A little less than two years ago, the consensus among market players was that there was “extremely low visibility” for the next few quarters and that “the occasion called for caution”. Considering that the world financial system was close to the abyss, it was indeed advisable to adopt a conservative attitude – though at times like those in 2008, to have high-quality real assets at very low prices seemed to us a more attractive alternative than lending money to governments. The “low visibility” issue, however, is a matter that deserves greater reflection.

Is it true that, over time, investors really alternate between times of “excellent visibility” and “very poor visibility”?  Or is it possible that this is an illusion of the human mind, and in reality investors alternate between times in which they think there is greater or lesser visibility? We believe that the second alternative is the one that best describes the real situation: the future is uncertain by nature and what varies is our perception of it. As Warren Buffett once said: “Forecasts usually tell us more of the forecaster than of the future”.

Many market players live under the illusion that the future is foreseeable, and using worksheets where projections cover from 5 to 10 years, they end up perpetuating situations and circumstantial results, ignoring the natural business cycles. This is one of the traits of the human cognitive system: the tendency to attach greater importance to recent events than to older ones. It is natural, therefore, that in a crisis environment, negative aspects prevail over positive ones, and that at good times the opposite occurs. Perhaps even more worrying is the fact that events with fat-tail[1] characteristics start being neglected in analyses. In another curious trait of our cognitive system, Daniel Kahneman, who won the Nobel Prize for Economics in 2002, calls attention to the difference in individuals’ perception of gains and losses. An individual who loses R$50,000 tends to feel a negative impact greater than the positive impact of a R$50,000 gain.

All these aspects help to explain why the markets are doomed to alternate times of under-valuation and over-valuation. When the economic environment deteriorates, there is a general perception that “visibility” is lower, so that analysts and investors not only revise their projections downward (perpetuating low returns and results), but also their portfolios, usually in order to bring painful financial losses to a halt. During the process, prices start to better reflect the uncertainty of the future. When the economic environment improves and remains positive long enough, the opposite occurs and the visibility illusion appears again. All goes well until a new and “unexpected” adverse event occurs, and the cycle starts again. History shows us that turbulence and adverse events occur more frequently than investors would like: something always happens! That is why discipline and patience are necessary.

Just to illustrate some of the problems that are prowling around us at present: growing domestic inflation and interest rates in a rising trend; slack domestic fiscal policy, including the dangerous use of state-owned banks; default on the debt of several countries in the Euro zone; the sustainability of the Euro as a single currency; the possible mass adoption of mercantilistic policies (which lead to competing devaluations among the main currencies, rising protectionism and reduced world trade); rises in taxes worldwide; the “unexpected” rise in US debt (due to aid for bankrupt states); the Chinese growth model giving signs of  exhaustion; the ageing of the Japanese population and its impacts (difficulty in refinancing Japanese government securities); etc… As Ronald Reagan would say, “Government is not the solution to our problem, government is our problem”.

In the month of May, 431,000 new jobs were generated in the USA, of which 411,000 resulted from government hiring of temporary workers for the 2010 US census. How long will the government manage to support the US economy?

The thing is that, at present, there are a great number of possible adverse events that may trigger a reduction in “visibility” and in the appetite for risk worldwide. And when we look at the Brazilian market, we continue getting the impression that a great many asset prices already reflect optimistic expectations and there is little room for surprises. As Nassim Taleb said: “Beware of calm waters”… In this context, we continue waiting for clearer opportunities where we may allocate more funds safely, and meanwhile we receive over 10% per year in interest for being patient – which is not bad at all.

Where may we be wrong? One possibility, for example, is that Brazilian assets in general might accompany a possible appreciation in the US stock market, which in turn would occur only to offset the continuous issuing and loss of value of the US currency, and the loss of control over US inflation. Thus, the nominal appreciation of assets would only serve to keep the value of companies constant in real terms. We do not believe there is any justification for the Brazilian market as a whole to accompany this appreciation, unless Brazilian domestic inflation also gets out of control. And even if this happened, the risk/return ratio would not be worthwhile. According to Warren Buffett’s teaching in his fantastic article of 1977, “How Inflation Swindles the Equity Investor”, at times of high inflation, investment in equities is only the least mediocre alternative among many others. The perverse effects of inflation also impact companies’ results and investors’ gains. When adjusted for inflation, the gains, in real terms, tend to be very poor.

The article’s title had us thinking of another issue, one that’s just as important.

That’s because the title is obviously inspired by Jon Krakauer’s book “Into Thin Air”, which shared the first-person, dramatic account of a tragic Everest climbing attempt that claimed five lives. In the best-selling book, Mr. Krakauer very elegantly and convincingly singled out russian super-climber Anatoli Boukreev as guilty of omission and almost destroyed his career – until Mr. Boukreev’s own version of the tale appeared in the book “The Climb”, contradicting Krakauer’s book point by point as effectively or more. The debate raged for years until Mr. Boukreev’s death in another climb.

The point is: even EX-post, clear-tempered analysis of mistakes can lead to further mistakes. Just the attitude of looking back isn’t enough; one must be prepared to hear all sides of the tale with an open mind… even if that means a constant “sparring” of contradicting ideas in one’s mind. For every piece of hard-to-dig “evidence” there’s likely a solid counter-argument that should be considered just as diligently.

Taken together, it’s a reminder that it’s difficult enough to “learn lessons” from crises, but it’s extremely hard to actually implement changes. We would even point out that when changes are implemented, it’s not always an improvement… This means that the door is still open for human behavior + twisted incentive systems that eventually use these loopholes to create havoc. Recognizing this and controlling oneself is the first step to trying to take advantage of this.

The key point Mr. Loyola touches on is the lack of accountability of our congressmen. There are very little “checks and balances” in the current system other than the elections themselves.

Another key point, and something we will never get tired of saying, is that one cannot forecast that the good times will go on indefinitely and assume that one can increase costs because the income is rising, incur in debt, and so on. There are always downturns, and they are made more troublesome precisely because one has loaded up the costs before the income melts away. This is an ages-old, proven concept that is apparently extremely difficult to accept and work with, and one doesn’t get more popular by saying “calm down, let’s save up instead of spend away our new-found wealth” in politics – yet that’s precisely the commendable conduct.

We try to do it with our money, which is invested alongside our clients’. It tends to make us go up less than the market in euphoric times, but it also tends to dampen setbacks when things go south. “To finish first, first you need to finish”.

- Memos From the Chairman, the book from which we’re taking the following quote, should be mandatory reading for everyone – but especially for government officials. One phrase that seems especially applicable: “When mortals go through a prosperous time period, it seems to be human nature for expenses to balloon.”

- In this post about our Q4 2009 report, we highlight the risk of extending to 2010 the mood seen in 2009 in the brazilian equity markets. One of the reasons to be careful was the election year.

- From our Q3 2009 report:

“There is no doubt that the decrease in interest rates, the outlook for the pre-salt oil and the benefits of Brazil’s growing role in the globalized world have been contributing positively and should continue that way. But two factors concern us: the State’s hypertrophy and prices. Stock prices in general reached a reasonable level for a scenario of harmonious growth. But political trends seem to drive us away from harmony.

The continuous increase in the State’s size compared with the economy as a whole is mathematically unsustainable. In our opinion, this is unsustainable and tends to generate a serious cost if not reversed. Also, its effects are delayed given the inertness of economic mechanisms. We will only feel the consequences of what is being made in a few years.

We have been studying the health sector globally and an analogy is clear: governments are like the immune system. They are central to life, defending the organism from predators and incompatible elements. When they are uncontrolled and exaggerate, such as autoimmune diseases, they attack healthy cells and organs, leading the organism to death if they are not controlled. In our opinion, many countries are suffering from autoimmune diseases.”

Q1 2010 report excerpts

The last few months were a period of much study and few operations. Following a time with plenty of clear opportunities, since the last quarter of 2009 we have found ourselves in a phase with few new situations in which we could have great convictions.

During the first quarter of 2010, we took part in six conferences in Brazil and the USA, including some focusing directly on investors and some to do with companies themselves and sector professionals. There were over 200 presentations and there were advances both in getting to know companies and sectors better and in identifying potential new opportunities. In the short term, however, we did not find any that would fit the “easy as falling off a log” category (high value and low price) that we like so much. As the historic Peter Sellers character would say in the fantastic film “Being There”, “there’s a time for planting and a time for reaping”.

We take the opportunity to thank readers for their participation and suggestions in the Buysiders.com website, IP’s blog. We have recently started using Investidor    Profissional’s    pages    in    Facebook and in Twitter to publicize the new articles released in Buysiders.com. This is still an embryonic use of these tools, but it may make things easier for those who are already well acquainted with them.

PROSPECTS: Brazil

Lately, in addition to all the efforts applied to studying specific companies and sectors, we have allocated more than the habitual amount of time we dedicate to macro and political questions. In fact, we have “worked” more than ever and studied much more than the historical average. Mainly thanks to the maturity reached by the IP model, we have spent less time on commercial and managerial issues.

It is important to make it clear that we have not changed at all our fundamental belief in the way we should operate. Much to the contrary. But we always seek to take care not to allow the “execution mode” to prevent the basic assumptions from being revalidated from time to time. And recent times have clearly called for a revalidation. What is the risk of a swerve towards a more populist agenda, where property rights are less respected? After all, we have lived with movements like the “landless people’s movement”, and with growing rumors of coercion against certain companies and entrepreneurs, as well as restrictions to the press and controversial constitutional amendments proposed by the government. We have the example of “Chavismo”, which has not been repelled by the Brazilian government, indicating a lower degree of aversion than we would like to a regime that is so primitive and harmful to society.

What are the risks involved in the renewal of concessions, or in the creation of new and yet heavier taxes, rates and “contributions”?

Our conclusion up to now? If we have not reached (and are not even close to) an “all in” position, like the famous Warren Buffett declaration regarding the US economy (…) we are moderately optimistic regarding the Brazilian economy in the medium term. By fits and starts, the institutionalization of Brazilian politics is taking place. Even the worst elements are not succeeding in perpetrating greater and more lasting damage to the extent of annulling the advances achieved in the last 16 years (…). Our fears of a greater and longer negative discontinuity in the fundamentals are relatively low.

President Lula is an example of the fact that, with a certain degree of common sense, even historical opponents of a liberal capitalist society end up surrendering to most of the evidence contrary to their ideological beliefs. The government’s efforts to continue the initiatives of the previous Administration in order to make the real-estate market viable are another example. This is a sector that keeps the economy spinning, but one which did not have “wealthy sponsors” (…). Fortunately, the logical thing happened and things are moving.

In economic terms, in addition to the (already commonplace) commodities, the domestic market development case becomes better consolidated day by day, based – by order of solidity and importance – on the demographic profile, the formalization of the economy, credit expansion, and a not-so-bad political scenario.

Companies and their businesses do not exist in the void, and whenever we identify “clouds of change” on the horizon, we pay much greater attention. So far, so good…

So we should explain why we do not “fill up the bucket” in view of such good fundamentals for the Brazilian economy, and manageable disturbances. As always, we have to weigh up the asset price factor. The present levels, in general, already take into account a large portion of the prospects listed. Turbulence does happen, and when it does, many people panic. The best moments to fill the bucket are these: good fundamentals plus panic caused by the situation of the moment. Until then, we maintain our positions in companies that not only have fundamentals that lead them to consistently surpass market expectations, but also have a good cash reserve.

PROSPECTS: Global

We remain quite cautious. The improvement observed in the symptoms are a result of the “liquidity flooding” measures taken since the 2nd half of 2008 – and not of a frontal attack on the fundamental causes that weakened the markets. Populist policies in the main economies continue to set the tone of governments. They all seek an exchange-rate depreciation as a way to improve their trade balances and boost their economies. Obviously, in a scenario like this, this brings us to a race towards the bottom.

Economics is far from being an exact science. The FED, still the great protagonist of the world economy, seeks a narrow path between the precipice of depression and the “dragon” of inflation. In difficult situations like this, the stronger aversion tends to prevail. “Helicopter” Ben was given this nickname because of his thesis in relation to Depression, where he concluded that the solution was to “print” money until the economic agents lost their fear and returned to economic activity. It makes sense, but the risk is obvious. A loose monetary policy brings inflation, with a few years’ lag. The most likely scenario at the moment is that of constant growth in the inflationary risk in the USA, borne by many people who focus on the American Government’s gains arising from the depreciation of its debt – largely fixed-rate, in Dollars. In a scenario like this, the majority lose. Or rather, feel in their pockets the costs of the party, the incompetence, hypocrisy, and irresponsibility of the past. Those with greater power to adjust prices and hold long-term fixed-rate liabilities gain – or suffer less. (…)

An interesting exercise is to try building a counter- case. What could go so right as to neutralize the clouds on the horizon? We imagine events that would radically alter our general perception:

1. Reduction in conflicts based on religious extremism.

2. Radical productivity gain in the healthcare sector – which every day consumes an ever greater part of societies’ resources – in line with what happened to the production of clothes and food.

3. A pick-up in the speed at which knowledge and education are disseminated. This is where we see the strongest driver and the one most often present, which has made itself keenly felt in the last two decades with the advances in telecommunications in general, and the Internet in particular.

4. Improved public governance systems. The predominant government models today seem to us clearly deficient and a much greater threat to the well-being of mankind than the famous global warming, for example (which, if true, reflects a flaw in public governance itself). A reduction in the general hypocrisy is the greatest target to be pursued and the event that would bring the greatest gains to mankind.

Unfortunately, for certain problems, the speed of progress seems to be lower than what is needed to avoid more acute crises, which are historical catalysts for many necessary changes.

Obviously, the short list above says much more about our lack of capacity than about the real probabilities of results. One of the determining factors for advances in History lies in the fact that some societies and civilizations sometimes change on account of a single individual. But, for each case like the US rally of the eighties and nineties, there is a USSR, just to mention the biggest and most recent examples. After all, “lost civilizations” is a very commonplace expression (about 494,000 quotations in Google in 0.28 seconds…).

“Let’s hope for the best but prepare for the worst…”

Last but not least, for those interested in an inside view of the crisis, in the value of an independent view and in yet another report on the general institutional blindness (to say the least), we strongly recommend the videos and articles written by Michael Lewis when publicizing his book “The Big Short” (which we also emphatically recommend). The links to the relevant videos and articles can be found on Buysiders.com.

FOOD FOR THOUGHT

The Italian political scientist Antonio Gramsci was, as is well known, a great thinker. Gramsci’s Marxist convictions do not invalidate many of his ideas and observations. One of his lucubrations is about the significance of the dominant power exercised through ideology and culture, where the values of the bourgeoisie become the “consensus”. Everyone then identifies with this consensus, helping to maintain the status quo. Although Gramsci was obviously referring to the class struggle between the proletariat and the bourgeoisie, one wonders whether this has not been replaced by (or at least is not comparable to) the present situation between the big shots of corporate America (including, of course, the big banks) and the “rest”, here including most investors? Or people in government versus those they govern, in general?

MISCELLANEOUS

“The problem with socialism is that eventually you run out of other people’s money.” – Margaret Thatcher

“Only the paranoid survive” – Andy Grove

“If you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before.” – Martin Barnes

“The best way to think about investments is to be in a room with no one else and just think (…) What you are looking for is some way to get one good idea a year. (…) Wall Street makes it money on activity. You make your money on inactivity” – Warren Buffett

Seth Klarman

We highlight below a few quotes from the always interesting annual report by Seth Klarman about what lessons investors should have learnt from the 2008 crisis, with which we agree 100%:

• “Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.”
• “Risk is not inherent in an investment…Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.”
• “Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.”
• “A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.”
• “Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.”
• “Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.”
• “To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.”

Twenty years. The very fact that it seems like ancient history shows how far we’ve come, yet it still serves as a fresh warning.

There’s lots of interesting content in Amazon.com’s launch page for “No One Would Listen”, the book by Harry Markopolos – the main whistleblower in the Bernie Madoff saga. The timeline in particular is very impressive: it shows that all in all it took ten years to uncover the mess – nine since the first contact with the SEC – by which time the problem was irreversible. And that’s far from the only case, which begs a question…

Apart from the “I want/ need to believe”-type mental traps that individuals fall into, how do we justify still having institutions supposed to keep watch so unready and unwilling to investigate red flags? Lack of funding, qualified personnel, IT infrastructure… they all seem like weak arguments even put together.

We won’t go into the Taleb argument that one must be highly skeptical of “results”, and let’s not recall the Bob Rubin “focus on processes, not outcomes” (great) advice. Let’s just highlight two other books on fraud or lack of oversight – one caught, one still perhaps on the loose.

The most Madoff-like story is David Einhorn’s Fooling Some of The People All of The Time, about his years-long struggle with Allied Capital. Again, the pattern of ignored warnings is troubling, and while the story eventually played out to Mr. Einhorn’s thesis (see the 5-yr chart here), it wasn’t due to regulatory action – the credit crisis almost did the company in.

The other book is a quick read – Barry Minkow’s Cleaning Up – about ZZZZ Best, the company he founded and took public as one of the youngest persons ever to do that (remember that this is quite pre-dot.com days!). Nice story, if it wasn’t all a Ponzi scheme, and one that also took a while to uncover. Since this account is in first person and Mr. Minkow later helped the FBI uncover several corporate frauds, it’s pretty interesting lore. We’ve watched the guy live in the first Value Investing Congress and he’s a decent speaker as well.

UPDATE (March 19th, 2010): Nice and funny video interview with Mr. Markopolos on Jon Stewart’s Daily Show.