Reading Roundup: April 2023
The Panic Of 1907, The King Of Capital, The Art Of War, and Railroader
We plan to grab a beer (or two) at Blatt Beer & Table after the Berkshire meeting today. Anyone who would like meet up and hang out is welcome to wander over. Blatt Beer & Table is located at 610 N 12th which is about a block from the Berkshire meeting. We’ll get there a little early, around 2:30.
This Month We Read:
The Panic of 1907: Heralding a New Era of Finance, Capitalism, and Democracy by Robert Bruner and Sean Carr
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone by David Carey
The Art of War by Sun Tzu
Railroader: The Unfiltered Genius and Controversy of Four-Time CEO Hunter Harrison by Howard Green
The Panic of 1907: Heralding a New Era of Finance, Capitalism, and Democracy
The Panic of 1907 was one of the most severe financial crises in American history and its effects can still be felt today. Its roots go back to the San Francisco earthquake of 1906 which devastated the city and caused damages estimated at 1.5% of the US Gross National Product. British insurers bore the brunt of the losses. In response Britain raised interest rates and banned gold shipments abroad. Both constrained the US money supply and tightened credit.
The real trouble began in the fall of 1907 when Otto Heinze attempted to corner United Copper. Their plan backfired, causing the price of United Copper shares to fall by 80%. Heinze and his associates lost so much money it spooked the depositors in banks associated with them. A run on the National Mercantile quickly spread to the Knickerbocker Trust, which was known to have close ties to Heinze.
The Knickerbocker was one of the largest trusts in the country. Back then trusts were shadow banks. Although they took deposits and made loans like a bank, they weren’t regulated and routinely used 20-1 leverage. Trusts had grown rapidly in the preceding bull market by catering to wealthy individuals.
In 1836 President Andrew Jackson refused to renew the Federal Reserve’s charter so there was no central bank to turn to for help in 1907. The Knickerbocker turned first to the New York Clearing House (NYCH) for help. Since it wasn’t a member the NYCH declined. Next the Knickerbocker appealed to J.P. Morgan who also declined. Morgan wasn’t sure that the Knickerbocker was solvent and didn’t want to throw good money after bad.
Without help the run on the Knickerbocker intensified until it suspended withdrawals. This escalated panic into a full-fledged financial crisis and no institution was spared. As the contagion spread to the Trust Company of America (TCA) Morgan said, “This is the place to stop the trouble.”
Morgan invited the presidents of the ten largest trusts to his office to organize a bailout. The found enough money to keep TCA open but not enough to stop the panic. Trusts were selling securities at fire-sale prices and calling in loans to raise cash at any cost. Securities prices plummeted and threatened to wipe out several brokerage houses.
The president of the New York Stock Exchange called J. P. Morgan to ask for a $25 million loan. Morgan secured the loan from a syndicate of 14 national banks before the end of the day, keeping New York’s financial system afloat, just barely, for another 24 hours.
The panic abated when two things happened. First, the NYCH issued $100 million of clearing certificates to its 53 member banks. Clearing certificates were a form of interbank money and injected massive liquidity into the system. With this, the worst of the crisis passed.
Second, savings banks instituted a requirement of 60-day notice for withdrawals. This created a shadow market for cash, which traded at a premium, and resulted in substantial gold imports from abroad. The influx in gold effectively lowered interest rates and helped New York recover.
In response to the panic of 1907 the government created our modern Federal Reserve.
The Panic of 1907 provides some valuable lessons that we can apply to the present day.
“History is just one damn thing after another.” A decade of ZIRP pushed investors into risky, unprofitable investments and Covid stimulus threw gasoline on the fire. Deposits flooded into SVB who invested like the good times would last, but they didn’t. When rates rose SVB’s losses spooked depositors who fled. The SF earthquake tightened credit making the system ill-prepared for the shock of the failed United Copper corner. Losses from the corner spooked depositors, who fled and caused the financial system to nearly unravel. Seemingly innocuous and unconnected events can combine to produce catastrophic results (see WW1). It’s only in hindsight that we’re able to connect the dots. Virtually no one sees it coming or understands it during the moment due to the “fog of war.” We cannot predict but we can prepare.
Perception is reality in banking and finance. It didn’t matter whether SVB or First Republic were insolvent, only whether their depositors believed they were insolvent. The same goes for trusts in 1907. The perception of insolvency creates insolvency.
Panic only stops when confidence is restored from a credible and resource-rich institution. In 1907 it was J.P. Morgan’s syndicate and the NYCH. In 2009 it was JPM, BAC, Buffett, and the Fed. In 2012 it was ECB President Mario Draghi’s “whatever it takes” speech. In 2020 it was the Fed and Congress. In 2023 it was the FDIC, JPM, and FCNCA.
Reputation takes a lifetime to build and a second to destroy. It’s also true about people but also about brands. Even if First Republic could have shored up its balance sheet it would never be as valuable as it was two months ago because its reputation had been permanently impaired. Businesses that rely on their reputation can go bust the instant their reputation is tarnished, correctly or incorrectly. Investors should tread lightly in financials knowing that.
Shadow banks have always been around and always will be, in some form or another. In 1907 it was trusts and in 2021 it was crypto. Both met similar fates. Governments respond to the carnage with more regulations. New shadow banks eventually form in new areas in response to the regulations.
Nothing gets done until something really bad happens. Morgan and the NYCH turned down the Knickerbocker’s first request for aid but changed their mind once the trust suspended withdrawals and ignited a full-fledged financial crisis. In 2008 Congress voted not to pass the first TARP bill but reconsidered after the stock market tanked. As Churchill once said, “The Americans always do the right thing, after they’ve tried everything else.”
Matt
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone by David Carey
King of Capital is the founding story of the behemoth alternative asset manager Blackstone and its larger than life (figuratively only, he’s actually known for being very short) founder and CEO Steve Schwarzman. As owners of Brookfield, and having formerly worked in private equity we are keenly interested in the industry and King of Capital is an excellent book for anyone interested in the space.
Perhaps the most important, albeit unsurprising, lesson is how resilient and high quality the major private equity /alternative asset managers’ businesses have proven. With the extreme leverage they put on portfolio companies in the late 1980s and again in the mid-2000s, it would stand to reason that the investment firms themselves would have blown up at some point. While individual investment results (many portfolio companies’ equity was wiped out during the GFC and tech bubble bursting) have varied, overall returns have proven quite resilient for the scaled alternative managers like Blackstone, KKR, Brookfield, and Apollo. Despite subpar periods of performance, through-cycle returns have been attractive enough to draw in trillions of dollars of high margin AUM across the industry.
Additionally, nowadays the illiquidity “offered” by PE firms that was formerly seen as a detractor is being viewed as an asset. Whether or not it’s appropriate (there are valid arguments both ways), illiquid investments don’t have to be marked down along with the wild swings in the stock market. Institutional managers love this as their allocation to alternative managers dampens reported volatility on the downside.
This trend of large institutions allocating an increasing percentage of their assets to alternative managers has been tested over many cycles and is unlikely to diminish any time soon. While falling interest rates have certainly been a tailwind that I wouldn’t count on continuing any time soon, the firms have invested across a number of cyclical and interest rate environments, and have increasingly attracted more than their fair share of capital. With 10+ year committed funds, Blackstone and their peers are set to continue earning attractive profits for years.
It’s also helpful to understand what investments drove the returns for these firms and, more importantly, which types of investments turned out to be disasters. The book profiles tons of useful case studies of investments on both ends of the spectrum. The pattern of failed investments is particularly useful and once again, not surprising. Green outlines the theme for investments that went bust across the industry in the aftermath of the dotcom bubble bursting:
“All were highly cyclical companies whose fortunes seesawed with the economy. None were dominant, or even terribly competitive, in their fields…No one inside Blackstone really understood the businesses that well. On top of all that, Blackstone bought many of them at the wrong time in the economic cycle. It wound up overpaying and piling on too much debt. It had stacked the deck against itself”.
This pretty much sums up what not to do in the public or private markets and needs no further explanation. Many alternative managers learned an old lesson the hard way back in the early 2000s; but the biggest players have soldiered on to become exceptional businesses despite many setbacks.
Dan
The Art of War by Sun Tzu
I’ve long wanted to read the oft-referenced Art of War which was written around 2,500 years ago by Chinese military genius Sun Tzu. I don’t want to get too carried away comparing business or investing to war, because that comparison couldn’t be farther from the truth. That said, there are helpful behavioral lessons to be learned from superior military commanders that can be applied to capital allocation to improve one’s odds of success.
The book is organized into thirteen chapters, each focusing on a specific principle. A few principles that can be applied to investing include:
Never besiege a walled city. Sun Tzu preached the best way to win a battle was to win it without fighting, and the very last option should be to attack an enemy who is heavily fortressed. There is no reason to make things harder on yourself. Wait until you have an opportunity where the odds of winning are heavily in your favor, then pounce. In investing terms, there are no points for difficulty, as Buffett often reminds us. Don’t talk yourself into a complex investment or pay a price that dictates many accurate and difficult predictions go your way. Wait for the obvious time to act, and then do so without hesitation.
Be like water.
“Water shapes its course according to the nature of the ground over which it flows…just as water retains no constant shape, so in warfare there are no constant conditions”
Successfully investing for the long run requires staying true to principles, but applying them differently depending on the landscape. No one has done this better than Buffett, who began by buying cigar butt investments in the 1950s and now currently owns more than 5% of Apple; two examples of investments that on the surface couldn’t be more different. Buffett has applied his principles of value across decades of changing landscapes by being like water.
Munger constantly reminds anyone who will listen:
“to a man with a hammer every problem looks pretty much like a nail”
Don’t be a man with a hammer. It doesn’t work in the military or investment world. In investing, principles can remain constant, but the application of those principles is bound to change as the world unfolds.
There are five dangerous faults which can affect a general:
Recklessness, which leads to destruction;
Cowardice, which leads to capture;
A hasty temper, which can be provoked by insults;
A delicacy of honor which is sensitive to shame;
Over-solicitude for his men, which exposes him to worry and trouble.
Any of these emotional conditions can ruin a general and his army, and likewise the same faults can ruin an investor who cannot master his or her emotions.
Dan
Railroader: The Unfiltered Genius and Controversy of Four-Time CEO Hunter Harrison by Howard Green
Hunter Harrison is synonymous with the railroad industry. Over a 50+ year career Harrison was the CEO of four major railroads and created extraordinary value for shareholders, likely over $50B across his career. His career was not without controversy as Harrison was a force to be reckoned with both with his employees and in the board room.
Railroader is a balanced look at Harrison’s life - the good, bad and ugly – written by a man who spent countless hours with Harrison and his many constituents. It’s a great view of the tradeoffs that came along with the wealth (for investors and himself) Harrison created.
There are many takeaways for investors and operators from Harrison and two that stand out are Harrison’s attention to the small details and his skin in the game.
Harrison was famous for remaining close to the action – he would close glamorous headquarters in downtown high-rises and move his employees to a railyard so they could be near where the value was created. While CEO, Harrison famously once was prowling the mailroom of Canadian National and asked a low-level employee where a FedEx box was headed. She told him it was headed to a town about eight miles away. Always eager to prove a point about keeping costs low, Harrison berated the employee for paying to route a package thousands of miles out of the way (FedEx’s hub is in Memphis, they were in Canada) and he threw it in his car and drove it to the other location himself.
Harrison ruthlessly focused on bringing costs down and it was an accumulation of the small things like this that added up to huge improvements everywhere he went. It culminated with the invention of precision scheduled railroading that is widely adopted across the industry today and has made the class-one railroads far more profitable than anyone imagined a few decades ago.
There are multiple parallels for investors here. First, it’s always best to have laser-focused operators and management teams at the companies in which you’re invested. There are many ways to get a feel for this, from proxies to conference calls and most importantly by assessing their historical batting average.
Second, the little things really add up. This is true both in terms of knowledge and investment returns. For investors, learning a little bit every day (about a new company, an existing investment, financial markets, etc.) builds on itself and over the course of a year or two or three you can become a much more skilled investor. The same is true of investment results. A sound investment approach will not make you rich quickly in the stock market, but it can make you rich slowly. Compounding good returns over decades is our favored approach rather than aiming to make a killing in a few short years.
Dan
The Best of the Rest
FT: Charlie Munger. “Charlie Munger has warned of a brewing storm in the US commercial property market, with American banks “full of” what he said were “bad loans” as property prices fall.”
Pershing Square Holdings: Annual Letter.
“While we have sought to hedge the potential economic risks from all of the above risks, there are no particularly good hedges. Our best protection against geopolitical risk is to own businesses that can survive the test of time, ones that are largely immune to the events that they or we cannot control…Investment selection is our most important risk mitigation strategy in an uncertain world.”
“We prefer less rather than more investment-related activity as it is an indication that we have made good decisions about where to invest our capital for the long term. Constant turnover of the portfolio of a so-called long-term investment manager is generally an indication of poor investment decisions that had to be reconsidered.”
I, Pencil. “Does anyone wish to challenge my earlier assertion that no single person on the face of this earth knows how to make me? Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others.”
Jason Zweig: Want to Beat the Stock Market? Avoid the Cost of ‘Being Human’. “Most portfolio managers own too many stocks to focus on their best ideas—but not enough to maximize the odds of finding a giant winner.”
FT: Financial engineering by tech dinosaurs pays off. “Just over a decade ago, Oracle started repurchasing its shares in earnest… Simply by sitting on his holding and not selling, Ellison has seen his personal stake increase steadily, to reach 43 per cent of Oracle.”
Howard Marks: Lessons from Silicon Valley Bank. “You may be familiar with one of my favorite sayings: “Never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average.” Surviving on average is a useless concept; you have to be able to survive all the time, including – no, especially – in bad times. Borrowing short to invest long powerfully threatens that ability.
Sequoia Fund Q1 Portfolio Review. Sequoia does a detailed walk through of their thesis on Schwab and touches on other investments like Credit Acceptance, Capital One, and Bank of America.
Semper Augustus 2022 Letter. “[S&P 500] companies spent roughly 60% of profits to purchase 2.7% of their market capitalization each year, yet only reduced the share count by 0.7% annually.”
Overconfidence, Under-Reaction, and Warren Buffett’s Investments. A 2010 academic paper that shows Buffer has higher stock turnover (not dollar-weighted) than many may expect. “We observe a median holding period of a year, with approximately 20% of stocks held for more than two years. At the other end of the spectrum, approximately 30% of stocks are sold within six months.” This Week In Intelligent Investing did a podcast episode on the paper.
Chris Mayer: The Best Businesses To Own. “The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return.”
John Huber: 3 Engines of Value. “A stock that averaged 12 P/E for a long period of time is going to create far more long term value than if this same company traded at 30 P/E, because the market’s lower valuation allows the company to reduce far more shares than they otherwise would have.”
Bloomberg: Get Ready for Lower Fuel Prices — and Slower Inflation. “The world is building new refineries and expanding older ones at a speed unseen in nearly two generations.” This is capital-market’s theory in action (covered in Capital Account) where high refining margins incentivize new refining supply.
WSJ: The Bear Market’s Survivors Share Their Biggest Lessons. “The S&P 500 has been stuck in a bear market—down more than 20% from its high—for 221 days. That is the longest such stretch since 1973, surpassing the selloffs that coincided with the bursting of the dot-com bubble in 2001 and the financial crisis of 2008.”
Do you have a “stranded” 401k from a past job that is neglected and unmanaged? These accounts are often an excellent fit for Eagle Point Capital’s long-term investment approach. If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.