”, doesn’t mean that a New Economic Theory has been born that will replace the old, nor that lecture fees for Nobel laureates in “Economic Science” will suddenly dry up.

I would say that it might take another twenty years before “Modern Economic Theory” is completely dead — and that would be an optimistic estimate.

“Economic Science” — the oxymoron

One of the most revealing paragraphs in the lead editorial of “The Economist” starts as follows:

But economists were hardly naive believers in market efficiency. Financial academics have spent much of the past 30 years poking holes in the “efficient market hypothesis”.

Now, what is interesting about this comment is the idea that it is necessary to “poke holes” in a hypothesis. If economics were really a “science”, the proper order of things would be:

1. Someone advances a “hypothesis” — an idea based on some facts, but not yet “proved”. It is the job of the promoter of the hypothesis to try to provide the proof.
2. After a “hypothesis” is extensively tested against real world evidence, it advances to the level of being called a “theory”. At this stage, scientists from across the globe turn their withering skeptical gaze on this newcomer, calling for further evidence and proof.
3. Finally, after a “theory” has been extensively tested and no “holes” can be found, it is accepted as being “true”. If it is of sufficient importance, it may even be called a “law”.

	Modern Economics is not quite yet a science

Now, the “Efficient Market Hypothesis” never went through this process.

Instead, it jumped from the paper of a doctoral candidate to being generally accepted, without any proof whatsoever.

Although it continued to be called a “hypothesis”, it was treated as a “law” and incorporated into the development of further hypotheses by other economists and major real world applications (like Index Funds).

Economics as a religion

Most of modern economics is not really a science, but rather a belief system, like a religion.

There are different “schools” of economics, like various branches of a church — each claiming to know the “truth” based on the writings of some earlier economic prophet, like John Maynard Keynes, Joseph Schumpeter, or Ludwig von Mises.

	No economists have been burned at the stake yet.

Some years ago, I was speaking at a seminar in Washington DC on the topic of capital market development. After the lecture, a young academic came up to me, eagerly asking, “How does what you say square with the paper of Dr. Goobledegook on the Reverse Potential of Hysterical Demand?” Of course, since I didn’t have the foggiest idea of what he was talking about, I politely declined to criticize the illustrious Dr. Goobledegook. Furthermore, I had only made, what seemed to me the obvious point, that it is difficult to create liquid markets in jurisdictions with very small populations.

But that is how “Modern Economics” works. Rather than appeal to real world evidence or commonsense, the economist is trained to base his or her “proof” on the writings of other economists.

The futile search for “economic laws”

In the final analysis, economics is a social “science” related to the constantly changing behavior of large populations.

It is one thing to document such behavior and try to understand how certain things came about. It is another to assume that society is somehow constant — like the number of protons in a gold atom — and that a universal law may be derived from the behavior of people in Southern France in 1913.

The problem that economics faces is that Nobel prizes are given not to those who merely observe and document economic history, explaining how and why things happened at a particular point of time, but rather to those who sit in ivory towers, spinning fanciful theories based on theories spun by other inhabitants of similar towers.

In general, Modern Economics seems to rush to draw conclusions based on insufficient evidence and faulty data, and then to vigorously defend such conclusions on purely theoretical grounds.

One might say that Economic Science is to Real Science what Creationist Theory is to the Theory of Evolution.

The failure of Modern Economics is nothing new

Paul Omerod published “The Death of Economics” in 1994 — over a decade ago — stating that modern economics was largely “an empty box”.

Initially shunned by mainstream economists, his thoughts are now echoed by Nobel laureates like Paul Krugman, who was quoted in “The Economist” article as saying that much of the past 30 years of macroeconomics was “spectacularly useless at best and positively harmful at worst”.

Of course, Professor Krugman does not advocate any real change in the direction of “economic science”, only a return to the writings of John Maynard Keynes.

On this website, there are numerous essays decrying the failure of modern economics, including “Fallacies of the Nobel Gods“, published in 2004.

However, as already stated, the death of one set of erroneous beliefs (perhaps prematurely declared) does not portend substitutions by new and better beliefs.

We shall have to see what emerges as a substitute for “Modern Economic Theory” before celebrating.

In Q1 2009, according to the Federal Reserve flow of funds table F.102, after-tax profits of US non-financial, non-farm corporations, on an annual basis, were about $589.9 billion.

However, about 50% of these after-tax earnings were disbursed through stock buybacks, primarily to support prices and give value to executive options. See: Stock buybacks refusing to die live on!

The “cost” of employee stock options, according to FAS Rule 123 of March 2004 must be “disclosed but not recognized” by issuers in their financial reports.

There is no easy way of knowing whether or by how much the earnings behind S&P price-earnings-per-share figures have been adjusted for executive stock options.

However, it is certain that, whatever the adjustment, it is far less than the cost to long-term shareholders in terms of cash no longer available for dividends or corporate reinvestment.

	Investor monkeys contemplating the unknown

FAS Rule 123 vastly understates the real cost of stock options

Ever since 1982 when the US Securities and Exchange Commission granted “safe harbor” to corporations using stock buybacks to manipulate prices in order to give value to executive stock options, a increasing portion of corporate earnings have been diverted from dividends that would benefit ordinary shareholders to stock buybacks for the benefit of corporate executives.

While accountants argue technicalities as to whether the Black-Scholes model or the Binomial model best represents the “cost” of executive options that should be disclosed, the fact is that the true cost to shareholders is far greater than the actual benefit to executives, since it takes more money to manipulate prices upwards by using buybacks than executives actually receive as profits when exercising their options.

In other words, the buyback fraud lives on. See: The Great Misleading.

Money for dividends that would benefit long-term shareholders is diverted for manipulative purposes and is not registered as a cost at all, but, according to Generally Accepted Accounting Practices, is posted directly to the capital accounts of the company.

If buybacks were only a tiny portion of the market — as was the case in, say, 1980 — we might ignore this accounting foible.

However, in Q1 2009, despite the shortage of credit and the need to conserve cash to get through hard times, corporate executives, in general, supported by subservient boards of directors, continue to recklessly misuse stock holders funds to support prices for their own benefit through the use of buybacks. See: Stock Buybacks: A Simple Fable.

And the US SEC commissioners continue to avert their gaze from this shameful practice.

Is the real S&P 500 price-earnings ratio 18 or 36? — no one knows

If the S&P 500 PE ratio was 18, as now appears in the newspapers, one might conclude that stocks, although over-priced, were still a reasonable investment.

However, if the real PE ratio was closer to 36 — but hidden by the loopholes in GAAP, the current market “recovery” would appear to be a mere bounce in a bear market heading for further losses.

It would seem that it is a little early to break out the champagne and to start celebrating economic recovery.

	Sweeping up worthless currency: Hungary 1946

First of all, the Federal Reserve Bank does not foresee inflation as a problem in the immediate future:

As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period.

This seems to reflect the Carter-era mistake of confusing economic recovery (measured in terms of employment and business activity) with inflation.

Flawed dependence on “managing” depository reserve balances

The most powerful tool that a central bank has to sop up money created by excessive government spending is to increase mandatory, non-interest-bearing reserve requirements of depository institutions. This method has the potential of effectively “sterilizing” money that the government deposits in bank accounts in payment of imprudent Congressional spending, while reducing interest charges on government deficits.

In the United States, however, in response to lobbying of the banking industry, plus regulatory confusion between banking and the securities market, the Federal Reserve’s powers in this area have been dramatically reduced.

1. Most “bank deposits” are now with money market funds, rather than banks, thereby escaping Federal Reserve control. (See: Money Market Funds will tell us when inflation is here. )
2. Since the early 1990s, mandatory bank reserves have fallen sharply. In 1990, reserve requirements on large time deposits were eliminated. In 1992, reserve requirements on transaction accounts were reduced. Banks have introduced “sweep accounts” which automatically transfer funds from regular deposit accounts to time deposits or money market funds, both exempt from reserve requirements.
3. The largest portion of mandatory reserve requirements that now remain are relative to vault cash or purely operational needs of banks, having little effect on the money supply.

For the Federal Reserve to effect changes that would restore its powers to neutralized excess government spending, it would need to go before Congress and obtain such authority. There are four formidable barriers to restoring such powers:

1. Opposition from the powerful banking lobby.
2. Opposition from factions seeking to reduce Federal Reserve power in general.
3. Opposition from undeclared factions favoring “easy money” and currency devaluation as a means of reducing debt burdens on a profligate population.
4. Opposition from the securities industry and securities regulators who will fight to keep money market funds away from the powers of the Federal Reserve.

Perhaps recognizing the impracticality of having anti-inflationary powers restored by Congress, Chairman Bernanke has focused on using the newly granted powers of paying interest on bank reserve requirements as a means of controlling the money supply.

In other words, Bernanke has effectively taken “The Nuclear Option” off the table as a tool to fight inflation. (See: How the US may avoid inflation: The Nuclear Option. )

Bernanke’s false hope: fiddling interest rates on bank reserves

According to Chairman Bernanke’s WSJ article, the primary inflationary threat comes from excess bank deposit with the Federal Reserve resulting from government actions taken to stimulate the economy in the early stages of the crisis.

These emergency reserve-producing actions consist of such things as the Fed acquiring securities and loans from banks to provide liquidity support in the immediate crisis. Such amounts on the Fed balance sheet are now more than $800 billion above “normal” levels. Of course, these balances must be worked off.

However, most of the Obama “spending is stimulus” measures have not yet reached the stage where funds have been disbursed. As this happens, money will enter the banking system and will be swept into money market funds and time deposits, exempt from Fed banking reserve requirements. Money market funds in particular are a parallel banking system outside of Fed control. With no reserve requirements, while presenting all the features of demand deposits, these funds have the potential to be highly inflationary due to the “multiplier effect”.

Chairman Bernanke’s plan is to use the newly granted power of paying interest on bank reserve requirements as a sort of free market enticement that will attract bank reserves to federal control. This, of course, has an obvious, glaring disadvantage compared to traditional mandatory non-interest bearing reserve deposits — the interest paid by the government will add to the government debt burden at a compound rate.

Increasing the interest rate on federal reserve deposits will contribute to higher interest rates throughout the economy — a typical effect of inflation, while increasing the cost of doing business — a measure to reduce economic activity. In other words, a recipe for stagflation.

Another problem with Bernanke’s formula is that unless the Fed takes decisive, believable actions against inflation, primary buyers of government securities — holders of debt representing the accumulated trade deficit — will shun government securities and move into non-financial assets. (See: How long will it take to work off the US trade deficit?)

Finally, the Bernanke formula seems to ignore the fact that interest rates are not the sole, or even primary determinant of money flows in an inflationary environment. In an open, global economy, funds will flow out of the United States to economies with stronger currencies.

Of course, before we get to the point that inflation begins to kick in, management of the Federal Reserve may change — for better or worse. Furthermore, with the popularity of the Obama administration teetering over reactions to the “spending is stimulus”, “cap and trade”, and Obamacare packages, there is no assurance that current policies, for better or worse, will persist.

These are trying times.

	Foreign trade based on dollars

Most of US financial assets held by foreigners are the result of the fact that the United States has been importing more from the rest of the world since 1971 than it has been exporting and that the sellers of foreign goods have been happy to receive US dollars in payment.

US financial assets held by the rest of the world consist mostly of debt instruments denominated in US dollars.

About $5.6 trillion is made up of direct investments and miscellaneous assets like real estate. Another $1.6 trillion is in US traded equities. The balance, about $9.6 trillion, is dollar-denominated debt owed to non-resident holders.

Although this “foreign debt” poses no real threat to US citizens, since it is denominated in US dollars, many people, including economists who should know better, think otherwise.

So, how long would it take to “work off” this debt?

What would happen if foreign exporters suddenly refused payment in dollars?

As long as the rest of the world accepts dollars in payment for exports, while the US continues to import more than it exports, the US trade deficit will continue to grow.

The decline in the value of the US dollar is nothing new. It has been going on for over half of century, since President Roosevelt rescinded convertibility into gold. The decline accelerated with President Nixon’s complete abandonment of the gold standard. Current variations in the value of dollar are hardly a blip in the long term trend. (Of course, other fiat currencies have also been declining in value.)

	The US dollar has declined since FDR abandoned the gold standard

Let’s pretend, however, that foreign exporters suddenly decide that they will no longer accept dollars in payment for their goods and rush to get rid of their holdings of US financial assets.

Here is what would probably happen:

• The value of the dollar against other currencies would plunge.
• US export goods would become incredibly cheap in terms of foreign currency. This would tempt foreign holders of US dollar debt to trade it for cash and buy export goods.
• By dumping dollar bonds to buy export goods, interest rates on US bonds would soar as prices fell. This would tempt some foreign holders not to sell.
• American importers, unable to pay in dollars as in the past, would need to borrow foreign currencies to import essentials like oil. Imports of “non-essentials”, like plastic dolls from China, would drop. Oil prices would rise. Americans would use their cars less.
• Foreigners holding dollar assets would find that the only way to get rid of the now-unwanted dollars would be to use them to buy non-financial assets from Americans (such as real estate and export goods). Dollars are legal tender in the US. There is plenty of US real estate and other non-financial assets to absorb the accumulated trade deficit.
• US exports in Q1 2009 were running at an annual rate of $1.5 trillion. At this rate, it would take a little over six years to “work off” the dollar-denominated financial debt due foreigners by selling them US goods and services. Of course, if the rest of the world was really anxious to get rid of their dollar debt, they could buy US export goods at a faster rate, while rushing to buy US real estate and making direct investments in US businesses (which by now would be humming along quite nicely to supply the booming export market.)
• Faced with soaring prices of oil and the inability to pay in dollars, the US would suddenly forget the “green dream” of wind farms and bio-energy and rush to drill in the Gulf of Mexico, while building nuclear plants in every state.
• As foreigners got rid of US financial assets, a major source of credit card financing would dry up. Americans, by necessity, would become thrifty.
• As a major source of easy credit disappears, corporations would be forced to turn to old-fashioned methods of equity financing. Stock buybacks would be a thing of the past. Stock prices would fall — effected by rising interest rates.
• Foreign exporters, faced with falling demand from the United States that now lacks the currency with which to pay for their products, would have to lay off workers, while employment picks up in the United States in the export sectors. Foreign governments might even seek to boost the dollar.

In other words, if the rest of the world were suddenly to turn against the dollar, the trade deficit might be eliminated in a few years, causing a boom in industrial production and real estate in the US, radical changes in economic behavior, and less employment in former exporters to the US.

What could cause this to happen?

The easiest way to destroy the credibility of the US dollar would be to jack up government spending to the point of bringing on hyper-inflation. In other words: just follow the current policies of the Obama administration.

However, there are countervailing forces that make the above scenario unlikely:

	US Senator Al Franken (D-Minnesota)

• The US is still a representative democracy: Despite the bizarre seating of the not-so-funny comedian Al Franken as a US Senator and the presence of representatives of “safe districts” like Nancy Pelosi and Barney Frank, the public can still be counted to turn away from its leaders, once the “misery index” gets above 15%. Since unemployment is expected to surpass 10% soon, while even modest recovery should send inflation above 5%, the current government is likely to be voted out of office once the public finally understands that Obama promises have been false. Just as in the days of Jimmy Carter, a return to conservative government will restore confidence in the dollar, as steps are taken to curb inflation and reverse Obama policies.
• A cheap dollar will boost American exports: As foreign factories cut back production to meet declining US demand, there will be pressure to accept payment in dollars, as before. After all, many countries have dollar balances, while balances in other currencies are far smaller. Because the value of the dollar has fallen, the value of goods that can be purchased with a dollar will have increased. As foreign unemployment rises, the urge to return to the dollar will also increase. A stronger dollar means not only more sales for foreign factories, but less competition from US exporters.

This “thought experiment” shows that fears of America’s children and grandchildren having to work for years to pay off debt to foreigners are unfounded.

The trade deficit would quickly disappear in an extreme inflationary environment. The system has self-correcting mechanisms.

Illustrations: Wikimedia Commons

The main thrust of the Obama plan is to increase taxes on individuals earning more than $250,000 a year, while forcing all but the tiniest businesses to purchase health insurance coverage for employees.

The money raised by these taxes will be transferred as subsidies for those who do not have health insurance — primarily due to low earnings and inability or unwillingness to purchase health insurance without government assistance.

Proposed legislation on Obama care, drafted by House Democrats, covers more than 1,000 pages. Some analysts claim that this huge document contains clauses that will eventually force millions of American to acquire government health insurance.

Typical of Obama reforms, the measure is being rushed through Congress without adequate discussion of consequences, without bi-partisan consensus, and with scant disclosure by the Democrat party that has filibuster-proof control of the US Congress. Most Republicans are expected to vote against the measure.

Increased inflation and unemployment

Most new employment in the United States is created by small and medium-size business — precisely the people that President Obama wants to tax in order to raise funds that will be transferred to poorer, less-productive sectors of the economy.

Businesses being hit by these massive new taxes have only a few ways to respond:

• Reduce the number of employees or delay hiring new employees.
• Pass the costs of higher taxes on to consumers.
• Increase outsourcing of labor costs to offshore suppliers.
• Compensate for rising taxes by reducing wages.

In other words, the immediate impact of Obamacare is likely to be increased unemployment and higher prices — stagflation.

The Obama administration claims that costs of subsidized health insurance will be compensated by undocumented “cost savings” — but these claims are contested by the Congressional Budget Office.

In the next decade, Obamacare is estimated to cost over $1.5 trillion.

Why health costs will continue to rise

Over the last fifty years, costs of health care in the United States have steadily increased faster than other consumer prices.

There are many reasons for the escalating costs of health care, but the two main drivers have been:

1. Medical advances: Many life-saving medical procedures are available today that were impossible fifty years ago. Organ transplants are a case in point. The existence of these procedures creates demand. However, many of these procedures are extremely expensive, well beyond the financial capacity of most of the population. In good times, many employers have been willing to give workers free health insurance to cover such costly procedures.
2. Employer paid health insurance: The common practice of large businesses providing free health care insurance to employees as a fringe benefit, often written into employment contracts, has created vast inefficiencies in the pricing of medical services, as beneficiaries of health care were disassociated from the normal need to shop for the best service at the lowest price. At the same time, because of the nature of insurance contracts, doctors were paid per procedure rather than for results. The costs of health insurance for individuals not covered by group plans became too high for many to afford.

To these basic structural reasons for escalating health care costs, the Obama plan adds the extra price driver of increasing the size of the market for health services (by offering subsidized coverage to the poor), without a corresponding increase in the number of doctors and nurses.

A missed opportunity

Barrack Obama was elected on a platform calling for change and there is general consensus that reforms of the US health care system are needed.

However, by forcing through a plan that seems almost certain to increase unemployment while spurring inflation, the so-called misery index (inflation plus unemployment) is likely to rise far above the level that prevailed when President Obama took office. Over the last two generations, a rising misery index has portended that the incumbent President will be removed from office by the voters.

This, perhaps, is why President Obama is anxious to pass this highly controversial legislation before his popularity sinks to the point where such legislation will not longer be possible.

Along with mismanaged “spending is stimulus” package and the “cap and trade” legislation, the Obama healthcare plan may seal the fate of this administration.

The following is quoted from the abstract of this research paper:

Few purely financial decisions rival stock repurchase programs in their bearing on the well-being of shareholders. Absent better financial reports on buybacks, an occasional tally of results seems appropriate. The current “Monitor” extends an earlier study back to 2000 to look at profitability of $263 billion of buybacks executed by a sample of 273 corporations, largely in the technology sector, with total equity market value of $655 billion. 66% of sampled companies engaged in buybacks. While this studies’ reporting methodology tends to significantly overstate buyback profitability, only 25% of buyback programs are currently reported to be profitable.

The average sampled company that engaged in buybacks paid out 43% of its current equity market value to buy shares that subsequently declined in value by 19.7%. Had buybacks not been executed, share prices for these companies now would be at least 8.4% higher (or, after adjustment for bias in methodology, more than 13% higher).

Buybacks are undesirable corporate behavior

This study provides evidence on the company level that stock buybacks — exempted from normal legal sanctions for stock manipulation since 1983 by SEC Rule Rule 10b-18 — are not as beneficial to investors seeking short-term capital gains as usually claimed.

The proponents of stock buybacks have long argued that capital gains are better for investor than dividends. Without stock buybacks, cash dividends could have been much higher over the last generation, which would have contributed far more to investor wealth than unrealized, fleeting capital gains.

Until the 1960s, dividend yields on US equities usually surpassed bond yields. From the 1980s onwards, capital gains became the goal and dividends faded in importance.

In the article section, The Wisdom of Dividends, there is an analysis showing that over the long run, if the former practice of favoring dividends over capital gains had persisted over the last three generations, investors would be much better off today.

However, the SEC continues to sanction and encourage equity buybacks, and to allow misleading total return statistics to distort mutual fund reporting. The government imposes double taxation on cash dividends and the Obama administration is proposing even higher taxation of dividends in order to pay for various “spending is stimulus” programs and nationalized healthcare.

M.A. Gumport’s recent research paper on the effect of buybacks on stock prices contributes to the growing body of evidence against stock buybacks that, eventually, may influence government policy and investor opinion.