Review & Outlook

Our take on the investing, financial, & economic themes of the day

Fourth Quarter

10 January, 2007 by admin in Quarterly Letters

Let me take this moment, as we end one good year and begin what we hope will be an even better one, to report on a personal development. This month marks my 20th anniversary at O’Brien Greene and Company. In an industry where long-term is usually some time next month, I am rather proud of this milestone. Perhaps I can be forgiven a few words on the difference between now and 20 years ago, which I will try to frame as a comment on the investment outlook for 2007.

At first glance, the answer to the question (what’s the big difference between now and 20 years ago?) is the computer on my desk. The office I took over on February 10, 1987 did not have a computer. Today I spend the entire day working on the computer, as do my associates Dodi, Sally and Lisa. Indeed, it is hard to imagine the business without the mountains of research and analytical power and global reach of a personal computer linked to the Internet.

If, however, you shift the perspective to do a double-take on the question, you quickly conclude that the computer, though important, is still just a means, and only a relatively minor means at that. The great end of the investment process is, of course, the generating and preserving of wealth. And this end is unchanging. But getting there involves the choice of competing means.

Should the means be making money as fast as possible? Or more money than the next guy, which in investment terms is called beating the index? Or should the means be one of avoiding fads disguised as innovation, and aiming merely for a “reasonable” rate of return as measured over a period of years? It is the last that we have tried to hew to over the years, and it is no easier to do today than it was twenty years ago, with or without computers.

One more observation on January 1987: when I took over the firm, an investment innovation called “portfolio insurance” was receiving a good deal of attention. A complex computer trading program, it promised to make money in up markets and – – this was the important part – – in down markets, through options and futures on stocks and stock derivatives. For a time portfolio insurance worked, though outside a few financial engineers on Wall Street, no one knew how. Late-to-the-game investors rushed to get in on the secret, but fortunately portfolio insurance proved to be relatively short-lived. By October 1987, it was over.

In the last 20 years there seems always to have been a “portfolio insurance” out there in one form or another. It typically begins as an effective innovation and ends in a rush of reckless imitation. In terms of the present time, a troubling development is the widespread rush out of traditional stocks and bonds into real estate, commodities, asset allocating funds, hedge funds, and private equity funds. In the years 2000-2006, these so-called alternative assets did better than traditional stocks and bonds. Now, investors, especially deep-pocketed institutions that missed the initial waive in 2000-2006, are trying to catch up. There are signs of cresting valuations in these alternative-asset groups.

For instance, real estate investment trusts (REITs) were one of the very best-performing asset classes last year; they rose twice as much as the larger stock market. How can this be, you ask, when real estate slid into a nation-wide slump, registering at the end of November a 28% decline in new housing starts, a 34% increase in existing house inventory, and a 4% decline in existing home sales prices? What’s propping up valuations?

The answer would appear to be endowments at universities, foundations and cultural institutions, and state and private pension funds, that are allocating billions to private equity funds. The latter are independent third parties that invest in private assets, that is, assets that are not listed on public, regulated exchanges, in return for a 1% annual fee plus 20% of the final profits. Before the private equity funds can collect their annual management fees, they must put the new money to work. And one of the fastest ways to put large amounts of money to work is to buy big real estate properties. Thus in the fourth quarter, for instance, the Blackstone Group paid $20 billion dollars, plus $16 billion in debt assumption, to acquire the holdings of Equity Office Properties.

Bottom line is that institutions are selling the common shares of GE, Microsoft, Intel, Johnson & Johnson, Merck, Home Depot, Citibank, and American International Group, which are quite cheap, in order to buy real estate and other alternative-asset classes, which are quite expensive. With the world awash in money, institutions are looking for home runs. Thus they have a high tolerance for risk. Such expectations seldom end well. We would leave private equity and alternative assets to the institutions, as we did with portfolio insurance 20 years ago.

We spend a good deal of time reviewing economic forecasts. This year’s crop boils down to something along these lines: “the economy in 2007 will continue to do what it did in 2006, although at a reduced pace.” In other words, last year was good, and economists expect this year to be almost as good. While we do not put a great deal of store in economic forecasts, we can take comfort in knowing that, clearly, the economy is not sick, as it was in the late 1970s. Employment and corporate profits are robust. Inflation appears under control and the new Federal Reserve chief Bernanke appears determined to keep it that way. Long-term interest rates, which help determine levels of long-term business investment, are still low enough to be stimulative. The price of oil, although not as important as it used to be, has fallen sharply in recent weeks.. The big cloud on the horizon for the economy, if not the stock market, is the housing sector. If housing prices fall, people feel poorer. Insofar as two-thirds of the American economy is directly related to consumer spending, anything that affects consumer sentiment bears close scrutiny.


Mark O’Brien