Monday, July 24, 2006
Awash in a Sea of Debt
Dean LeBaron, Chairman, Virtualquest; Publisher, Complexity Digest
By SANDRA WARD
AT A CONFERENCE ON CONTRARIAN INVESTING last fall, Dean LeBaron excused himself from the luncheon table in search of a "hot spot." This time he was hunting for WiFi Internet access in rural Vermont, but looking for hot spots has defined much of LeBaron's career.
Long fascinated with applying technology and complex systems to financial analysis, LeBaron counts among his investment innovations index-investing, from his days at Batterymarch Financial, which he founded in 1969 and sold to Legg Mason in the mid-'Nineties. He was also early in using quantitative models to exploit opportunities in overseas and emerging markets.
Through affiliations with the Santa Fe Institute and the New England Complex Systems Institute, LeBaron continues his quest to develop new ways of investing that take advantage of available technology through his firm, Virtualquest, and a Webzine he publishes, Complexity Digest (www.comdig.com1). We caught up with him recently at his home in New Hampshire, where he resides when he's not at his home in Switzerland. You can also find him at www.deanlebaron.com2.
Barron's: What do you make of the state of the world?
LeBaron: Since the sale of Batterymarch Financial roughly 10 years ago, I've had the opportunity to stand back and rethink some basic beliefs, academic groupie that I am.
One area I revisited was globalization, which I had always thought would work according to a North American model, whereby English would be the global language, the dollar would be the global currency and U.S. law would serve as the so-called rule of law.
That is not taking place as I imagined. Countries have become a little more different than alike. Although if you look at the correlation of markets, it's clear markets have been moving closer together.
Dean LeBaron
But antagonism towards the U.S. has suggested that people don't want to hold that much in dollars as a reserve currency and are breaking away from that. They are not conforming to U.S. law; in fact, they are not even sure what U.S. law is, nor is it clear that we in the United States know what the rule of law means. In any event, a decade ago, it looked as though the U.S. was going to be the leader towards globalization and now we have a higher degree of separation from the rest of the world.
Is this the result of the current administration, or would it have evolved this way, anyway?
It certainly is aggravated by who is in power, but it couldn't have happened without the acquiescence of Congress or even the American people. I don't think we can blame it all on 9/11. The world was going to go in another direction after the Cold War, a bilateral war, and I thought industries would matter but countries wouldn't make any difference. It seems countries make a difference. The second area I reconsidered was networking.
In what sense?
In the sense that we have tools like computers and the means of connecting people and ideas faster and cheaper than ever before imagined. Research is better, information is better, investing is better.
It used to be academics would collaborate only with people in their own institutions and particular departments. Now you are as apt to collaborate with somebody in Bratislava or Kuala Lumpur as the person in the next room from you. Networking has been much, much more important and faster than I might have expected. It provides the luxury of allowing 100% of your time feeding your intellectual appetite, which is just extraordinary.
What are the implications for investing?
I'm still in the stage of wanting to have a lot of investment flexibility. I'm a bargain hunter. I'm perfectly willing to find bargains in places around the world where no one else is currently investing. A bargain, by my definition, is two or three times earnings or three times cash, and it might mean investing in Brazil at a time in which the currency is blocked, or investing in Russia when it is still in the midst of transition. Networking provides the tools to get to these markets early.
Are there really any bargains left, since networking makes all these far-flung places easier for everyone to invest in?
One of the problems with investment activity now is there are too many of us investment people. It is very hard to find any hole that is uncovered. Central Africa might well be the last place. There are fewer places because there are so many of us engaged, certainly in the U.S., in financial services.
Financial services is about the only thing left that the United States does that is superior in the world. Interestingly, in a recent interview with Charlie Rose, Warren Buffett said he had absolutely no candidates to buy on his plate and that has rarely happened. Also, he emphatically thinks the dollar is going lower. He believes as long as we have a negative trade deficit, he has to sell assets. He is right. It's a long slow burn.
Most American portfolios are more heavily weighted in dollar-related assets than non-dollar related assets, and if the dollar is going down against other currencies, then we've got it backwards.
You were a pioneer in emerging markets. What's your take on overseas investing?
For much of the past 20 to 30 years, I have been looking at where the economies of the world were moving in relationship with one another. Roughly, I would take a take a map of the world and rank the countries not according to population but according to gross domestic product, and look at where the map balanced.
The central point used to be roughly around Bermuda because it reflected the economies of all of Europe and the U.S. Then it started moving south and east as the southern economies have been doing better and the Asian economies do better. The world is moving in that direction, and away from the U.S. But most portfolios are not moving in that direction, although we are still developing speculative techniques in the U.S. with derivatives and the like, doing remarkably clever things.
What else concerns you?
I am concerned there is too much debt in potentially very weak hands. Strange things are happening, in that Japan has been shrinking its liquidity base and liquidity has started to contract here in the U.S. There has been an awful lot of money sloshing around. Ian McAvity of Deliberations Research in Toronto has a marvelous chart that shows how much extra liquidity it takes to increase a dollar's worth of GDP. We're up to almost $5 of liquidity to create $1 of GDP, and it's been steadily rising.
Where are you putting your money?
Most of it is in cash or cash equivalents. I will admit to being a gold and silver bug.
What is that a reflection of?
It is a reflection of my concern about the currency's contractual role to provide value, whether it's the dollar or euro or whatever. With so much currency around, not all the contracts can be kept. Gold is a traditional storehouse of value. In the U.S., with the GLD [streetTracks Gold Shares] exchange-traded fund, you can buy bullion very easily.
Is gold too expensive at these levels?
No. And I hope it is the wrong investment. If gold is the right investment, then a lot of the rest of what we could be invested in would be in trouble. Gold is something you do as a grubstake for crisis, and it allows you to keep going, or to get started.
What else are you investing in?
I do some private investments. I have been fascinated the last two or three years with predictive markets. Predictive markets, on the one hand, is gambling, but in another sense it reflects the consensus view as people put money on an outcome that looks like it has some information to it. I follow these companies quite carefully.
What's being predicted?
Hillary Clinton is the most favored Democratic presidential candidate and bird flu is likely to arrive in the United States before the end of this calendar year.
Do you use the information in some contrary way?
You would think so, wouldn't you? Yet I haven't seen a case where 100% of the people were thinking one thing and taking the bet on the other side would be worthwhile.
Academics are enamored with this business, because it gives them much information about forecasts.
Companies use it for product research. They'll give their employees a certain amount of money to wager on which product is likely to be their best product and where they should be putting their research and so on. That is a very sharply growing field for companies.
Do you hold quaint investments like stocks and bonds?
Not very many, and no U.S. equities other than some private companies.
What's keeping you from investing in stocks, especially U.S. stocks?
They don't seem cheap enough to make it compelling. By and large, markets have been relatively flat for five years.
What's your prognosis for the markets?
I'm not sure I have one. I'm trying very hard not to be on the gloomy side. To the degree to which there is too much money moving around that has to be absorbed, one way of absorbing the money is by repudiating debt. There's a glimmer of that in house sales, where foreclosures are running at the highest rate they have ever run before, and yet house sales aren't disturbed much.
If you were to create a list of things to be bullish about and things to be bearish about, which would outweigh the other?
Unfortunately, the bearish stuff. Debt is the No. 1 worry. I am concerned about the probability that the debt can't be repaid.
The original notion of debt way back was that it would always be repaid out of the fundamentals of a business. Currently, that's an archaic view.
Now debt is repaid out of refinancing, and the notion is that somebody will always come along to buy the asset. But the markets do not always accommodate and help take you out of the investments you have, and that kind of repayment risk is not factored into bond pricing.
Secondly, as I said, there are too many investment people. Who would have expected 10 years ago that hedge-fund fees would be as accommodative to hedge-fund managers as they are currently?
Their attraction as an investment vehicle, as near as I can tell, are to individual investors and endowment funds, who used to be the most fee-sensitive. I also find the aggregate numbers of hedge-fund performance a little on the slippery side. I don't mean the numbers are manipulated, but they have hindsight bias as people move around. But mainly there are too many of them, and they are too high-priced. Anything that is likely to be interesting is likely to be covered and well-covered, and not necessarily by intelligent people who are correctly motivated. Information moves very fast.
Is the geopolitical scene among the bearish factors?
Yes. I've always said that investment managers should not have a political view, but individual investors were allowed the luxury. The U.S. has done incredible damage to itself. I see this in Switzerland. The Swiss people are pretty tolerant of anyone in the world, but they really have an attitude about the United States.
My impression is, most of the world would like to get as far away from the U.S. as possible, be neither friend nor enemy.
Russia goes its own way now. Who would have imagined 10 years ago that Russia would have paid down $22 billon of international debt to the G7 countries and pay a premium of a billion dollars in order to prepay? It is phenomenal. From a financial standpoint, it makes sense if the dollar is declining in value to leave the debt there and pay it off more cheaply. But I think it is just a matter of: Let's just get it away from the United States, let's distance ourselves.
Even China, which does an enormous amount of trade with the U.S., doesn't particularly care what we do anymore. They are concerned with their own domestic market, which is growing at a very rapid rate. If there is some export business on top of that, that's fine. The Chinese will buy up a nickel company in Cuba, or an energy company in the Canadian oil sands. They'll dance around the U.S., and what we do doesn't really affect them too much.
What are you bullish about in the world right now?
Education is taking a major leap forward by moving online. The Massachusetts Institute of Technology puts its courses online and makes them available free to anyone in the world to promote science. They intended to put all of their courses online, but some of the professors balked, so there are about 75% of their courses online -- lectures, notes, the whole works. That's a big deal.
Usually the concern about education is that we spend too little on it.
That's right. Traditional education is very, very high-priced. But people in other countries who are trying to move up faster and playing catch-up are using tools like online learning, a big deal.
What else do you view favorably?
Pharmaceuticals. I even have a vial of my own DNA here.
Are you trying to clone yourself?
Essentially, we are very close to the breaking point where there is a particular class and set of drugs that will deliver individually targeted treatments and hopefully will revolutionize medicine. Even the notion of statistics is revolutionizing medicine.
My friends at the Dartmouth Medical School have done something that sounds pure and simple, but was really quite difficult -- and that is, they've looked at the medical outcomes and treatments across the country by zip code. They discovered there were best practices in unexpected places like Des Moines, for example, using this statistical study. Those practices can be applied to other areas. Again, this is the beauty of networking.
Stem-cell research is a big deal. The Bill and Melinda Gates Foundation, which has had so much publicity recently, has been absolutely right that the whole area of tropical diseases has been uncovered because it hasn't been terribly profitable. For $10 a year, you can give a child the chance to live when they would otherwise die.
More and more people are voicing concerns about the big gap between the rich and the poor.
It will lead to trouble. The response to it seems to be building bigger fences. The U.S. is going to build a fence on the border of Mexico and the Israelis want a fence between themselves and the Palestinians. A Swiss friend pointed out Americans spend a million dollars to kill one Iraqi when they could hire that person for $10,000. It is such a bargain.
You make it sound simple to end poverty and hunger. Where do you start?
With clean water. Half the world doesn't have clean water. It is not terribly difficult to get clean water to everybody.
Dean, thank you. |
